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High-yield debt securities versus bank loans
Discuss the major differences between high-yield debt securities and bank loans in your jurisdiction. What are some of the critical advantages and disadvantages?
One of the key differences of high-yield debt securities compared with bank loans is regulatory. Only duly authorised credit institutions and financial companies can conduct, on a professional basis (isolated transactions are excluded), the activity related to granting of loans, guarantees and other commitments. Investment in securities (such as debt securities) does not require a licence. This gives greater flexibility for companies to search for a wider range of investors on high-yield debt securities as opposed to bank loans.
Another key difference is found in the covenants package. Bank loans have financial maintenance covenants, while high-yield bonds have incurrence-based covenants. Typically, financial maintenance covenants are triggered if the borrower does not meet certain leverage ratios (eg, debt-to-earnings before interest, tax, depreciation, and amortisation (EBITDA)) or a certain limit of interest coverage (eg, EBITDA-to-interest expense) or some other coverage metric set forth in the business model. The loan agreements usually establish exceptions for investments, disposals and liens that are in line with the business model. Cash sweep mechanisms that force the borrower to prepay the loan if there is excess cash flow are also common. In incurrence-based covenants of high-yield bonds, however, covenants are only potentially breached when the issuer raises new debt, makes an acquisition, pays a dividend, or undertakes some other relevant corporate action - namely it requires an action from the borrower. From the issuer’s perspective, incurrence-based covenants are preferable because they give more flexibility.
Also as a consequence of the difference in respect of covenants, the process for obtaining waivers or consents in a bank loan is easier and more flexible, with the borrower being able to approach a limited number of lenders and agree with them on waivers or consents within a short period, while in the case of high-yield bonds the issuer has to communicate with a wider range of investors, the threshold for amending key economic terms is higher and the process is more costly and time-consuming.
Finally, another relevant difference is the level of disclosure of information, in particular if there is a public placement of the securities or if they are admitted to trading (see question 6).
Are you seeing increased regulation regarding either high-yield debt securities or bank loans in your jurisdiction?
Bank loans have recently been subject to stricter regulation, in particular regarding interest rates, interest payments and information disclosed to the borrower.
As to high-yield bonds, investment in such securities is not a regulated activity. However, several applicable securities laws have been toughened in recent years with a view to providing greater protection and information to investors; high-yield bonds are traded on secondary markets or non-regulated markets where information level requirements are lower, thus not providing investors with adequate information for the risk being taken.
From a regulatory perspective, the Markets in Financial Instruments Directive (2014/65/EU) (MiFID II) has entered into force and the last implementation measures of MiFID II are now being concluded. This is expected to have some impact on high-yield bond transactions and distribution public offers in general, as a result of the need for the definition of the target market for the bonds.
Current market activity
Describe the current market activity and trends in your jurisdiction relating to high-yield debt securities financings.
Last year was a record year for the European high-yield market (including the Portuguese segment). It not only recovered in 2017 compared with 2016 but it also reached new records in terms of issuance values and deals. According to capital structure data, the value of European high-yield bonds increased to €110 billion in 2017 and the number of deals went up to from 266 in 2016 to 339 in 2017 with the average total size of each deal being €466.5 million. Pricing tightened further with an average coupon of 4.4 per cent and there was a strong trend for issuer-friendly terms with the environment of low interest rates clearly favouring more appetite for risk from investors.
However, the trends at the beginning of 2018 are not very positive. There has been a sharp drop of 38 per cent up until February and the news is not positive as the expectations of an increase in interest rates by the Federal Reserve in the second semester of the year keep growing. Pricing also went up in the beginning of the year with the average yields raising 3.4 per cent.
As with 2016, 2017 saw no specific sector experience increased levels of high-yield debt activity. We have seen issuances in the telecommunications, power and energy, security and alarms, and pharmaceutical sectors among others.
High-yield bonds are mainly regulated by New York law governed indenture, pursuant to which a trustee and a security agent are appointed to represent the interests of the holders of high-yield bonds. With the significant increase in European high-yield bond issuances, we have seen in recent deals the indenture being ruled by English and, in some cases, German law.
Other typical documents in high-yield bond transactions are the purchase agreement pursuant to which the purchasers underwrite the bonds issued by the issuer; the intercreditor agreement between the bank lenders, the bondholders and the issuer; and the security agreements pursuant to which the several companies of the issuer’s group grant security in case of secured deals. Legal opinions and accountants’ comfort letters are also a necessary element of these transactions.
In terms of security, and aside from the classic corporate guarantee granted by Portuguese subsidiaries, share security and certain types of in rem security (eg, bank accounts, insurance policies, receivables) are taken without impacting the day-to-day business activity of the company.
High-yield bonds are usually exclusively offered to qualified investors; not to retail investors. They do not entail a public placement in Portugal for the purposes of the Securities Code and have a nominal amount of at least €100,000. Investors in high-yield debt securities are usually mutual funds (eg, corporate bond funds, high-yield funds and income mutual funds), insurance companies and pension funds.
Finally, we confirm that there has been, in the majority of financings, a clear overlap between high-yield debt securities and loan financings, although the greater portion of the financing arises from high-yield bonds.
