CAPITAL MARKETS HIGH YIELD Time to reconsider? · 2019-02-28 · Adler Pelzer Group: In 2017, the...

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FEBRUARY/MARCH 2019 | IFLR.COM | 1 S ubstantially, all fixed rate international high yield bonds include a non-call period during which the bonds can only be redeemed at a prohibitive make-whole premium. This limitation has been historically unpopular with sponsors and corporates who want greater flexibility, particularly when buying or selling a company or to more aggressively de-lever on an IPO. On the other hand, these provisions are equally important to investors who want to build portfolios with clear visibility on returns. Non-call periods have shortened in recent years, and floating rate high yield bonds, portability features and more relaxed restricted payment provisions have provided additional options and flexibility to alleviate non-call concerns. Still, non-call periods are included in substantially all fixed rate international high yield bond offerings. Now, given the proliferation of the term loan B (TLB) product in Europe and elsewhere, historically low interest rates and other factors, is it time to consider variations? The development of international high yield: the advent of the TLB Following the 2008 financial crisis, the combined forces of market regulation, limited bank liquidity and conservative bank risk profiles led to the establishment of a prolific international (i.e., non-US) high yield bond market. High yield bonds also gained popularity post-crisis because of their incurrence-based covenants, which did not automatically require a sponsor or corporate to seek a waiver from its bank group if it failed to meet a periodic financial test during the volatile post-crisis years, and also provided additional flexibility for conducting business generally compared to a legacy-style LMA bank facility. The international high yield bond market lagged behind the US market until this tipping point due to numerous factors. These factors included: the availability of low-cost bank lending in the international and local markets; the reluctance of senior lenders to grant the high yield bonds viable credit support protections and the uncertainty of CAPITAL MARKETS HIGH YIELD Time to reconsider? Non-call protections have never been popular with sponsors and corporates, but an investors’ market has kept them around. Baker McKenzie lawyers Rob Mathews and Haden Henderson question if now is the time for that to change 1 MINUTE READ Non-call protections in fixed rate international high yield bonds have been historically unpopular with sponsors and corporates, who want greater refinancing flexibility, particularly when buying or selling a company or to more aggressively de-lever on an IPO. On the other hand, these provisions are equally important to investors who want to build portfolios with clear visibility on returns. During recent years, flexible options have been introduced, such as floating rate high yield bonds, portability features, and more relaxed restricted payment provisions. Yet still, non-call periods are included in almost all fixed rate offerings. With the shift towards term loan B in Europe and beyond, historically low interest rates and other factors, is it time to consider variations?

Transcript of CAPITAL MARKETS HIGH YIELD Time to reconsider? · 2019-02-28 · Adler Pelzer Group: In 2017, the...

Page 1: CAPITAL MARKETS HIGH YIELD Time to reconsider? · 2019-02-28 · Adler Pelzer Group: In 2017, the Adler Pelzer Group issued senior secured notes that provided, during the first 18

F E B R U A RY/ M A R C H 2 01 9 | I F L R . C O M | 1

Substantially, all fixed rate international high yield bonds includea non-call period during which the bonds can only be redeemedat a prohibitive make-whole premium. This limitation has been

historically unpopular with sponsors and corporates who want greaterflexibility, particularly when buying or selling a company or to moreaggressively de-lever on an IPO. On the other hand, these provisionsare equally important to investors who want to build portfolios withclear visibility on returns.

Non-call periods have shortened in recent years, and floating ratehigh yield bonds, portability features and more relaxed restrictedpayment provisions have provided additional options and flexibility toalleviate non-call concerns. Still, non-call periods are included insubstantially all fixed rate international high yield bond offerings. Now,given the proliferation of the term loan B (TLB) product in Europeand elsewhere, historically low interest rates and other factors, is it timeto consider variations?

The development of international high yield: theadvent of the TLB

Following the 2008 financial crisis, the combined forces of marketregulation, limited bank liquidity and conservative bank risk profilesled to the establishment of a prolific international (i.e., non-US) highyield bond market. High yield bonds also gained popularity post-crisisbecause of their incurrence-based covenants, which did notautomatically require a sponsor or corporate to seek a waiver from itsbank group if it failed to meet a periodic financial test during thevolatile post-crisis years, and also provided additional flexibility forconducting business generally compared to a legacy-style LMA bankfacility.

