Covenant Trends: 2022 High Yield Wrap: In Turbulent Year, Day One General Capacities Reduce While Favored Credits Still Command Aggressive Features

The inflationary climate of 2022, high energy prices and geopolitical instability caused by the war in Ukraine has cast a long shadow on the European high yield market.

Overall high yield bond issuances in 2022 declined even though the year started strong. January 2022 recorded a robust level of issuances, albeit lower than in January 2021. Conditions deteriorated as the months went by, with deal issuances down to a trickle in the third and fourth quarter.

According to Reorg data, approximately €33 billion-equivalent of high-yield bonds priced in the European high-yield market in 2022 compared with approximately €191 billion-equivalent in 2021. Excluding high yield-lite deals and offerings launched but subsequently pulled, we tracked thirty-five New York law governed high-yield bond issuances in our Market Maker database (Market Maker) in 2022, down from 146 deals in 2021.

Established issuers found it easier to access the market, which opened in fits and bursts throughout 2022. Given the turbulent conditions, a variety of distribution strategies were also used. Direct lending solutions were seen as an effective alternative to broadly syndicated transactions, with underwriters often running dual-track processes. Issuers and underwriters also became comfortable with private investors holding significant positions in the cap stack as they moved to find liquidity in an increasingly difficult market. In April 2022, £1.2 billion of 6¾% senior notes due 2029 to support the acquisition of Wm Morrisons were privately pre-placed with Canada Pension Plan Investment Board as the market was increasingly cooling after Russian tanks rolled into Ukraine. Belgian chemical distribution company, Manuchar, also chose to pre-place €75 million of its senior secured notes due 2027 with a private investor before marketing its €350 million senior secured notes due 2027. In a more novel distribution strategy, Italian paper producer Fedrigoni issued €1.025 billion of senior secured fixed and floating rate notes due 2027 in a transaction in which holders of €147 million of its outstanding floating rate notes “rolled over” their notes into the new floating rate notes in a cashless exchange.

This year-end wrap examines covenant-based trends seen in the European high-yield bond market in 2022, and expected to be seen in 2023, in the context of the global macroeconomic climate. We base our analysis on 35 New York law governed high-yield bond issuances launched in the European market which we tracked in our Market Maker database (Market Maker) in 2022 (the “2022 deals”), and 146 deals in 2021 (the “2021 deals”). Both datasets include only fully covenanted deals and exclude high yield-lite deals and offerings launched but subsequently pulled.

We will cover the architecture and trends in 2022 European sustainability-linked high yield bonds in a separate report. An analysis of the trends seen in the European restructuring market is available HERE.
 
A confluence of adverse factors in 2022 pushed coupons to double-digit figures, particularly in the fourth quarter, and led to an increase in yield to maturity. This is one of the most notable change in high yield bond terms in 2022. Issuers had to pay a premium to access the European high yield market. The high cost of capital in the latter half of the year together with market turbulence froze debut issuers out of the European high yield bond market, with most deals coming to refinance and/or bolster issuers’ liquidity.
 
We observed a steady increase in coupons for fixed rate bonds throughout the year, with coupons crossing the 12% mark in the fourth quarter of 2022. NewDay senior secured notes due 2026 issued in November offered the highest coupon of the year at 13.25%, followed by EnQuest senior notes due 2027 at 11.63% which priced in October. None of the issuances in the fourth quarter of 2022 priced in the 3%-6% coupon range, in contrast to the first quarter of 2022 where the majority of issuances priced in that range. Only 5% of deals in the first quarter of 2022 offered a coupon in the 10% to 12% range, with Swiss cigarette filter manufacturer Cerdia senior secured notes due 2027 clocking the highest coupon in the first quarter at 10.50%, which would have been middle of the pack for the coupons offered in the fourth quarter.
 
The majority of issuers in 2022 primarily came to the moribund market to refinance their existing debt. CVC-sponsored La Liga €850 million senior secured notes due 2029 and Fabbrica Italiana €350 million senior secured notes due 2027 were the only deals in 2022 financing a payout to equity owners.
 
