Overview

As the world continues to adapt to the COVID-19 pandemic and its effects on humanity as well as economics and finance, market participants are increasingly focused on potential liquidity issues and debt incurrence capacity of issuers, in particular of high yield debt securities. Faced with the prospect of significantly declining cash flows, many companies are in various stages of evaluating the possibility of raising additional capital through loans or other debt.

While any required consents of lenders under credit facilities to incur additional debt may be obtained comparatively easily, securing consents from a diverse bondholder group can be significantly more complicated, especially on the short timelines that many issuers may be facing in these difficult times. As a result, it is critical to evaluate debt incurrence capacity under a company’s outstanding high yield bond indentures and to understand how that capacity may be impacted by deteriorating economic and financial conditions. It is also important to understand to what extent any newly raised debt financing could be senior to or dilutive to already outstanding debt.

It’s Critical to Act Now

For a number of reasons, it’s critical for many issuers of high yield bonds to act now to understand their headroom to incur additional debt under the terms of their indentures. These include:

• Impending Financial Impact: An element of most debt incurrence covenants permit debt incurrence based, in part, on the issuer’s EBITDA for the last four fiscal quarters. Because of the expected impact of COVID-19 to EBITDA, issuers may find that they have significantly greater borrowing capacity today than they will in a matter of weeks. See “Ratio Debt” below for more information. Similarly, issuers with “soft cap” debt baskets that grow based on a specified metric may lose all or a portion of their incremental “grower” capacity as a result of the downturn.
• Marginal Investment-Grade Issuers: As a result of the pandemic, issuers that currently have investment grade ratings may be downgraded to a high yield rating. Many of these issuers may have outstanding high yield bonds that include covenants that have been suspended because of the current investment grade rating. In many cases, upon a downgrade, these covenants will “spring back” and issuers may find that they have substantially impaired debt incurrence capacity after a downgrade.
• Government Rescue: Issuers evaluating whether to take advantage of government rescue programs, including through the CARES Act, should understand that many of these rescue programs will take the form of loans. As a result, current and future debt incurrence capacity should be tested in connection with assessing these sorts of government loan opportunities.
• Unanticipated Debt Incurrence: As issuers evaluate strategic options, it’s important to be aware of the potential for unexpected debt incurrence. In particular, the deferral of payment obligations for property or services for over a year may constitute debt under the company’s indentures. As issuers evaluate options, they should be cognizant of potential unanticipated consequences under bond indentures.
• Limited Forbearance Ability: While companies may be able to secure a temporary forbearance from lenders to avoid making periodic interest payments on other debt, altering payment obligations under high yield bonds would require the consent of all holders affected, thereby significantly limiting flexibility. As many companies will face substantially limited cash-flows, they may need to plan now to fund bond interest payments with additional borrowings.

Evaluating Alternatives

High yield issuers and potential lenders or other debt investors should be very focused on the following factors as financing alternatives are evaluated:

• What is the issuer’s current incremental debt incurrence capacity?
• How does a continued economic downturn impact that capacity?
• To what extent can any new debt be secured to an equal or greater extent than the issuer’s other existing indebtedness?
• Can any new debt be structurally senior to existing debt?

A summary of the various types of debt that issuers may seek to raise, including relative seniority to existing high yield bonds, is below.

Credit Facility Debt

Within the capital structure of high yield issuers, the most senior type of debt generally will be permitted “credit facility” debt. This type of debt will typically be incurred via a specified credit facility basket in the debt covenant and a related permitted lien in the lien covenant. The amount of permitted credit facility debt may be set at a fixed amount or may increase (but not decrease below the fixed amount) based on a metric such as total assets or EBITDA. In some cases, issuers can make a determination that such capacity is deemed to have been drawn in order to preserve borrowing capacity, even if the related debt is not immediately incurred. Issuers should be evaluating now whether to incur debt or, if applicable, deem it to be incurred to maximize liquidity.

For issuers with unsecured senior debt securities, the entire amount of any existing or new credit facility debt will be effectively senior to the outstanding bonds because the credit facility debt will typically be secured by substantially all of the assets of the issuer and its subsidiaries (subject to certain exceptions, including with respect to foreign subsidiaries for U.S. domestic issuers) up to the full amount of the credit facility debt.

For issuers with secured bonds, the credit facility may share equally in the collateral securing the bonds. Conversely, depending on the terms of the debt and lien covenants, all or a portion of the company’s secured credit facility debt may hold a priority lien on the collateral as compared to the bonds. In circumstances where all or a portion of the credit facility debt is secured at a higher priority than the bonds, the holders of notes would only benefit from the shared collateral after the company’s obligations under the priority lien are satisfied.

