Another item that differentiates leveraged loans from high yield bonds is “covenants,” or the financial health metrics that issuers must adhere to.
Leveraged loans have maintenance covenants, which are more restrictive in nature compared to covenant-lite high yield bonds. Maintenance covenants require the issuer meet certain leverage ratios (like debt-to-EBITDA) or a certain limit of interest coverage (like EBITDA–to–interest expense) or some other coverage metric every quarter irrespective of any corporate action taken. Violation of the financial covenant may result in a penalty.
Some leveraged loans are issued as covenant lite loans, (cov-lite), meaning they have fewer covenants than the typical loans. When the market is bullish, the percent of cov-lite issuance increases.
Unlike leveraged loans, high yield bonds have incurrence-based covenants that require issuers to comply with the financial metrics set by borrowers. This means the covenants only apply when raising new debt, making an acquisition, paying a dividend, or undertaking some other relevant corporate action.
For example: if the limit on debt is 5x EBITDA, then for a maintenance covenant, the issuer is required to stay below the 5x threshold at the end of every quarter when the covenant is tested. In incurrence-based covenants, the 5x limit would only be tested when a relevant corporate action takes place, rather than quarterly.
From a lender’s perspective, maintenance tests are preferable because they allows lenders to take action earlier if an issuer experiences financial distress. However, issuers prefer incurrence covenants precisely because they’re less stringent.
Leveraged loans have an amortization, or repayment schedule, that partially repays the outstanding value of the loan prior to maturity, with the balance being paid at maturity. Most leveraged loans are Term Loan B’s, which pay a 1% amortization per year. While the amortization is minimal, it reduces the potential loss in case of bankruptcy.
As a side note, term Loan A has higher amortizations, but these are generally bank loans, which are usually illiquid and wouldn’t be part of an index tracked by a secured loan ETF.
High yield bonds are bullet obligations, which means they only pay the interest rate until maturity, at which point the full amount of the debt is repaid.
The amortization of leveraged loans acts as a safeguard for lenders in the case of default, as they might have recovered some portion of the loan already. The expected recovery value in case of default is therefore lower for bonds since none of the principal is repaid until maturity.
Please read on to the next part of this series to learn about the differences in investor base for leveraged loans and high-yield bonds.