Bonds generally have an asymmetric risk profile, meaning they have more downside risk than upside potential. For example, if you invest $100, your possible return may be 5%, or $5. However if a borrower is unable to pay their debt, an investor could lose 100% of their investment, or $100. To help protect against this asymmetry, nearly all corporate bond issuances include covenants. Simply put, a covenant is a contractual agreement or requirement for the borrower that protects the buyer of the bond. Covenants can be ‘affirmative’ (i.e., actions that the borrower is required to do), or they can be ‘negative’ (i.e., specifying what the borrower is prohibited from doing). Not all covenant packages are created equal, however, and that is a key difference an investor must be aware of when comparing public debt versus private debt.
Because the private placement market is aimed at a much smaller group of potential investors who typically invest and hold a bond to maturity, liquidity in the private market is much thinner than in the public market. So for a private placement investor, the strength of the covenant package is very important because of the limited opportunity to trade that debt in the future. Alternately, the covenant package associated with public debt is not as robust and typically includes fewer stipulations. For example, a covenant package for an investment grade public issue may include a negative pledge, restrictions on the sale of assets, and possibly a change-of-control trigger; whereas, a private debt issuance is more comprehensive and may include the following:
- Maximum debt/EBITDA (i.e., a leverage test)
- Minimum interest coverage
- Minimum net worth requirement
- Restricted payments test (limiting payments to equity holders)
- Negative pledge (limiting secured debt issuance)
- Subsidiary guarantor protection
- Limitation on asset sales
- Most favored lender provisions (designed to keep private placement investors on the same legal footing as bank lenders and other investors)
Credit quality also plays a role in determining what covenants are included in the covenant package. The lower the credit quality of the issuer, the more covenants are likely to be included and the more restrictive the covenant thresholds are likely to be, relative to the current condition of the issuer. This can be a differentiating factor when deciding between public and private bonds of the same credit quality.
Over our tenure as a private-placement manager, we’ve been in many situations where having a strong covenant package has allowed us to exit a deteriorating investment at no economic loss, prevented potential leveraged buyouts, or improved the economics of a deal via coupon increases. Let’s look at two examples.
Example 1: A consumer products company had been facing operational challenges that resulted in several rating downgrades from the credit rating agencies following our original purchase. The company was on the verge of violating an interest-coverage covenant and needed relief from its lender base for a second time. Because of continued concern over the weakening credit, lenders were unwilling to provide additional relief and, ultimately, the company ended up prepaying the notes early with a premium in order to avoid being constrained by our covenant.
Example 2: A global manufacturing company sought covenant relief regarding a leverage covenant during the 2008/2009 economic downturn. In return for allowing a temporary increase in the leverage covenant, we received an amendment fee and a sliding-scale coupon bump that depended on the level of the leverage. Furthermore, we added a 125-basis point coupon bump if the bonds were downgraded and fell to a high yield rating; this would help to compensate us for increased capital costs. Had we not originally had this leverage covenant as part of our purchase, we wouldn’t have been able to negotiate and improve the economics of the transaction as the credit weakened.
These are two examples of many that illustrate the importance of a strong covenant package. Covenants will continue to play a large part in determining which market we invest in (i.e., public versus private). They also help us figure out if an issuance is attractively priced for the credit risk we are assuming, and if the lack of yield is offset by the protection and benefits we will receive through a robust covenant package. Over time, the price of a bond may decrease, but the value of its covenant package will remain true.
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