A Deeper Dive into High-Yield Debt

I’ve been thinking…Just what are Restricted Payment Baskets and how do they work?

In my experience, investors in high-yield debt use a set of negotiated covenants to protect their investment without unreasonably restricting the ability of the debtor to successfully operate its business in order to timely meet all of its material obligations.

For a high-yield offering to go forward, the debtor must first have satisfied all of the material elements of the negotiated financial and non-financial covenants, the so-called “incurrence” covenant test.  Key definitions are provided in the trust indenture document, which discloses the material terms and conditions of the high-yield offering to potential investors.  For example, a widely used financial covenant is a limitation on the debtor’s use of leverage, commonly measured by (i) a minimum debt-to-equity ratio, calculated as of the closing date of the offering, and/or (ii) a minimum EBITDA-to-debt service ratio, calculated using the latest 12 months of the debtor’s performance data.

In general, restricted payment covenants place strict limits on the debtor’s use of so-called “trapped cash” for specific restricted payments, including limits on the amounts of dividends paid, early redemption of outstanding debt and certain investments in unrestricted subsidiaries (versus restricted subsidiaries).  The distinction between restricted and unrestricted subsidiaries is important and is discussed below.

The cumulative amount that can be paid out in the form of restricted payments is commonly referred to as a “basket,” a “dividend basket” or the “restricted payment basket” amount.  In my experience, the available basket amount is commonly increased by 50% of consolidated net income earned by the debtor (including net income of specific subsidiaries designated as restricted) in the periods after the high-yield debt has been issued.  In contrast, the available basket amount is typically reduced by 100% of consolidated losses.  If the debtor or restricted subsidiaries raise equity, the amount of equity raised works to increase the available basket amount dollar for dollar.

In my experience, most subsidiaries are deemed restricted, which means that cash and other assets can flow freely between the parent and restricted subs.  The formal designation between restricted and unrestricted is the sole choice of the debtor and the decision is often a function of expected operating performance of specific subsidiaries, with an eye towards the potential negative impact on the available amount in the basket that can be used for restricted payments.  For example, if a debtor has a newer subsidiary that is expected to incur heavy losses in its start-up years, such a sub is often designated as unrestricted because of the outsized and negative impact of consolidated losses on the available basket amount, as discussed above.

There are a number of common features in high-yield offerings.  For example, while no principal reductions are typically scheduled during the life of the debt, interest payments are most commonly due semi-annually.   Most high-yield debt securities are issued with senior creditor status in the debtor’s capital structure.  In addition, there is typically no covenant default if the debtor’s financial performance in the normal course of business fails to maintain the incurrence covenant qualifications set at the inception of the offering.  Moreover, it is customary for a high-yield offering to be issued subject to Rule 144A of the Securities Act of 1933, with the initial investors being large and sophisticated “qualified institutional buyers.” Such an offering requires the issuer to become a reporting company with the U.S. Securities and Exchange Commission and, therefore, make required financial and other disclosures timely available to existing investors and the market.