Longer and longer the sequel: bonds follow the trend
European Leveraged Finance Client Alert Series: September 2020
9 min read
Following from the European Leveraged Finance Client Alert Series article "Longer and longer: the ever lengthening loan agreement,"1 the White & Case team compares similar trends in high yield bond documentation that have led to longer documentation, and the reasons behind this.
Description of Notes vs. indenture and the lengthening trend
The full equivalent of a loan agreement for a high yield bond is the high yield indenture, which is the contractual form of the "Description of Notes", the section of the high yield offering memorandum that describes the material provisions of the indenture. We are often asked which document prevails. The indenture is the governing contract of the bonds, which some investors may find surprising given they are often not able to review the indenture pre-purchase of the Notes. However, two points can be noted: firstly, that at closing, legal counsel provides an opinion that the Description of the Notes, in so far as it is a summary, fairly summarises the applicable provisions of the Notes and the indenture, and secondly, that a provision in the amendment provision permits corrections to the indenture to the extent it is meant to be, but turns out not to be, a verbatim repetition of the Description of the Notes. These two factors highlight the close relationship between the Description of Notes and the indenture.
As we previously described with loan agreements, over time, the length of the Description of Notes has increased substantially. Taking one sample issuer, and comparing their debut bond and refinancing five years apart, the Description of the Notes increased by approximately 15%, in a trend following the market generally. The reasons for the increase are described below. Interestingly, this compares to the much larger increase in loan agreements described in our prior article. This is primarily attributable to the convergence of large leveraged finance loans to incurrence covenants, which tend to be longer than the LMA-style "permitted" style covenants, while the high yield product has stayed more in line to its fundamental core terms.
What drives the drafting?
Before focusing on the clauses in question, it is important to assess the main factors driving the increasing length of documentation. In our prior article with respect to loans, we attributed this to three things: (i) practical experience, (ii) flexibility and (iii) evolution. For bonds, the split is slightly different, focusing in our view on (i) mechanics and (ii) market trends (encompassing in essence flexibility and evolution as per loan agreements).
Mechanics is important in both bonds and loans, but particularly in bonds, where it is more difficult to procure amendments given the free tradability (and anonymous nature) of clearing systems, compared to a loan register. Thus, certain mechanical issues have required drafting to fix them. This has been mainly focused in an area where bonds and loans differ in particular – redemption clauses. Bonds feature no-call periods and redemption price step downs. This differs from most loans, which require pay back at par.
In terms of market trends, changing practices or evolution within the market, driven in particular by the trend towards more flexible documents in the last five years, has led to additional provisions being added to documentation.
Below, we examine some of the clauses in indentures that have increased the length of these documents within the frameworks stated above.
Traditionally, notice of redemption clauses were irrevocable once triggered. This means that once an issuer gives a notice to redeem the notes, they must follow through with the redemption. However, in order to provide commercial flexibility, redemption provisions were amended to feature a conditions precedent element. This provides that certain conditions precedent may need to be satisfied before redemption can take place. The benefit of this is that the issuer is not locked into redeeming the notes at the point of giving the notice but only once they have taken further steps. Recent formations of these clauses have included even more flexibility such as allowing the issuer to extend the notice of redemption period if they are not able to satisfy the relevant conditions precedent in time. This can roll for periods of up to 60 days. If, within that time, the issuer realises they will not be able to fulfil these conditions, they can revoke their notice of redemption and/or reissue a notice of redemption to restart the 60-day period.
Distribution of funds to bondholders
The time period for distributing funds on redemption changed from thirty days to ten days a number of years ago. However, one mechanical factor that has been solved in more recent deals with additional drafting is the issue of "negative interest rates" which had been charged on amounts deposited with Trustees and/or Paying Agents following ECB actions in the past. The combination of long redemption periods (now shortened) and negative interest rates was impacting issuers' all in transaction costs and mitigating the advantages of refinancing. This was addressed by permitting money deposited to repay notes on a redemption date to be released early for noteholders, provided they are paid in full through the end of the redemption period. This allows the issuer to avoid paying fees or incurring additional costs, whilst still being able to release themselves from the covenants of the bond prior to the original redemption date.