Identify the main participants in a high-yield debt financing in your jurisdiction and outline their roles and fees.
The main participants (aside from the issuer, guarantors, legal advisers and auditors) in a high-yield debt financing and their roles are as follows:
- Initial purchasers and underwriters: the role of the initial purchasers is to advise the issuer on the structure and timing of the offering and to coordinate and market the transaction. They have a major role in the discussion of the offering memorandum with the legal teams and accountants. They underwrite the securities from the issuer under the purchase agreement and resell them to investors.
- Security agent: given that neither the trustee nor parallel debt is a recognised legal concept in Portuguese law, the security agent has a major role in high-yield bond transactions. It is a party to the intercreditor agreement and the security documents, and is responsible for monitoring and enforcing the collateral guaranteeing the notes in an enforcement scenario.
- Paying agent: the role of the paying agent is to make payments of principal and interest to the bondholders.
- Rating agencies: ratings are issued by two of the big four rating agencies (eg, DBRS, Fitch, Moody’s and Standard & Poor’s).
Fees of the initial purchasers are usually calculated as a percentage agreed on an individual basis of the aggregate principal amount of the notes. The other parties referred to above receive market-standard fees (usually flat fees) in connection with their engagement.
Describe any new trends as they relate to the covenant package, structure, regulatory review or other aspects of high-yield debt securities.
Covenant packages vary considerably depending on the economic and credit cycle. They are more restrictive if there is more risk aversion and interest rates and spreads are higher. If, however, there is less risk aversion and interest rates and spreads are lower, the covenant package is less restrictive.
Covenant trends in 2017 continued to be very favourable to issuers. Covenant-lite issuances were predominant and increased in relation to 2016, as did soft-cap grower baskets calculated on the higher of a fixed amount or a percentage of assets or EBITDA. There was also a trend for broader exceptions to the ability to redeem bonds and for shorter periods of non-exercise of call options, which are now less than half of the tenor of the high-yield bonds.
In addition, European (including Portuguese) high-yield bonds continue to provide issuers with more flexibility to redeem bonds and equity claws are more and more common.
How are high-yield debt securities issued in your jurisdiction? Are there particular precedents or models that companies and investors tend to review prior to issuing the securities?
Transaction documents are prepared based on recent relevant precedents, including the offering memorandum or prospectus, purchase agreement and the indenture as well as, if combined with a loan financing, the relevant senior facilities agreement.
Previous issuances by the same issuer will tend to set a precedent, as will issuances by companies in the same industry or sector or with a similar credit risk profile. The lead bank’s (and, in a sponsored deal, also the sponsor’s) standard covenant form typically also plays an important role in negotiating the covenants.
Maturity and call structure
What is the typical maturity and call structure of a high-yield debt security? Are high-yield securities frequently issued with original issue discount? Describe any yield protection provisions typically included in the high-yield debt securities documentation.
Typically, high-yield debt securities have maturities that generally range from five to 10 years.
In relation to redemption or call rights, it is rare to have mandatory redemption provisions requiring an issuer to prepay the outstanding notes prior to maturity, and it is very common for the issuer to have call rights.
Notwithstanding, there are usually non-call periods and declining premium redemptions. As mentioned in question 5, in recent years, high-yield bonds have provided issuers with more flexibility to redeem bonds, namely with shorter non-call periods and widespread use of the equity claw redemption.
How are high-yield debt securities offerings launched, priced and closed? How are coupons determined? Do you typically see fixed or floating rates?
The launch, pricing and closing of high-yield bonds issued by a Portuguese issuer follow the standard process and steps of a typical high-yield offering. The offering is launched by preparing and distributing the preliminary offering memorandum to investors. Then there is a roadshow with several investor meetings, which typically lasts from three days to two weeks.
The roadshow ends with pricing the offering, which basically means executing the purchase agreement. While the company is on the roadshow, company counsel will be negotiating the purchase agreement with the banks and the purchasers. The most significant aspect of the purchase agreement, beyond the price of the bonds, is the dramatic and temporary change it engenders in the relationship between the company and the initial purchasers.
Prior to executing the purchase agreement, the company and the initial purchasers have an informal arrangement to do a deal if there is one to be done. Either party can walk away at any time with no liability being triggered. Once the purchase agreement is signed, the parties are bound to close, typically on the third business day after pricing (T+3) but sometimes up to nine business days later (T+9).
The closing of a high-yield offering is relatively uneventful. The initial purchasers will initiate a bring-down due diligence call in which they will ask the company whether there have been any material events since the pricing. After that, the transfer of funds and delivery of the notes will take place.
The majority of high-yield bonds have a fixed coupon. The coupon is determined based on investor demand, which in turn depends on several factors, including, among others, the general market development, the financial condition of the issuer, the covenant package and the prospects for the industry in which the issuer is operating. However, we note that in recent years there has been an increase in floating rate unsecured high-yield bonds.
Describe the main covenants restricting the operation of the debtor’s business in a typical high-yield debt securities transaction. Have you been seeing a convergence of covenants between the high-yield and bank markets?