In the second half of 2022 when market activity dropped to its lowest, the majority of refinancing issuances came with covenant terms often materially similar to their existing bonds, possibly hoping to clear the market in short order. Some issuers sought to increase debt capacity by either increasing or including grower baskets (like Intrum senior notes due 2028 and EnQuest senior notes due 2027) or adding new debt baskets (like EnQuest senior notes due 2027 which introduced a 1x contribution debt basket compared to its previous issuance). Some issuances proactively offered up investor protections like J.Crew blockers (including House of HR senior secured notes due 2029 and Fedrigoni senior secured notes due 2027 (FRNs)), even though weak in scope.

Despite many issuers presenting conservative or “known” terms to investors in the second half of the year, House of HR, a Belgian human resource company, was still able to clear with aggressive terms in December in its €415 million senior secured notes due 2029. The bonds were issued to partially refinance Bain Capital’s bridge facility for its acquisition of the issuer (the issuer had come to market in September but pulled the offering, likely due to pricing concerns) and ultimately priced with a coupon of 9%. This suggests that if the macroeconomic conditions persist in the first half of 2023, issuers can still get aggressive terms in their notes, in exchange for higher coupons.

Buysiders are increasingly exposed to a higher degree of investment uncertainty with high-yield bonds in the European market issued with shorter tenors and consequently shorter non-call periods. Almost 71% of deals in 2022 were issued with a tenor of five years or less, increasing from 66% of 2021 deals. Deals with a tenor of five years typically had a non-call period of two years.
 
Aggressive Terms Dialed Back in Roadshows in Over a Quarter of High Yield Bonds in 2022

We recorded investors push back to strengthen documents in 26% of 2022 deals, from 14% in 2021 deals. In line with the trend of enhanced pushback which started in the last quarter of 2021, pushback activity continued in 2022, achieving more success in the first half of the year.

While the frequency of pushback increased overall in 2022 compared with 2021, there was a degree of variability by quarter reflecting market volatility in 2022. As illustrated in the graph below, successful pushback was high in the first quarter at 32% (compared with 12% in 2021), fell to zero in the third quarter, reflecting the lack of deals in that quarter, and was 20% in the fourth quarter (compared with 30% in 2021), with the variation due to factors including issuers refinancing based on documentation close to their previous issuances and changes in investor appetite at different points in the year.
 
Our Covenant PushBack Tracker closely tracks changes made during the roadshow for all material covenants in a high yield bond.

Provisions relating to value leakage, calculation flexibility, asset sales and change of control saw more successful pushback in 2022 compared to 2021. The graph below compares the areas of investor pushback in 2021 and 2022 as a percentage of deals which saw pushback within the respective years.
 
Below is a breakdown of the commonly seen pushback points in 2022.
 

Covenant Pushbacks in 2022
Covenant	Pushback Description
Calculation Flexibilities	Cost savings and synergy adjustments: 33% of deals with pushback tightened up adjustments for cost savings and synergies by introducing caps and a time horizon for achieving cost savings and synergies. All introduced a 24-month time horizon and caps ranging from 25% to 30% of EBITDA. Kane senior secured 2027 which launched in the first half of 2022 introduced a higher cap set at 30% of EBITDA. Exclusions of debt from ratio calculations: 33% of deals with pushback removed the exclusion for working capital/revolving debt from ratio calculations, making the ratios more closely reflect the true leverage of the issuer.
Debt incurrence	Reduction of “free and clear” amount and ratio tests(s) levels in the credit facilities debt basket. Removal of dividend-to-debt toggle capacity.
Value Leakage	Reduction in capacities by reduction in basket sizes and/or ratio test levels (Novolex 2029/2030 bonds and Fabbrica Italiana SSN 2027). Removal of the ratio-not-made-worse flexibility for use of the ratio-based permitted investments (Novolex 2029/2030 bonds).
Asset Disposals	Tightening of ratio levels in asset sale leverage grids to limit the diversion of sale proceeds away from reinvestment or debt repayment. Removal of ability to make restricted payments from proceeds through the application of proceeds “optional waterfall." Reducing proceeds application time periods.
Change of Control	Tightening ​​ or removing portability exceptions.
Redemption	Removal of redemption of 10% of bonds annually at 103% (888’s SSN 2027s). Removal of ability to use the equity claw redemption to redeem 100% of the bonds, thereby avoiding the make-whole payment (Renta’s SSN 2027)

