Bond Covenants

1. Bond Covenants

2. Key risk areas

3. Key risk areas in high-yield bonds Today we’ll will cover 4 areas in depth with obvious ratings implications • 1. Distributions / value transfers to other parties • Risky investments • 2. Debt incurrence / leveraging • Change of control (covered in Pt. I) • 3. Liens subordination risk • 4. Structural subordination risk • Long-term bond value • All 4 will, where relevant, show examples of: • Investor friendly, conservatively structure • Average – “Market norm” • Issuer friendly, loosely structured, LBO structure etc. • HY covenant packages in Europe and Americas are substantially the same • But beware of “covenant-lite” bonds

4. Distributions / Value Transfers To Other Parties

5. 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 • 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)

6. Debt Incurrence / Leveraging

7. 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

8. Liens subordination risk

9. 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

10. Structural subordination risk

11. 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