High-yield debt

High yield debt is essentially non-bank debt that does not carry an investment grade rating and that typically bears interest at a higher rate as compared to investment grade issues. The min­imum rating for long term debt to be considered “investment grade” is BBB – for debt rated by S&P, Baa3 for debt rated by Moody’s and BBB (low) for debt rated by DBRS.

In addition to the rating, there are also many features of high yield debt that are typically not associated with investment grade issues. The most significant difference is in the nature of the covenant pattern. Depending on the particular industry of the issuer and the issuer’s individual circumstances, investment grade debt typically carries with it very few covenants beyond the covenant to pay back the money borrowed with interest. High yield debt is much different in this regard.

High-yield bonds are debt securities issued by corporations with lower-than-investment grade ratings. The issuing companies usually are seeking money for growth (via M&A, perhaps), working capital or other cash flow purposes. The non-investment grade ratings – lower than BBB- by Standard & Poor’s, Baa2 by Moody’s and BBB- by Fitch – suggest a higher chance of an issuer default, wherein the company does not pay coupon interest or the principal amount due at maturity in a timely manner. Thus, these companies must offer a higher interest rate – and in some cases additional investor-friendly structural features – to compensate for bondholder risk, and to attract buying interest.

Other terms for high-yield, such as “speculative-grade” and “junk bond,” have given the asset class some negative connotation over the years, but high-yield has matured into a solid 20% of the overall corporate bond market, which itself is estimated at roughly $5 trillion, larger than both the U.S.Treasury market ($4 trillion outstanding) or the municipal bond market ($2 trillion outstanding), according to Bond Market Association estimates.

HighYield Debt Standard Covenants

Covenants of this nature include limitations on restricted payments (i.e., dividends and distributions to share­holders, investments and redemptions of junior and, in some cases, pari passu debt), limitations on the incurrence of debt, limitations on liens, mergers or amalgamations, limitations on asset sales, repurchases upon a change of control, limitations on business activities and limitations on transactions with affili­ates. While these covenants tend to be heavily negoti­ated and contain numerous permitted exceptions to the restrictions, the essence of these covenants is the preservation of cash flow so that there is sufficient cash to repay the debt.

Purpose of Covenants

• Protect or upgrade, over time, the credit quality of the Company
• Protect ranking of the Notes in the capital structure of the Company
• Limit discretion of management while providing flexibility to operate and expand the business
• Generally, incurrence tests; not maintenance tests

Issuance

High-yield bond issuance usually entails three steps:

• Investment bankers draft the offering proposal and negotiate conditions with potential investors
• Once terms are finalized, the securities are allocated to bondholders
• Soon the bonds are available for purchase and sale in the aftermarket, or secondary, via broker/dealers

There are a variety of bond structures across the landscape of high-yield, but two characteristics are constant:

• Coupon, or the rate of interest the entity pays the bondholder annually
• Maturity, when the full principle amount of the bond issue is due to bondholders

Investment Grade:

• Restrictions on Liens Securing Debt
• Limitation on Sale/Leaseback Transactions
• Consolidation, Merger and Sale of Assets
• Purchase of Notes Upon Change of Control and Ratings Event

High Yield:

• Limitation on Incurrence of Indebtedness
• Limitation on Liens•Limitation on Restricted Payments
• Limitation on Transactions with Affiliates
• Limitation on Dividend and Other Payment Restrictions Affecting Subsidiaries
• Purchase of Notes Upon Change of Control
• Limitation on Asset Sales
• Consolidation, Merger and Sale of Assets

Restricted and Unrestricted Subsidiaries

• Restricted Subsidiaries are subject to the indenture covenants, and their earnings (and losses) will generally count towards the consolidated net income and the consolidated adjusted EBITDA of the restricted group for purposes of the covenants.
• Unrestricted Subsidiaries and Equity Investees are not subject to the indenture covenants, and their earnings will generally only count towards the consolidated net income and the consolidated adjusted EBITDA of the restricted group for purposes of the covenants if received by the restricted group in cash, and their losses will not.

Additional Subsidiary Guarantors

Limit structural subordination by requiring restricted subsidiaries to guarantee the notes if they guarantee other debt

• Limitation on Indebtedness

Limit the incurrence of additional debt based on the ability of the Company to service its overall debt

• Control structural subordination

Generally based on a 2-1 fixed charge to adjusted EBITDA coverage ratio or a debt to adjusted EBITDA ratio, plus agreed-upon baskets

• Limitation on Liens

Limit the ability of the Company to use assets to secure other debt and therefore limit effective subordination of the notes

• Transactions with Affiliates

Limit transactions with large stockholders or other affiliates•Generally, transactions above a threshold require arm’s-length terms and board approval, and transactions above a higher threshold also may require a fairness opinion

• Limitation on Dividend and Other Payment Restrictions

Prevent cash flow needed to service debt from being trapped at a Restricted Subsidiary

• Change of control

Protect against change in controlling equity interest by an investor or a group of investors

Requires the Company to make an offer to repurchase the notes at 101% in the event of a change in control.