Creditor Protections Against Dilution, Priming and Leakage Increase in 2022

Issuers’ day-one capacities to dilute or layer senior secured bondholders, or divert cash or assets out of the hands of bondholders fell in 2022, according to Reorg’s proprietary flexibility scale analysis. This trend is not surprising given the strength of the market in 2021 compared with 2022, accompanied by increased investor pushback in 2022. Most significantly, the risk of collateral dilution fell by 20% to 192% of EBITDA in 2022 from 241% of EBITDA in 2021.

In addition, day-one value leakage capacities also contracted by 5% for potential transfers to unrestricted subsidiaries and 15% for dividend payments.

   
In recent years, issuers and sponsors have continued to introduce innovative provisions to maximize extraction of value either for dividend payments to shareholders or to fund investments outside the restricted group.

The innovative value extraction trends we saw in 2021 maintained a presence in the market. Surprisingly, a handful of these off-market terms allowing a sponsor to extract more value and subordinate creditors while restructuring a stressed portfolio company increased in 2022 as compared with 2021.

“Available Amount” Second Builder Basket Seen More Often

An Available Amount basket is an additional builder basket that comes side-by-side with the traditional 50% CNI builder basket and increases the scope for value leakage. The Available Amount basket typically builds from excess cash flow and a variety of other sources including debt and IPO proceeds, but some of the sources overlap with those that increase the CNI builder basket. Although more common in leveraged loans, the inclusion of this second builder basket is still off-market. But its presence increased to 11% of 2022 deals from 5% of 2021 deals.

Ratio Based Investment Baskets Proliferate and Conditions for Use Reduce

Leverage ratio-based investment baskets are becoming common in sponsor-friendly European high yield bonds, featuring in nearly half of the 2022 deals (44%) from 28% of 2021 deals. These baskets are another import from the European leveraged loan market. Capacity from such a basket can be used to release value from the restricted group into joint ventures and unrestricted subsidiaries, which could then be used to pay dividends to sponsors or provide unencumbered assets to other creditors.

In bonds, it is typical for the basket to be capped by a net leverage test, but in some deals, such as House of HR senior secured notes due 2029 and Verisure senior secured notes due 2027, the basket is capped by a narrower senior secured net leverage ratio. There was variability in the application or otherwise of a “default / event of default” stopper.

The weakness of such baskets is exacerbated in 9% of 2022 bonds (compared to 8% of 2021 bonds) by allowing access to the basket when the specified leverage ratio cannot be met on a pro forma basis, so long as the relevant ratio is not made worse - this feature was removed in Novolex 2029/2030 bonds.

A total 73% of the 2022 deals with a ratio-based investments basket set the ratio higher than the ratio tests for the ratio-based restricted payments, which is questionable given the ease with which an investment can be converted into a dividend, while the remaining deals have the same ratio for both baskets.

The majority of the 2022 deals with the basket required deleveraging between 0.26x and 0.5x to access the basket, with few requiring deleveraging above 0.75x (0.8x in BestSecret senior secured notes due 2027 and 1x in WFS senior secured notes due 2027).
 

Erosion of CNI Builder Basket Protections Continue

Among restricted payment baskets, the 50% consolidated net income builder basket is viewed as a significant source of potential leakage. In 2022, issuers continued to ease the conditions for accessing this basket, including after a default.
 
Weak default blockers continue and on the increase:

Defaults generally rise as stress in the economy increases. In such times, a creditor’s ability to block an issuer from taking credit-negative actions comes to the forefront. Traditionally, the 50% CNI builder basket would become inaccessible as soon as any default - including a potential event of default - occurred. Shareholders were blocked from accessing this substantial basket at the first whiff of trouble. The market has already accepted a dilution of this traditional standard and now often allows the basket to be accessed in the absence of an “Default or Event of Default”. This is a crucial distinction to note - a “Default” and “Event of Default” are not the same in a high yield indenture. A default matures into an Event of Default only upon notice and/or the passage of time. If the builder basket is blocked only by an Event of Default, issuers and sponsors can access this basket until a Default matures into an “Event of Default,” for example during the grace period after a cross-default to other debt. In recent years, this already diluted standard has been further watered down by issuers reducing the scope of the Events of Default which would block access to this basket. 23% of 2022 deals, a notable jump from only 14% of 2021 deals, blocked access to the 50% CNI basket only in the case of the occurrence of a limited sub-set of events of default such as non-payment or bankruptcy related events of default.

