Understanding the covenant package is an integral part of appreciating the risks of investing in a high-yield bond. Digging through the carve-outs and definitions in the offering memorandum is often key to understanding the true scope of the covenants and how they can influence the shape of potential outcomes, both on the upside and downside.
A weak covenant package of itself is not a reason to avoid a bond issue. Likewise, a strong covenant package is not a reason to buy a bond issue, particularly as the covenants may be tight because the issuer is weak. The key is to judge whether the yield being offered by investing in the bond compensates for the potential outcomes of returns from the bond.
Influencing the upside
Covenants may constrain potential gains (or upside) through the call structure. Typically, high-yield bonds are callable at set prices at predetermined dates. The traditional call structure for fixed rate bonds is a call price of par (100) plus half the coupon on a date half-way through the bond’s life, with a declining call price on scheduled dates thereafter. However, call structures are negotiated, so the first call date can be shorter and the premium above par lower.
Before the first call date, the issuer can repurchase the bonds by paying a ‘make-whole’ premium, usually at a yield of 0.5 percent above government bond yields. From an issuer’s perspective, this is expensive and thus is an incentive to negotiate shorter call periods. The benefit is that the bonds can be refinanced before the maturity date at a level that gives the investor some upside, but at a less penal rate to the issuer.
The downside for investors is that if a bond has a coupon higher than the market yield for the company, the issuer is likely to refinance the bonds at the first call date. This leads to negative selection in the investor’s portfolio, as the better-quality bonds are refinanced and the lower-quality bonds remain outstanding until maturity.
Some covenants allow for a portion of the bonds to be repurchased by the issuer before the first call at a price much lower than the make-whole level. This could be up to 10 percent of the issue each year at a price of 103. This provision can limit the upside to an investor by capping the market price (which might otherwise be higher than 103) [and] reducing the liquidity of the issue as the amount outstanding will be lower.