Moreover, issuers of first lien secured bonds should evaluate capacity to incur second lien debt, based on the definition of the consolidated senior secured leverage ratio, which may allow for substantial additional borrowing capacity.

It’s important to note that the definition of “credit facilities” in most high yield indentures is much broader than the term would typically imply and will permit the incurrence of a wide range of debt, including, in many cases, additional debt securities.

Ratio Debt

In addition to the credit facility basket, high yield indentures will also permit incurrence of debt so long as a specified ratio test is satisfied. Typically, the ratio incurrence test will tie to the company’s fixed charge coverage ratio and will permit incurrence of additional debt if the fixed charge coverage ratio would remain below 2.0 to 1.0 on a pro forma basis after incurrence of the new debt. Debt incurred under the debt incurrence ratio will typically be unsecured, however, in some instances, depending on the debt and lien covenants, issuers may be able to allocate unused permitted lien capacity to incur secured debt under the ratio.

The fixed charge coverage ratio is typically based on a calculation derived from EBITDA (as defined in the indenture) in the four most recently completed fiscal quarters. Special attention will need to be paid to the ability of companies to adjust EBITDA calculations, including by adding back extraordinary losses or charges related to the COVID-19 pandemic in current or upcoming periods. In addition, because the debt incurrence covenant is an incurrence covenant and not a maintenance covenant, it may be possible for a company to incur ratio debt based on a trailing four fiscal quarter period prior to a deterioration of EBITDA and a decline in the resulting ratio incurrence capacity. Companies should evaluate debt funding needs now and plan accordingly if a reduction in ratio capacity is expected as a result of the pandemic.

Generally, only the issuer and guarantors of the bonds are permitted to incur indebtedness under the ratio. However, this is not always the case. See below for a discussion of the potential impact of non-guarantors incurring debt.

Other Permitted Debt

In addition to the credit facility debt and the ability to incur ratio debt, high yield indentures will also include a number of generally smaller debt incurrence baskets. Examples include a general debt basket, debt that can be incurred by non-guarantor subsidiaries and certain debt incurred to finance acquisitions. Similar to the credit facility basket, some of these baskets will include “soft caps” that grow with a specified metric, such as total assets. This additional debt capacity will usually be unsecured unless specific permitted lien capacity is available, such as through the general permitted lien basket. Generally speaking, these types of debt baskets tend to be on the smaller side and will not permit meaningful debt incurrence on their own but should be reviewed for incremental incurrence capacity as they can be combined with other baskets and ratio capacity to further increase borrowing flexibility.

In addition to standard permitted debt baskets, issuers should also consider whether their indentures permit certain receivables financing transactions, which could afford issuers another option to raise additional capital in the current challenging environment.

Non-Guarantor Debt

Typically, most debt incurrence capacity will be limited to the issuer and its guarantors. Allowing non-guarantors to incur (or guarantee) other indebtedness makes that indebtedness structurally senior to the bonds and potentially senior to the company’s credit facility, which generally shares the same guarantors as outstanding bonds.

However, some indentures permit non-guarantors to incur certain categories of basket debt and may also permit ratio debt to be incurred by non-guarantors. Any non-guarantor incurrence flexibility may be limited to non-guarantor sub-caps. Issuers considering raising non-guarantor debt should also determine if such debt can be secured by the property and assets of the non-guarantor via a permitted lien basket.

Other Considerations

As high yield issuers evaluate alternatives to increase liquidity, including through raising additional debt, a number of other considerations will be involved, including the following:

• Liability Management Alternatives: In order to achieve the flexibility required, issuers may need to engage in a liability management transaction, including possible consent solicitations to, for example, permit borrowing under government rescue programs and exchange offers to alter debt covenants or extend bond maturities or change other payment terms.
• Anti-layering Restrictions: Issuers considering incurring debt that is subordinated to other debt in the capital structure should review applicable anti-layering requirements, which will generally prohibit issuing certain types of subordinated debt if the new debt is not also subordinated to the bonds.
• Affiliate Transactions: Companies considering receiving loans or other support from private equity sponsors or other backers should be aware of the affiliate transactions covenant and the potential impact, including the need for board approval or a fairness opinion, on these types of transactions. Similarly, issuers receiving additional equity investments from sponsors may realize increased debt or restricted payment capacity as a result.
• Asset Sales: High yield issuers considering disposing of assets to raise capital should analyze the impact of a sale of assets on their asset sale covenants and the potential need to offer to repurchase outstanding bonds with asset sale proceeds.

Conclusions

As the impacts of the COVID-19 pandemic continue to evolve, it is likely that many issuers of high yield bonds will face challenging liquidity situations. It’s critical that issuers and investors review debt incurrence capacity to understand how the evolving economic situation may impact the ability of issuers to incur additional debt now and in the future.

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