Ratio test inapplicable for making investments:

Typically, access to the builder basket is subject to the group meeting the pro forma ratio debt test, usually a 2x fixed charge coverage ratio. In 20% of 2022 deals, the issuer does not need to meet any ratio test to make an investment from the builder basket - an increase from the 12% of 2021 deals which had this issuer friendly flexibility. While on the face of it the omission of a ratio test for investments from the builder may appear harmless, this flexibility will allow a stressed issuer to use accrued capacity in its builder basket to “invest” valuable assets into an unrestricted subsidiary, removing those assets from the reach of its creditors, that is execute a controversial “drop-down” transaction which could result in its creditors being subordinated.

Use of “Free and Clear” starter amounts on the rise:
Starter amounts provide immediate capacity for dividends without requiring any “build-up” based on financial performance. These baskets are now standard, being present in 57% of 2022 issuances, up from 49% in 2021. The basket is usually sized to include a grower element (commonly an EBITDA based-grower), with the grower commonly set at 30% of EBITDA. Only two deals set the grower component at 40% of EBITDA in 2022 (House of HR senior secured notes due 2029 and CeramTec senior notes due 2030).

Ratio Levels to Access Ratio-Based RP Basket

Ratio-based permission for making dividends and other restricted payments was present in 89% of 2022 deals, down from 94% in 2021 deals. It is typical for this ratio to be based on the net leverage ratio and for issuers to require deleveraging from opening day ratios to access this basket. In 2022, 34% of 2022 deals in our Market Maker required deleveraging of between 0.5x to 0.9x, while 23% required more than 1x. It is atypical for headroom to be available on the day of issue. Where present, the headrooms vary - of the five deals in 2022 with a headroom, three cleared market with a headroom of between 0.4x to 0.5x and the remaining two cleared with a headroom of more than 1x.

Inclusion of J. Crew Blockers Falls Marginally

A bondholder protection, the inclusion of J Crew blockers fell slightly in 2022 and was included in only 6% of 2022 deals versus 8% of 2021 deals. These blockers appear in multiple variants. The J. Crew blockers often only restrict transfer of material intellectual property to unrestricted subsidiaries, which would not offer much protection if the group’s business is not heavily tied to its intellectual property. In 2022, we recorded these blockers in manufacturing industry (chemicals and paper) deals, while in 2021 they appeared more often in the retail and food/beverages industry. For instance, the J. Crew blocker in McLaren’s senior secured notes due 2026 only covered “material” intellectual property without clarifying what intellectual property would be material to the business and did not extend to non-intellectual property assets like its racing division.
 
Issuers continue to include off-market and aggressive baskets in bond documentation, with some of these baskets not quantifiable on issuance of the bonds and which therefore have no impact on Day-1 capacity calculations in our flexibility scale. The use of dividend-to-debt toggles and uncapped baskets for absorbing acquired (not acquisition finance) debt increased significantly in 2022. The ability to incur contribution debt on a 2x basis only ticked up slightly from the level seen in 2021. The increases in these additional debt incurrence baskets are likely to be of concern to investors.
 

Dividend-to-Debt Toggle Gains Popularity

The dividend-to-debt toggle / or “pick your poison” / “Available RP Capacity Amount” basket allows conversion of unused capacity under some (or all) restricted payments baskets into debt capacity. See HERE for a primer on the mechanics of this provision, and HERE for an explanation on how the use of this toggle could impact an issuer’s leverage multiple.

