Transcript Liens subordination risk Risk
Bond Covenants
Key risk areas
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Key risk areas in high-yield bonds
Today we’ll will cover 4 areas in depth with obvious ratings implications
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1. Distributions / value transfers to other parties
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Risky investments
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2. Debt incurrence / leveraging
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Change of control (covered in Pt. I)
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3. Liens subordination risk
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4. Structural subordination risk
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Long-term bond value All 4 will, where relevant, show examples of:
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Investor friendly, conservatively structure
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Average – “Market norm”
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Issuer friendly, loosely structured, LBO structure etc.
HY covenant packages in Europe and Americas are substantially the same But beware of “covenant-lite” bonds 3
Distributions / Value Transfers To Other Parties
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Restricted payments covenant
Risk
» Management has incentive to extract cash and other forms of value to distribute to SHs and affiliates » It can do this through various avenues in the corporate structure » Bondholders are concerned if cash / value transfers at a time when such distributions decrease the issuer’s debt-servicing capacity
Restricted payments covenant
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Purpose / structure
. A company should be able to pay dividends but only if its cash flow permits after making adequate provision for debt servicing » Like most negative covenants, the covenant has a three-fold structure: – – (1) Prohibitory paragraph (2) Financial ratio tests that are an exception to the prohibitory paragraph – (3) List of carve-outs » See RP covenant diagram (handout)
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Debt Incurrence / Leveraging
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Overview
Risk
» Increased leverage can negatively impact bondholders by reducing the cushion of cash flow, increasing default risk in downturns as well as increasing mgt’s incentive to engage in shareholder-friendly actions » In liquidation, additional debt ranking equally with the notes dilutes bondholders’ claims against a company’s assets
Key covenants & provisions
» Debt incurrence covenant » EBITDA add-backs » Debt re-classification clause » Mergers / “all or substantially all” asset conveyance covenant » Debt retirement through asset sales proceeds
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Liens subordination risk
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Liens subordination risk
Risk
» Unsecured and secured bondholders do not want other creditors to have prior claims on assets should the issuer become insolvent » Additional liens subordination also negatively impacts the market value of their bonds
Key covenants and provisions mitigating this risk
» Negative pledge/limitation on liens » Sale/leaseback covenant
Secured bonds
» Many permutations in the capital structure involving secured bonds exist » As to the same collateral, holders are subject to – – dilution risk as to their specific lien position on that collateral subordination risk on that collateral, which can occur through a subordinated lien position or through a “first-out” feature in the proceeds waterfall in favor of another creditor, typically credit facility lenders » May be pari passu but “not equal”: enforcement/ control mechanisms can put secured bondholders at a disadvantage
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Structural subordination risk
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Structural subordination risk comes in many forms
Risk
» Cash flow : bondholders want a direct claim on issuer’s cash flow and its restricted subs » Assets: in an insolvency, unsecured bondholders do not want to compete with other unsecured creditors for assets » Bondholders don’t want more creditors to get ahead of them than they bargained for
Structural subordination can take many forms
» Other claimants get control over the free flow of cash within the restricted group, restrictions on dividends and superior claims by creditors of subsidiaries
Key covenant & provisions mitigating structural subordination risk
» Debt incurrence ratio test » Subsidiary guarantee provision » Refinancing provision » Application of asset sales proceeds » Limitation on restriction of dividends by restricted subsidiaries » Limitations on sale of stock of restricted subsidiaries
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