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 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