Slight Uptick in Inclusion of 2x Contribution Debt Basket
This basket allows issuers to incur debt up to 200% of the amounts contributed to their equity capital (through shareholder loans or issuance of equity) after the issue date of the bonds. Traditionally, this permission should be limited to a 1:1 basis. Debt incurred under the basket can be secured on the collateral on a pari passu basis without meeting any leverage test, diluting noteholders’ potential recovery. See HERE for a primer on the mechanics of this provision.

Uncapped Acquired Debt Baskets on the Rise

Gaining in traction in 2022, this basket allows an issuer to assume debt of a target (including if the debt was incurred by the target in contemplation of its acquisition) without complying with any ratio test. Traditionally, issuers are required to meet a standard 2x fixed charge coverage test (or a specified leverage ratio in some cases), typically on a “ratio no worse” condition, to demonstrate its ability to service the new debt. This flexibility would make the acquisition of debt-heavy targets easier and should be of concern where the issuer is highly acquisitive See HERE for a primer on the risk posed by such a provision.
 
In recent years issuers and sponsors have built ever greater flexibility into provisions for creatively calculating EBITDA, grower baskets and leverage and fixed charge coverage incurrence ratio tests. These “calculation flexibilities” could serve the issuer by artificially inflating the size of a basket when it wants to incur debt or pay dividends or by reducing leverage to meet ratio-based incurrence tests.

Adjustments for cost savings and synergies improved overall in 2022, with 46% of deals requiring the adjustments to be capped compared to 37% in 2021. However, other material calculations flexibilities increased in 2022 deals compared with 2021 deals.
Uncapped Adjustments for Cost Savings and Synergies

Pro forma adjustments to EBITDA or CNI calculations for “run rate” cost savings and synergies from a broad range of transactions can have a significant impact on incurrence capacities and ultimately filter through to financial ratios. See our primer HERE on the operation of the provision.

While these add-backs are standard in the market, there is a fair amount of variety as to whether they are capped in amount and whether there is a time limit for them to be achieved (or more frequently, whether there is a time limit during which actions are expected to be taken from which the cost savings and synergies are expected to be achieved). Some deals have both limitations, some neither and some have only one.

In 2022, there was a slight increase in deals which included both a cap and a time limit on add backs for cost savings and synergies, rising to 38% from 35% in 2021. There was also a slight increase in deals which had no cap or time limit. It featured in 32% of 2022 deals, slightly up from 30% of 2021 deals. As discussed above, investors achieved successful pushback on this during 2022, introducing caps and/or time limits during the marketing period.

Where only one limit was imposed, issuers in 2022, like in 2021, continued to favor applying a time limit as opposed to an outright cap on the amount of addbacks permitted. In addition, the applicable time period has tightened. In the deals where only a time limit was imposed, none of the 2022 deals imposed a time limit of more than 24 months (63% of 2022 deals imposed a 24-month time limit and the rest imposed either a 12-month or 18-month time period limit). This is relatively tighter when compared to similar 2021 deals where 9% imposed a 36-month time limit and 54% carried a 24-month time limit.

In deals where addbacks were capped, irrespective of whether a time limit for realization was imposed, the typical threshold was 25% of pro forma EBITDA. BestSecret senior secured notes due 2027 was relatively tighter than the market average capping addbacks at 17.5% of pro forma EBITDA with a 12-month time limitation for taking the actions and no time limit for realization of the addbacks.
 
Exclusions From Leverage Ratio Calculations Creeping Up

Increasingly, issuers are excluding debt drawn under revolving credit facilities or other working capital/redrawable facilities from leverage ratio tests. These exclusions can inflate covenant capacity by allowing the issuer to manipulate its leverage ratios and access baskets that may not have been available on the basis of its true leverage. A total 23% of 2022 deals excluded revolving or working capital debt from leverage ratio or FCCR calculations compared to 19% of 2021 deals. See HERE for our primer on this exclusion.

While this exclusion was uncapped in all 2022 deals, investors looking to push back on this flexibility could require the inclusion of a cap (as seen in Kloeckner Pentaplast senior secured notes due 2026 and the preliminary documents for Asda senior secured notes 2026) or disallow it for the restricted payment covenant (as was done in preliminary document of David Lloyd senior secured notes due 2027).