The international high yield bond market lagged behind the USmarket until this tipping point due to numerous factors. These factorsincluded: the availability of low-cost bank lending in the internationaland local markets; the reluctance of senior lenders to grant the highyield bonds viable credit support protections and the uncertainty of

CAPITAL MARKETSHIGH YIELD

Time to reconsider?Non-call protections have never been popular with sponsors and corporates,but an investors’ market has kept them around. Baker McKenzie lawyers RobMathews and Haden Henderson question if now is the time for that to change

1MINUTEREAD

Non-call protections in fixedrate international high yieldbonds have been historicallyunpopular with sponsors andcorporates, who want greaterrefinancing flexibility,particularly when buying orselling a company or to moreaggressively de-lever on anIPO. On the other hand, theseprovisions are equallyimportant to investors whowant to build portfolios withclear visibility on returns.During recent years, flexibleoptions have been introduced,such as floating rate highyield bonds, portabilityfeatures, and more relaxedrestricted payment provisions.Yet still, non-call periods areincluded in almost all fixedrate offerings. With the shifttowards term loan B inEurope and beyond,historically low interest ratesand other factors, is it time toconsider variations?

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international insolvency regimes; time andexpense in drafting and diligencing anoffering memorandum; and, to a lesser extent,aversion to the typical fixed rate high yieldconstructs of the non-call period and quasi-public reporting.Not to be outdone, in the recent low

interest rate period (2016 to 2018), the bankmarket has rebounded as the TLB product hasbecome a popular competitor and alternativefor the place in the capital structure oncedominated in Europe by high yield (forexample by TLB’s adopting bullet maturities,incurrence covenants and greatertransferability); but also, importantly, a TLBtypically includes a soft-call feature that allowsit to be more easily refinanced or repricedearlier in its term. The charts above show the growth of

EMEA high yield bonds from 2009 throughto 2018 and a comparison of the relativemarket position of high yield bonds and TLBsfor the period 2014 to 2018.

The fixed rate non-call period:why do we care?

All fixed rate high yield bonds are subject to anon-call period, which is the period of timefrom the date of issuance of the bonds untilthey become redeemable, which in theprevailing market typically provides for a firstcall at par plus 50% of the interest couponafter two years for a five-year or seven-yearbond and three years for an eight-year or 10-year bond, which then reduces linearly to parin subsequent years.During the period before the first call, the

bonds are considered non-redeemable,although they will include a feature that allowthe bonds to be taken out at a prohibitively

expensive make-whole premium, whicheffectively provides investors with the returnthey would have received had they held thebonds until their first call date (subject to anadjustment related to the applicable treasuryrate, plus 50 basis points). Two key situations in which the non-call

period can cause extra concern, particularlyfor active sponsors or corporates seekingfinancing flexibility, arise in the context of achange of control or an IPO. Typically, in the event a new entity or group

acquires greater than 50% ownership of a highyield issuer, the issuer is required to make anoffer to holders to redeem their bonds at 101%of their face value plus accrued and unpaidinterest. While this requirement would notblock the completion of a sale, it doespotentially create roadblocks. In particular, thiswould occur in situations where the bonds aretrading below par such that the 101% mayrepresent a substantial premium to marketvalue (or conversely where bonds are tradingabove 101% and investors are not likely toaccept any change of control offer, whichmakes deleveraging more expensive), or byrequiring a prudent board of directors to ensurethey have committed financing to purchase anybonds tendered in the change of control offer,which will add cost and complexity to the saletransactions.While high yield bonds typically include a

provision that allows corporates to redeem upto 40% of the outstanding high yield proceedsfrom an IPO at par plus the coupon plusaccrued and unpaid interest, the full couponpayment even for this portion is relativelyexpensive and may not allow for a corporateto reach its deleveraging target to ensure bestexecution of the IPO process.

Alternatives

There are multiple alternatives to alleviate theimpact of non-call periods and provide issuersand sponsors with flexibility during the non-call period, including:

Liability management: tender offers,exchange offers or open market purchases canbe used to repurchase bonds or change certainterms. Also, while it may require 90% ofholders to agree to a change in a redemptionschedule in a high yield bond indenture,many majority consent strategies are availableto provide flexibility.

Floating rate bonds: high yield floatingrate bonds typically have a much more relaxedcall structure, mirroring the soft callprovisions of a TLB or other creditinstrument. Typically, after one year the bondsbecome callable in the 101% range.Presumably, issuers and sponsors would prefera fixed rate bond in periods of rising interestrates, but hedging options are always availableto further alleviate rate concerns. We also notethat the recently issued Autodistributionfloating rate notes due 2022 are immediatelycallable at par, which syncs up with the issuer’sexisting outstanding bonds.

