In contrast, below are the few limited areas in which leveraged loan concepts have surfaced in high yield bond offerings:
- General – Portability: the ability to effect a change of control (under certain circumstances) without the need to repay bondholders is an aggressive high yield bond feature that is experiencing a revival in the high yield market. This feature is slowly spreading to European leveraged loans (though it is receiving pushback in the US).
Together with the fact that TLBs potentially offer quicker execution timeframes and lower transaction costs compared to high yield bonds, TLBs have surged in popularity, with sponsors opting for loans rather than bonds to finance their LBOs, or opting to refinance their existing bonds with loans
- Net Leverage: while historically high yield bonds used a “gross” leverage test for its covenants, many leverage tests are now calculated on a “net” basis, i.e https://www.paydayloanstennessee.com/cities/dayton/. gross debt less cashon hand (as has historically been done in the leveraged loans). This may have unintended consequences in a product that generally has a more permissive restricted payments regime than leveraged loans, thus providing more opportunities for sponsor/issuers to “game the system” by inject equity to temporarily improve the leverage ratio for purpose of permitting incurrence of a non-ordinary course liability, only to take the cash back out shortly thereafter.
- Erosion of Call Protection: call protection used to be a strong distinguishing feature for bonds. However, recent trends such as the shortening of non-call periods, combined with aggressive equity claw back 3 and other redemption rights (e.g. 10% of the bonds at 103% annually) have significantly eroded bondholder protection against early redemption. Further evidence of convergence in this area can be seen in floating rate bonds (“FRNs”), with their one year, call schedule. Comparing this with floating rate loans: at best, some loans will have the benefit of soft calls at 101 for six months or one year, but generally loans are always callable. Often, even the limited soft call provisions in leveraged loans have exceptions for repricing transactions in connection with an IPO, a change of control, a material acquisition, or an acquisition not permitted by the agreement –sometimes even for dividend recap transactions.
As illustrated above, the leveraged loan market is seeing more of an infiltration of high yield bond-style terms into leveraged loan documentation instead of the other way around. In that regard, the general shift in the market is towards a more relaxed incurrence-based covenant package and away from a restrictive maintenance-based covenant package.
Loan or Bond?
The convergence of loan and bond terms leaves borrowers/issuers with the question of which to choose. A quick comparison is set out below:
As a result of the convergence trend and recent supply/demand imbalance, pricing spreads between TLBs and high yield bonds have narrowed. However, it remains to be seen whether this level of activity in the TLB market can be sustained, particularly if any of the macro-economic factors described above changes the TLB pricing becomes less favorable.
Notwithstanding the popularity of TLBs, the high yield market offers certain benefits that the TLB market does not. The high yield markets, in Europe and especially the US, are deeper and more liquid than the TLB market. It also offers investors broader scope for secondary trading. In addition, while the initial transaction cost for a high yield bond may be higher than that of TLBs, and a high yield bond offering may be more time-consuming, once a sponsor/issuer has gone through the process of preparing an offering memorandum (particularly up to Rule 144A standards), it is that much closer to being prepared for an IPO, with much of the work already done and with management already familiar with the disclosure process. Indeed, in many cases high yield bonds are better suited than TLBs regardless of pricing or transaction costs, such as for issuers that have highly cyclical businesses where longer-term capital commitments in the form of bonds are more suitable than loans (which typically have shorter maturities and carry early repayment requirements), or in certain jurisdictions such as Italy where local lending rules are prohibitive toward non-Italian lenders making loans to Italian corporates.