Analyzing Covenant Packages in New Deals

Covenant packages in corporate and high-yield deals act as financial tripwires, but their design creates a perpetual tension: stronger protections often demand higher yields, while lenient terms increase credit risk. For investors, the challenge lies in identifying covenants that meaningfully constrain management without pricing out competitors in a hot issuance environment.

The workflow conflict emerges during due diligence. Structuring teams may push for incurrence covenants (e.g., leverage ratios) that delay restrictions until breaches occur, whereas monitoring teams prefer affirmative covenants (e.g., quarterly compliance tests). A 2023 BofA study found that high-yield bonds with financial maintenance covenants added 25-50 bps to yields but reduced default probabilities by 15-20% over five years.

Covenant Design Trade-offs Covenants must align with the issuer’s capital structure. For example, a leveraged buyout with a 6.0x EBITDA multiple may include:

• A debt/EBITDA incurrence test at 4.5x (triggering higher pricing on new debt)
• A fixed-charge coverage ratio floor of 2.0x
• Mandatory prepayments from excess cash flow (typically 50-75% of annual EBITDA)

These terms are not static. In 2024, 35% of HY deals included "covenant lite" structures, relying on incurrence tests rather than ongoing compliance, reflecting tighter market conditions and borrower resistance to rigid constraints.

Monitoring Triggers and Stress Testing Post-issuance, focus shifts to trigger thresholds and stress scenarios. A borrower with a 3.5x leverage covenant may face material constraints if leverage spikes to 4.0x, potentially limiting dividends or M&A. Historical data shows issuers with leverage above 5.5x EBITDA have a 30%+ probability of default within 18 months.

Key metrics to track:

• 12-month trailing leverage ratios
• Liquidity coverage (cash balances vs. near-term maturities)
• Interest coverage (EBIT vs. cash interest)

When negotiating covenants, prioritize terms that limit discretionary capital allocation during downcycles. For instance, requiring 100% excess cash flow sweeps if leverage exceeds 3.25x can preempt liquidity crises.

Covenant analysis is a negotiation between risk discipline and market realism. Start by stress-testing the issuer’s ability to maintain key ratios under a 200 bps rate hike and 15% revenue decline. The goal is not perfection but asymmetric protection: covenants that crystallize value when things go wrong without crippling the deal upfront.