This informal CPD article Understanding Security was provided by WiseAlpha Technologies, the UK's leading digital bond market giving private investors access to the world of corporate bonds. When it comes to debt investors their primary worry concerns the issuer ability to pay the interest and principal on their loan.
Security often comes in the form of bond documentation also known as the Indenture or the Offering Memorandum. This is a legal agreement that outlines the investors' rights as well as the terms and conditions under which the money is granted to the issuer. The term "security" refers to a lender's ability to ensure that value accrues to the correct lenders; this could come in the form of cash flow, asset value, or sale proceeds. Security keeps wealth from leaking away from lenders and into the hands of other capital sources. This means that cash earned throughout the course of the business should not be distributed to junior lenders or equity investors. Similarly, lenders want to make sure that using cash or debt to fund acquisitions does not considerably increase the risk of their investment or lessen their claim on assets. Security is vital in maintaining a transparent and equally beneficial agreement between both parties.
In this context, “security” translates to recovery value in times of distress or default. But what elements enforce these security measures? They are often referred to as covenants. Covenants are the legally binding rules that control how issuers, or stockholders, and lenders interact. These rules are stated out in the bond agreement for the bondholder and a bond issuer.
These rules generally fall into one of two categories. One being affirmative covenants and the other being negative covenants. Firstly, let's take a look at affirmative covenants; these essentially specify what the issuer must do in the usual course of business, such as provide financial information, pay interest, and basically follow the law of the land.
Alternatively, negative covenants are a restrictive measure upon issuers, by stopping them from taking particular actions or reining them in when certain metrics are breached. To give an example, the presence of negative covenants could stop a troubled issuer from selling assets to pay dividends to shareholders. It's important to note that asset sales, increased debt incurrence, pay-outs to shareholders, and the pledge of assets to other creditors are all subject to these covenants.
Now, let's delve further into the two types of negative covenant otherwise understood as rules enforced upon the issuer, as per the agreement for security of the lender. A maintenance covenant falls into this category of negative covenants. This type of covenant requires that specified metrics such as coverage or payback are monitored. These are usually for senior credit instruments such as bank loans and Revolving Credit Facilities (RCFs), and are evaluated for compliance on a regular basis, either monthly or quarterly. Another form of these covenants is known as ‘Incurrence covenants’. This measure stipulates that further debt or an acquisition will only be possible if pro forma coverage or repayment metrics meet the bond documentation's requirements. To compare both forms of negative covenants, the previously mentioned Maintenance covenants, are significantly stricter than incurrence covenants, and therefore are considered to provide the lender with more protection.
These covenants are typically made up of three parts. The first part sets out the requirements and the second then explains how it is measured. The last part sets out what exceptions or “carve-outs” are allowed. “Baskets” is a term used to describe the size of exceptions or carve outs to covenants. They can have a set size or be tied to a set of ratios. To put it simply, they accumulate value or allow issuers to borrow, utilise, or invest capital on a limited and conditional basis.
Another key thing to remember is that bond documentation is a legal document. As a result, capitalised terms like "Issuer," "EBITDA," "Controlling Persons," and "Restricted Subsidiary" all have legal definitions under the bond documentation's "Certain Definitions" section. This means we need to know how management defines these crucial terms and how they differ from standard definitions.
Security is a vital concern for both parties involved in this form of financial agreement. Therefore it is of equal importance to be fluent in the terminology often present in bond documentation. Security for both the issuer and investor is of great importance to ensure a smooth and coherent agreement process.
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