High Yield vs. Investment Grade Covenants

By: David Azarkh and Sean Dougherty, Simpson Thacher & Bartlett LLP

There are fundamental differences between the covenants of high yield and investment grade debt securities. While investment grade covenants tend to be less restrictive and more limited, high yield covenants are often much more onerous, in large part because of the creditworthiness of the issuer. This checklist outlines key debt covenants and explains their differences.

A COVENANT IS A PROMISE TO TAKE AN ACTION (AN affirmative covenant) or to refrain from taking an action (a negative covenant). Negative covenants in bonds are typically based on incurrence tests. These covenants cannot be breached except by incurring or taking some affirmative action, such as incurring debt or a lien or making a restricted payment. On the other hand, maintenance covenants must be maintained at all times or at regular intervals, such as maintaining a certain leverage ratio. Covenants in debt securities are almost always incurrence- versus maintenance-based.

Covenants Explained

While each covenant package is distinct and should be tailored to an issuer’s operations and industry, the key covenants are outlined in the adjacent chart. Most of these covenants have built-in exceptions, or baskets, capped at specific dollar amounts or percentages of certain financial figures (e.g., earnings before taxes, depreciation, and amortization (EBITDA) or total assets), also called a grower, and other exceptions, providing the issuer with the flexibility that it needs to operate its business and grow over the life of the bonds. Such exceptions are often numerous and wide-ranging and are often highly negotiated.

David Azarkh is a partner in Simpson Thacher’s New York office and a member of the firm’s Corporate practice. David’s primary area of concentration is capital markets, an area in which the firm has a preeminent U.S. and international presence. David regularly represents underwriters, corporate clients, and private equity sponsors in securities offerings ranging from high yield and investment grade debt offerings, leveraged buyouts, initial public offerings, and other capital markets transactions. He also assists companies with compliance, reporting, and establishing corporate governance programs. In 2016, David served as a contributing editor of the inaugural edition of “Getting the Deal Through: High-Yield Debt.” The publication provides advice and insight into the global high yield market, with chapters covering a range of international jurisdictions. David co-authored the opening segment titled “Global Overview,” and the “United States” chapter discussing recent activity in the high yield market. Sean Dougherty is an Associate in Simpson Thacher’s Corporate Department, focusing his practice on capital markets transactions. Sean regularly represents issuers, private equity sponsors and their portfolio companies, sovereign entities and underwriters in initial public offerings, follow-on offerings, investment grade debt offerings, high yield financings and other capital-raising transactions.

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RESEARCH PATH: Capital Markets & Corporate Governance > Debt Securities Offerings > Rule 144A/ Regulation S Debt Offerings > Checklists

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