Use of Super Grower Baskets Increases Slightly

There was a slight increase in this feature in 2022 deals to 14% from 12% in 2021, allowing the fixed component of grower baskets to automatically and permanently increase from time to time to the equivalent amount of the “grower” element (such as EBITDA). Once increased, there will be no subsequent decrease in the fixed amount if EBITDA falls. See our primer HERE on the operation of the provision.


Use of Carry Forward and Carry Back Baskets Increases Significantly

More than doubling in popularity in 2022, this feature allows 100% of the unused capacity under all or certain annual baskets to be carried forward into the next year or carried back into the current year. Of the 13 deals in 2022 with this feature, 62% permitted this allowance across all baskets. This can significantly boost basket capacities The mechanics of this basket is explained HERE.
 
The European high yield market has become comfortable with the issuer re-directing asset sale proceeds to make dividends or other restricted payments by utilizing existing restricted payments capacity. More deals in 2022 made use of leverage-based grids that reduce the portion of proceeds required to be applied for debt repayment or reinvestment. In some instances, the proceeds not required to be applied can be used for making restricted payments without further conditions.
 

Use of Asset Sale / Excess Proceeds Leverage-Based Grid Increase Significantly

The ability to reduce asset sale proceeds required for debt repayment or reinvestment if specified ratios tests are met increased to 26% of 2022 deals from 16% of 2021.
The majority (67%) of 2022 deals that have this feature apply the reduction to “excess proceeds” - proceeds that have either not been applied to or remain after, debt repayment, reinvestment or as otherwise permitted by the asset sale covenant optional waterfall. Other deals do not require the relevant percentage of proceeds to be applied according to the asset sale covenant optional waterfall to the extent the relevant leverage ratio is made.

Amounts retained as a result of the application of the leverage grid may then be used to make restricted payments, either through a dedicated restricted payments basket (if applicable) or any available restricted payments capacity. Our explainer on the operation of this provision can be seen HERE.

Retention of Declined Excess Proceeds for Dividends Increases

Dividend capacity can also be increased by allowing declined prepayment amounts to increase capacity under the CNI builder basket or be paid out under a dedicated restricted payments basket. 20% of 2022 deals had this feature, jumping from 2% of deals in 2021.

Earmarking Sale of Specified Assets for Restricted Payments
Proceeds from the sale of specified assets or assets not exceeding a specified percentage of EBITDA may be paid out as restricted payments with or without being subject to a ratio test or “no default” blocker. The use of this provision dipped slightly in 2022 to 6% from 7% of 2021 deals.
 
Portability held steady in 2022 compared to 2021. In total 51% of 2022 deals featured either a ratio or ratings based portability compared to 52% of 2021 deals, with ratio-based portability remaining similar in both years. Even though portability has become standard in the European high-yield market, the provision seems to have become slightly tighter in 2022 with a higher number of deals permitting portability to be used only once during the life of the bonds.


 

Of the 15 deals with ratio-based portability in 2022, 87% allowed single-use portability, up from 78% in 2021. Only CeramTec senior notes due 2030 and House of HR senior secured notes due 2029 featured multi-use portability in 2022, an aggressive step by current market standards.

The majority of 2022 deals, similar to 2021 deals, had portability either set at opening leverage or set above opening leverage. 27% of 2022 deals, increasing from 20% of 2021 deals, required less than 0.5x deleveraging to exercise the portability exception.

Consolidated net leverage ratio was the most commonly used ratio for the portability exception. Only Miller Homes senior secured notes due 2029 used a senior secured net leverage test.

 
Portability is not just a theoretical construct; it does actually get applied. In September 2022, SATS Ltd.’s acquisition of French air cargo handler Worldwide Flight Services (WFS) was completed without triggering the change of control put under WFS’ outstanding senior secured notes. WFS announced that it was able to meet the portability ratio test set at a pro forma 5.8x total debt ratio and exercised its single-use portability exception. Our analysis of WFS’ portability provisions is available HERE.
 
Overall, bondholder rights to call a default and vote on amendments have become weaker still when compared to 2021.

Sunset on Declaring Defaults on the Increase

Constraints on bondholders' ability to call default after the expiry of a specified time period (typically two years) grew to 20% of 2022 deals compared with 14% of 2021 deals.