Often has exceptions for equity sponsors and their affiliates

• Limitation on Asset Sales

Protect income-producing assets

Does not prevent sales of assets but governs the type of proceeds received and the use of proceeds

Net cash proceeds must be reinvested in the business or used to repay senior debt within a specified time frame or used to offer to repurchase the notes at par

Consolidation, Merger and Sale of Assets

Prohibit transactions that will cause the Company or guarantors to cease to exist or reduce the creditworthiness of the Company

Generally requires a successor company to assume the note and indenture obligations

Comparison of Bank and High Yield Covenants

Background

Corporate bonds have been around for centuries, but growth of the non-investment-grade market did not begin until the 1970s. At this time, the market was composed primarily of companies that had been downgraded for various reasons from investment-grade, becoming “fallen angels,” and which continued to issue debt securities. The first real boom in the market followed, in the 1980s, however, when leveraged buyouts and other merger activity appropriated high-yield bonds as a financing mechanism. One famous example is the $31 billion LBO of RJR Nabisco by private equity sponsor Kohlberg Kravis & Roberts in 1989. The financing backing the deal included five high-yield issues that raised $4 billion.

Since then, more companies have found acceptance with a growing pool of investors as the high-yield market developed. High-yield bonds still are used to finance merger and acquisition activity, including LBOs, and often back dividend payouts to sponsors, and the market still supports funding capital-intensive projects, such as telecommunications build-out, casino development and energy exploration projects. These days, though, the market also is a good deal of its own refinancing mechanism, with proceeds often paying off older bonds, bank loans and other debt.

The high-yield market matured through increasing new bond issuance, which reached peaks of roughly $140 billion issued per year in both 1998 and 2004, and via additional fallen angels, most notably Ford Motor Company and General Motors in 2005. Indeed, with the automakers’ combined $80 billion of fallen angel corporate bonds entering the market, high-yield has ballooned from around $200 billion in 1995 to roughly $1 trillion in 2006. Steady growth saw only a few notable speed bumps, such as the savings & loan scandal in the 1980s and the correction after the technology bubble burst in 2001.

The issuers

Companies with outstanding high-yield debt cover the full spectrum of industry sectors and categories. There are industrial manufacturers, media firms, energy explorers, homebuilders and even finance companies, to name a few. The one thing in common – indeed the only thing – is a high debt load, relative to earnings and cash flow (and, thus, the non-investment grade ratings). It’s how the issuers got there that breaks the high-yield universe into categories.

The first high-yield companies were the “fallen angels,” or entities that used to carry higher ratings, before falling on hard times. These companies might find liquidity in the high-yield market and improve their balance sheets over time, for an eventual upgrade. Some fallen angels often hover around the high-grade/high-yield border, and frequently carry investment grade ratings by one agency and non-investment grade by another. These often are referred to as “split-rated” or “five-B” bonds. Other issuers might never improve, and head further down the scale, toward default and/or bankruptcy.

Frequently, high-yield issuers are start-up companies that need seed capital. They do not have an operational history or balance sheet strong enough to achieve investment grade ratings. Investors weigh heavily on the business plan and pro forma financial prospects to evaluate prospects with these scenarios. Telecommunications network builds and casino construction projects are examples.

Other capital-intensive businesses, such as oil prospecting, find investors in the high-yield bond market. As well, cyclical businesses, such as chemical producers, use the high-yield market to weather downturns.

Leveraged buyouts (LBOs) typically use high-yield bonds as a financing mechanism, and sometimes the private investors will use additional bond placements to fund special dividend payouts. This part of the market saw explosive growth in 2005-06, amid a buyout boom not seen since the late 1980s.

Bankruptcy exit financing can be found in the high-yield market. Power producer Mirant is a recent example. The company emerged from Chapter 11 in late 2005 after securing $2.35 billion in exit financing, which included an $850 million issue of 7.375% bonds due in 2013. The deal was well received in market despite past investor losses with the credit and the complex restructuring efforts.

References and Citations –

• Standard & Poor’s LCD High-Yield Bond Marker Primer
• An Illustrated Guide to HighYield Debt Standard Covenants – PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP