The value of analysing high-yield bond covenants

The benefits of HYBs 

High yield bonds offer investors’ a number of benefits which, when combined, make a persuasive strategy for wider portfolios. For example, they have a low correlation with other mainstream asset classes and comparatively low
interest rate sensitivity. Although both qualities are important, the main appeal is the enhanced long-term risk/return profile they exhibit. 
 

The positive return profile relies on the ability of high-yield bond investors to capture in full the originally negotiated interest and principal repayments. In addition, they must be able to benefit from capital appreciation in circumstances where the market as a whole, or a specific issuer, justifies such an improvement. One of the main features that ensures bond investors can capture the upside is the non-call provision. This typically sets out that bonds are not allowed to be pre-paid for an initial period and if the issuer does want to redeem the bond early, it is required to pay a make-whole premium which, as a rule, is made up of the remaining coupons until the end of the non-call period discounted at prevailing government bond yields plus 50 basis points.  

The attractive risk/return profile in high-yield bonds is also achieved through an investor’s ability to encourage the issuer to maintain or improve the credit quality from what was prevalent at the time of issuance. It is important for investors to make sure that a company has enough flexibility to operate its business, but not so much that it purposefully or inadvertently increases the inherent riskiness of its credit. This could happen, for example, by adding more debt or leaking cash or assets out of the business. As such, it is not in the interest of a bondholder to allow for incremental debt to be added, particularly not debt that might rank above the investor. It is also not in the interest of a bondholder to allow any other meaningful changes that might negatively influence the likelihood of being repaid (a change in the control of the company can be such an event). 

In the event that a company encounters difficulties, it is important for investors to be able to enforce their rights and recover as much of the original investment as possible. In that scenario, an investor’s negotiating position will be significantly influenced by how easily solutions can be worked around their position and, therefore, an understanding of the legal enforceability of contractual rights are crucial. That enforceability is determined by many factors – not only the designation of the investor’s bond (for example, senior secured vs unsecured bonds) but, more importantly, how the security package is constituted and where in the corporate structure the bond sits.  

All of the above points are heavily reliant on the underlying bond documents. This is why a detailed review and understanding of bond documentation is a critical element of the high-yield bond investment process and just as important as the actual commercial credit quality analysis. The investor relies on such documents (and in particular the Offering Memorandum) to ensure that the spirit and the assumption on which the original investment was made can be enforced to its advantage. Any diligent investor, when reviewing the documentation of a bond, should therefore think about how any given clause might affect the potential investment outcome. While it is difficult (given the constantly evolving nature of the market) to compile a definitive list of all the points – and documents – an investor might need to consider,  some of the more important areas to focus on  are: 

 

  • any form of optional redemption;
  • change of control provisions;
  • securities and guarantees as well as the release of these under the terms of the  documents;
  • ranking and priorities of the bond, particularly in relation to other indebtedness that might have been incurred;
  • provisions relating to the sale of the asset and the allowable use of proceeds from asset disposals (and in particular whether the proceeds are to be used to redeem the bonds);
  • provisions regulating the incurrence of additional debt; and 
  • restricted payments (being in essence payments out to third parties including equity owners).

 

We believe there is a place, and a buyer base, for the variety of structures that exist. Above all else, it is important to understand the implications a high-yield bond covenant can have on the risk / return profile of an investment. In particular, investors must  analyse covenants in detail in order to:

 

  • Know what they are buying.
  • Know what rights and protections they have.
  • Know what they might have given up.  
  • Assess if they are being compensated appropriately in that context

 

The final point is key to ICG’s own investment philosophy. Only when an investor has identified the economic implications of the contractual agreement surrounding the credit investment can a proper discussion of return take place. We believe that this is the essence of investing in high-yield bonds.  ? 

 


Garland Hansmann
is a director and head of high yield at ICG, having joined from Credit Suisse Asset Management in 2007.  David Ford joined ICG in 2004 and is head of credit research and joined from PRICOA Capital Group   

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