Back to basics

We take you back to the credit basics to review everything you thought you already knew but were too afraid to ask..

Bond covenants are legally binding provisions in a bond indenture designed to protect the interests of the bondholders. Covenants specifically address activity that, if left unchecked, could be detrimental to the value of the bonds or put at risk their eventual repayment at par value. In essence, covenants provide a valuable means of reducing the risk of bonds. The basic idea behind bond covenants is to protect the bond from losing value in the following ways:

- by selling or transferring substantial operations or assets to an entity not governed by the indenture;

- by altering the bond's original hierarchical position in the capital structure through subordination to other or additional debt obligations; or,

- by significantly and purposely depleting the equity cushion from beneath the bond in the issuer's capital structure (for example, dividends and share repurchases)

There are two basic types of covenant. Positive covenants require an issuer to actively perform certain functions; negative or restrictive covenants prohibit or limit certain activities by the issuer and are the focus of any covenant package.

Bond covenant structures vary on an issue-by-issue basis, but tend to have similar characteristics depending on whether they are investment grade or high yield. Some of the areas covered by restrictive covenants are: mergers, consolidation or sale of assets; liens; sale and leaseback transactions; restricted payments (dividends, stock repurchase, etc.); anti-layering (subordination) provisions; transactions with affiliates; guarantees; permitted investments; incurrence of debt.

Generally speaking, investment-grade bonds have fewer covenants and are less restrictive than their high-yield counterparts. Investment-grade covenants mostly focus on addressing activities such as mergers and consolidations, the sale of assets, liens, and sale and leaseback transactions.

Bonds may also have industry-specific covenants. A good example of this is the REIT (real-estate investment trust) industry, which follows a 'standard' set of financial covenants including: total debt/assets, Ebitda/interest expense, secured debt/total assets and unencumbered assets. Not surprisingly, this stricter covenant discipline for REITs was adopted in reaction to the turmoil of the commercial real-estate market in the late 1980s.

A more recent phenomenon in bond covenants is the use of 'step language' for bonds issued by companies suspected by the market of being at heightened risk of a major debt leveraging event, such as a leveraged buyout. The step language provides for a series of increases in coupon rate triggered by decreases in credit agency ratings.

High-yield bond covenants have added emphasis on restricted payments and permitted debt. High-yield covenants are more restrictive and comprehensive in scope because, in a leveraged situation, bonds are much more susceptible to losing significant value if cashflow or equity capital is used for purposes of rewarding shareholders at the expense of debt reduction.

Covenant restrictions are not designed to hamstring the issuing company with onerous and inflexible operating constraints. Rather, they are structured with the intent of preserving and protecting the bond's position in the capital structure and preventing further subordination and subsequent reduction in its expected recovery value in a worst-case (i.e. default) scenario.

Joe Robison, chief credit officer at Allegiant Asset Management in New York, explains how bond covenants protect investors.

Glossary

Exempted or permitted debt: debt that may be incurred regardless of any debt covenant restriction and may include items such as bank debt, inter-company debt and debt equal to any new equity issuance.

Negative or restrictive covenants: covenants that prohibit or limit certain activities by the issuer.

Positive covenants: covenants that require an issuer to actively perform certain functions such as regularly filing financial statements.

Restricted payments: generally applies to limiting payments for dividends, share repurchases, prepayments of subordinated debt, etc.