Portability: while still not a universallyaccepted concept, portability features, whichpermit a change of control without therequirement for an offer to purchase tobondholders, on a change of control if a proforma leverage test is satisfied and restrictedpayment test reset provisions are included inthe documentation.

10% at 103 call: this has now become arelatively common feature for sponsors issuingsecured high yield bonds in Europe – enablingissuers to redeem 10% of their bonds annuallyat 103 during the non-call period. While there

CAPITAL MARKETS HIGH YIELD

EMEA HY bond issuance

EUR

(bills

.)

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High-yield bond volume and value by next callable year and issuer sector

Source: Bloomberg Finance

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are some limited exceptions, investors havesuccessfully resisted sponsors from getting thisflexibility in unsecured deals, furtherdistinguishing senior notes issuances fromsecond lien TLBs that have proved a popularalternative to senior notes issuances in theexisting market.Still, on balance, it is worth considering

whether the time has come to change thegeneral approach to the non-call, particularlygiven the proliferation of the TLB, which hasachieved market acceptance without theconcept.To give an indication of the size of the

market and the opportunities for potentialrefinancings or other corporate transactions inthe upcoming periods, the accompanyingcharts provide a snapshot of the EMEA highyield bonds that will become first callableduring 2019-2021, by industry andjurisdiction.

Case studies: some previousideas

From time to time, the international highyield bond market has tried some variationson the classic non-call period, but none havegained real traction. Two examples are:Mezzanine bonds of the early 2000s, such

as Focus Wickes and Baxi: This short-livedeffort to address the non-call period early inthe progression of European high yieldprovided that, in the event of an ‘exit event’(such as a qualifying IPO of change ofcontrol) after one year from issuance, thebonds could be redeemed at 103% plusaccrued and unpaid interest, reducing to100% by the end of the non-call period. Adler Pelzer Group: In 2017, the Adler

Pelzer Group issued senior secured notes thatprovided, during the first 18 months afterissuance, that the issue could redeem all or upto 40% of the outstanding notes at a specialredemption price of 102% plus accrued andunpaid interest (then reverting to a standardnon-call for the next eighteen months).

Market perspectives

We asked some market participants to sharetheir views on the non-call feature of fixed rateinternational high yield bonds, and therelevance of this feature in their decisionmaking as to whether to pursue a high yieldbond or some other form of financing.

Market-leading investors

With the help of the newly formed EuropeanLeveraged Finance Alliance Investor Group, wesurveyed a number of market-leadinginternational high yield investors. Theygenerally said that the non-call period remainsan important aspect of their investmentdecision. Some comments we received took astrong position. “Absolutely no way. Coupons are currently

so low and average maturities so short that we

should be pushing to have the same non-calllife protections that the investment grademarket enjoys. Certainly it is a key issue forus and a major determinant if we do or don’tinvest in the name.” The non-call period is of relevance when

determining the total return expectation andthe accuracy of pricing for a particularissuance. One investor noted that it is moredifficult to properly price any variation frommarket norms, which raises the concern ofvalue under-pricing for transactions withunique features. However, this investorindicated that, given the direct and indirectsoftening of the non-call protections, the non-call protection is less relevant than it was inprevious periods, and they would also focus

on other aspects of the bond terms, such asvalue leakage that the portability/restrictedpayment provisions might permit. “In reality what causes a make-whole

payment is not the non-call period. Thechange of control provision is a 101% put andit saves me money but it never makes memoney. If a credit is trading at 105% anddoing well you are never going to take the putat that price. The only reason that you get themake-whole is because there is something elsein the documentation that the company

doesn’t want to deal with under the proposedchange of control transaction, so I try andfocus my attention on the restricted paymentrestrictions. Of course, that has been difficultto achieve in a sponsor friendly environment,and I am worried that the market is notpricing this additional flexibility correctly.”The investors also noted that another

consideration when evaluating a floating ratehigh yield bond vs TLB (namely where thenon-call is less relevant) is the ease of repricinga TLB compared to a high yield bond.

“In a rallying market, TLBs are a veryattractive option for sponsors as they benefitfrom the fact that, notwithstanding a soft callperiod, they have the ability to perpetuallyrefinance or reprice their loan debt with

CAPITAL MARKETS HIGH YIELD

It is worth considering whether the time hascome to change the general approach to the non-call, particularly given the

proliferation of the TLB

2019

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High-yield bond volume and value by next callable year and issuerultimate parent nation (EMEA)*

Source: Bloomberg Finance

*Based on country of risk, which translatesto the country where most of the revenue isgenerated in the EMEA region.