Indentures in high yield bond transactions typically feature a change of control offer and asset sale offer clause. When there is a change of control (transfer of beneficial ownership) or particular asset sale within the issuer's group, then this clause requires the issuer to offer to buy back the bonds from the bondholders at a specified price (101 per cent for change of control, par for asset sales). If a large number of bondholders accept the offer, then this leaves small tranches of bonds outstanding. This can be an administrative problem for issuers. A sweep clause gives issuers the ability to purchase all of the remaining bonds when a certain percentage of investors accept the offer (typically 90 per cent). These remaining bonds are purchased at the same price as the other bonds. This prevents investors from holding onto bonds and demanding a higher price for repayment. This provides certainty for the issuer. Issuers know that if they enter into a transaction which triggers the requirement of an offer, they have the ability to buy back all the bonds if a substantial majority of investors accept that offer. This removes the worry of having to negotiate with a small number of investors who may be holding out.
As with loan agreements, in recent years the trend has been towards looser documents that provide more flexibility to borrowers in achieving their operational goals and/or avoiding any inhibitions on their business. This includes an increased number of exceptions to applicable covenants to allow for additional actions which would otherwise have been prohibited. Many of these have been discussed in earlier White & Case articles focused on specific provisions, such as debt incurrence. A few of these provisions are discussed below.
Incurrence covenant testing
Traditionally, covenant testing took place at the point when the relevant action associated with the covenant occurred. For example, for indebtedness, covenant testing would take place at the time the debt was incurred. For change of control, covenant testing would occur at the closing of the relevant transaction which caused the change of control. At this point the relevant test is carried out and if the issuer fails, then there is a breach of covenant.
Terms which allow the issuer to elect the date for incurrence testing have increased in popularity. Such terms allow the issuer to elect the date of when the relevant transaction agreement is entered into as the date for testing. If testing were delayed from the signing of documents to the actual close of the transaction, it is possible that the issuer's position may worsen and it might fail the tests on that later date. Clauses which allow the issuer to elect when testing happens provide the issuer with flexibility. Issuers can elect for testing to take place at a time they are certain they will be able to pass the test and this "locks in" the commercial action.
The drafting of these provisions has added to the word count of the Description of the Notes. Further, additional drafting is needed to balance investor protections against this issuer flexibility. If an issuer has locked in the ability to incur debt in future, it cannot then test its ratios disregarding this debt by adding in "reserved indebtedness" provisions.
EBIDTA add-backs have become more complex and comprehensive in bond documents in order to provide added flexibility to issuers. EBITDA is a base for the key ratios in high yield incurrence covenants. Add-backs have been made to "Consolidated Net Income" (the building block of EBITDA) and further add-backs to "Consolidated EBITDA". Particular focus on these add-backs in recent years have been "pro forma" adjustments based on acquisitions or disposals, but also actions such as synergies, cost savings or operational efficiencies. This in turn requires language for timeframes and caps for such add-backs in some cases. This all expands the length of these definitions and therefore adds another factor contributing to the increasing length of bond documents.
"Permitteds" – debt, restricted payments, investments, liens (and more)
The number of permitted items for issuers have significantly lengthened in recent times. This is a combination of practical items, additional flexibility and market evolution, with each clause adding, conservatively, three or four provisions. The existence of these terms and their qualifications can seriously add to the length of the Description of the Notes. However, they provide for commercial flexibility as they allow the issuer to engage in transactions that they would otherwise be unable to without breaching the covenants of the indenture.
Whilst there are many clauses and factors which have led to the increasing length of the Description of Notes for a bond, the importance of these clauses should not be overlooked. High yield bond issuances are inherently more complex in comparison to other types of bond transactions. Special attention needs to be paid to the issuer, the problems which have lowered its credit rating and its potential for growth going forward. The issuer and the bondholder ultimately want the same goal of a successful transaction which leaves both parties in a better position than when they started negotiations. In order to achieve this, the issuer requires flexibility and operational control of its business whilst the bondholder requires careful control and oversight of its investment. To meet these objectives, more complex wording and mechanics are needed to make the transaction work. Whilst this may lead to indentures getting even longer, this is a small price to pay if it ensures that issuers and bondholders are able to meet their overall goals after the ink has dried.
Anthony Isichei (Trainee Solicitor, White & Case, London) contributed to the development of this publication.
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