Uptick in Disenfranchisement of Net Short Investors

Issuers have sought to restrict the voting rights of certain classes of investors who may be more motivated (as a result of their holding credit default swaps) to push the issuer into a covenant default. In response to this, net short provisions require investors to confirm that they do not hold a net short position when voting on events of default. This provision also saw an uptick, appearing in 9% of 2022 deals compared to 6% of 2021 deals.

See our primer HERE for the operation of both provisions above.
 
Another import from the European leveraged loans market, 9% of 2022 deals (CeramTec Senior 2030, House of HR senior secured notes due 2029 and 888 senior secured notes due 2027) included an automatic increase in baskets by 50% upon the bonds achieving investment grade status. This is compared to 5% of 2021 deals.
 
Few people at the start of 2022 would have foreseen a war in Europe, a significant spike in oil and gas prices and a leap in interest rates and inflation. And so looking forward to 2023, it is worth remembering that one or more significant political or macroeconomic events, however unlikely they may seem now, could alter the landscape considerably.

It is also worth remembering that the ability of issuers and sponsors to demand aggressive covenant terms depends in part on the number of deals coming to market and the amount of money chasing those deals. Indeed, the aggressive terms now seen in European high yield deals, which would have been unimaginable before the global financial crisis, were made possible by central bank interest rates falling to zero or below, moving investors from other asset classes to the high yield market in a hunt for yield.

That relationship is changing somewhat now, but we suspect that short of a seismic market correction, the wide-scale erosion of documentary provisions that has entrenched in high yield bond documents is unlikely to wholly reverse in 2023. On the supply side, 2023 doesn’t have a particularly large number of bonds maturing that must be refinanced, with greater maturity walls coming in 2024 and 2025. As a result, issuers are likely to continue to be opportunistic in coming to market, waiting out periods of turbulence and keeping an eye on interest rate trends.

On the demand side, to the extent that investors remain spooked by the overall economic environment, we expect that they will continue to be selective in terms of which credits they choose to invest in and which aggressive terms they are willing to accept. Solid credits backed by reputable sponsors will no doubt continue to be able to command aggressive covenant terms. However, there are doubtless a number of companies out there that could make a decent investment case when interest rates were near zero but that won’t be viable when faced with paying double-digit yields and who will struggle to refinance regardless of the covenant protection they offer. In between the two, should the tide continue to go down, investors will look carefully to see who’s actually been swimming naked, or at least very scantily-clad.

Looking forward, trends we expect to see for covenants include:
 

• For stronger credits, we expect a continued migration of aggressive loan terms into high yield bond documentation. For example, we suspect that the increase in deals in 2022 with an “Available Amount” restricted payment basket will continue into 2023. We also wouldn’t be surprised to see the introduction of innovative toggles such as the investment-to-debt toggle (in addition to the dividend-to-debt toggle) which could allow sharing of capacities across all or multiple covenants.

• Calculation flexibilities are likely to remain in focus as issuers and sponsors continue to make inroads and innovate to facilitate debt incurrence and value leakage.

• More marginal credits may well struggle to refinance their debt or incur additional debt to provide needed liquidity and accordingly they will be looking for ways to create priority debt capacity to entice new money in. In response, we suspect that we may well see a number of “J. Crew” inspired drop-down transactions in which restricted payment capacity is used to create structurally and effectively senior debt capacity outside the restricted group, as they did in the Intralot restructuring. Whether uptiering transactions (where a majority of creditors consent to create a new class of priority debt at the expense of the minority creditors, as in Serta) begin to appear on this side of the Atlantic is more questionable given the creditor consent requirements in most European intercreditor agreements. But where there is a will there generally is a way, so we’ll be watching this space carefully.

Data used for this report is primarily based on final offering memoranda and pricing term sheets for the deals tracked in our Market Maker database and launched between Jan. 1 and Dec. 31 of 2022 and 2021. Where the final offering memorandum is not available, our data is based solely on disclosures in the preliminary offering memorandum for the applicable bond. This report excludes issuances in both years which were either pulled from the market or were launched without all material covenants (high-yield lite covenant package).