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relative ease compared to the European highyield market. This is a very valuable option forsponsors and while this is in large part due tostructural considerations of the CLO marketand, in particular CLO trade limitations, Iwould argue that loan investors could beasking for more in return.”

Top-tier sponsor

On the opposite side of the argument, a top-tier European sponsor advised us that thenon-call feature is the primary considerationagainst putting high yield bonds into itscapital structure: “We invest in highly cash generative

companies, and having a multi-year non-callperiod high yield bond in our capitalstructure that limits our ability to repay debtat a low cost is unattractive when comparedto the current TLB market.”The sponsor was also relatively indifferent

to the possibility of a rising interest rateenvironment and the effect of such adevelopment on its decision to issue fixedrate high yield bonds versus floating ratenotes or TLBs given the relative ease to swapfloating rate debt to fixed rate debt at a lowcost in the existing market. Accordingly, thesponsor thought that the addition of a call-ability feature that would limit the cost of anearly redemption upon a change of a controlor IPO would materially affect how itassessed the attractiveness of issuing a highyield bond versus a TLB. That said, thesponsor did highlight that there were otherfactors outside call periods that influencedits decision, including the amendmentprocess for TLBs (in particular, a closely heldsecond lien) being less onerous whencompared to high yield bonds.

Leading capital markets desk

Investment banks play an essential roleconnecting investors and issuers and have aninvaluable insight into both sides of themarket. To get the investment bankperspective, we spoke with DominicAshcroft, managing director, and co-head ofEMEA leveraged finance capital markets andsyndicate at Goldman Sachs. Dominicagreed that the non-call feature was one ofthe main driving factors that distinguished

high yield bonds and the TLB product,particularly since the TLB product hadmoved to a covenant-lite instrument: “You could argue that six or seven years

ago when we had covenanted loan deals,there was more of an even playing fieldbetween high yield bonds and leverage loansas sponsors and issuers had to balance thechoice between a covenant-lite non-callperiod high yield bond on the one hand anda callable covenanted loan on the other. Thatdistinction no longer exists and from anissuer perspective call-ability is probably thebiggest single driver.”But is the non-call feature of high yield

bonds going to change substantially? Whilethere are always exceptions, Dominic issceptical about such a development: “The traditional high yield investor has

normally held pretty firm on call protection.You may argue with an increasing amount ofexceptions but in reality the call schedulesand structures have been reasonably constantover an extended period of time.” On the flipside, will floating rate

investors demand more call protection if weget into a period where there is a fall off ininvestor demand from loan accountscombined with an increase on the supplyside? “Right now the reality is that loan

investors only get six months of soft call butyou don’t need to go back too far in timewhen we had 12 months of soft call and thennot too much further back when we saw ahandful of loan deals flex to 101 to 102%hard call. In that market, the gap in callperiods between high yield bonds and TLBsbecomes less pronounced.”

Outlook

While market participants are confident thatthe international high yield market willprovide a popular source of liquidity for the

foreseeable future in its existing form,circumstances may be favourable in 2019 forthe appropriate issuer at the right time andin a strong market to test the boundaries ofthe non-call period, in particular in the caseof sponsors and/or corporates looking foradditional flexibility for key market eventslike changes in ownership or IPOs.Further, if the market mix for financial

products continues to weigh towards theTLB in preference to the high yield bond,investors who require or wish to holdportfolio investments in bond form maybecome more amenable to this broaderthinking, in particular if the market balance

affects the quality and scope of the availablecredits.There is also a question of whether TLB

investors have gone too far and are notpricing the additional flexibility of theirproduct correctly – will this and/or otherfactors, such as the end of a rallying marketand the possibility of raising interest rates,result in a rebalancing towards the high yieldbond market without substantive change tocall structures?Structural factors such as the strength of

the European CLO market and the effect ofglobal economic uncertainty dampening theprospects of central banks raising interestrates may suggest otherwise, but watch thisspace in 2019.

Rob MathewsPartnerBaker McKenzie, LondonE: [email protected]: +44 20 7919 1832

Haden HendersonPartnerBaker McKenzie, LondonE: [email protected]: +44 20 7919 1711

CAPITAL MARKETS HIGH YIELD

The international high yield bond market hastried some variations on the classic non-callperiod, but none have gained real traction