As mentioned above, covenants for high-yield bonds are generally incurrence-based, as opposed to maintenance-based. The issuer will not typically be required to maintain any financial ratios, but will be restricted from taking certain actions (including in relation to subsidiaries, except if it is an unrestricted subsidiary), unless it meets an exception to the relevant restrictions. Typical covenants relate to:
- fixed charge coverage ratios;
- credit facility and debt baskets;
- permitted investments;
- limitations on payments, liens and asset sales; and
- transactions with affiliates.
Are you seeing any tightening of covenants or are you seeing investor protections being eroded? Are terms of covenants often changed between the launch and pricing of an offering?
As mentioned above, covenant trends in 2017 were still very favourable to issuers, with covenant-lite issuances and soft-cap grower baskets being frequently used.
Covenant terms are often redrafted and renegotiated between the launch and pricing of an offering and in the marketing process, with additional covenants sometimes being added and others deleted.
Are there particular covenants that are looser or tighter, based on a particular industry sector?
If the relevant industry sector is characterised by certain customary specifics or requires more investment (eg, telecommunications), the covenants will contain adequate exceptions to reflect such industry specifics and grant more flexibility to the issuer.
Change of control
Do changes of control, asset sales or similar typically trigger any prepayment requirements?
Typically, high-yield bonds documentation establishes that, upon a change of control, the issuer is forced to make a repurchase offer for the bonds at a fixed percentage, which is usually 101 to 103 per cent. Portable change of control provisions have become increasingly popular.
There are also put option rights of the bondholders upon the sale of certain assets to the extent the cash proceeds of the sale are not reinvested in the business or used to repay debt.
Do you see the inclusion of ‘double trigger’ change of control provisions tied to a ratings downgrade?
Yes. Some high-yield bonds include a ‘double trigger’ change of control covenant, meaning there is only a requirement to make a change of control offer if there is a change of control event, which is followed by a ratings downgrade. However, this is not very common.
Is there the concept of a ‘crossover’ covenant package in your jurisdiction for issuers who are on the verge of being investment grade? And if so, what are some of the key covenant differences?
Yes, a ‘crossover’ covenant package is common for issuers who are on the verge of being investment grade. Usually there is no restricted payments covenant and limitations on indebtedness covenant might only apply to secured debt, as well as the basket mechanics.
Describe the disclosure requirements applicable to high-yield debt securities financings. Is there a particular regulatory body that reviews or approves such disclosure requirements?
In case of a private placement, there are no specific statutory disclosure requirements to be complied with and the typical high-yield debt offering disclosure standards are followed. The private placement offering memorandum does not need to be approved by the Portuguese Securities Market Commission (CMVM).
Public offerings of high-yield notes in Portugal, as well as the listing of debt securities in a Portuguese secondary regulated market, require the filing of a prospectus for prior approval by the CMVM and its registration. The CMVM will verify that the prospectus contains all necessary information concerning the issuer and the securities for investors to make an informed investment decision and that it complies with the applicable regulations (mainly EU Prospectus Directive regulations).
The prospectus shall contain all information which, according to the particular nature of the issuer and of the securities offered to the public or admitted to trading on a regulated market, is necessary to enable investors to make an informed assessment of the assets and liabilities, financial position, profit and losses, and prospects of the issuer and of any guarantor, and of the rights attaching to such securities.
Use of proceeds
Are there any limitations on the use of proceeds from an issuance of high-yield securities by an issuer?
There are very few limitations on the use of proceeds by an issuer from an issuance of high-yield securities. The more important limitations are financial assistance rules set forth in the Portuguese Companies Code (which prohibit the use of the proceeds to fund the acquisition of own shares) and anti-money laundering or similar laws, which limit the possible use of proceeds.
Restrictions on investment
On what grounds, if any, could an investor be precluded from investing in high-yield securities?
Any investor can invest in high-yield securities. A variety of investors participate in the high-yield notes market either directly or indirectly via funds investing in high-yield securities.
However, if high-yield securities are offered by way of a private placement, the nominal value of the notes must be at least €100,000 and all actions that could permit a public offering of any of the notes in Portugal or for the offering memorandum to be distributed in Portugal are prohibited, except in circumstances that will not be considered as a public offering under article 109 of the Portuguese Securities Code.
Are there any particular closing mechanics in your jurisdiction that an issuer of high-yield debt securities should be aware of?
No, there are no particular closing mechanics in the case of the issuance of a high-yield bond by a Portuguese issuer.
Guarantees and security
Outline how guarantees among companies in a group typically operate in a high-yield deal in your jurisdiction. Are there limitations on guarantees?
In Portugal, a high-yield deal comprises the granting of guarantees by material subsidiaries of the issuer (upstream guarantees) and, in cases where the issuer is not the top holdco, also by its parent company (downstream guarantee), as well as any material sister companies (cross-stream guarantees). The guarantors are usually the same as the guarantors under the senior facilities agreement.
Pursuant to Portuguese law, Portuguese guarantors may only guarantee third parties’ obligations if (i) the company has a justified corporate interest in the granting of the guarantees or the collateral, or both, or (ii) the company is in a group or control relationship with the entities whose obligations are being secured.
Under the Companies Code the definition of ‘controlling relationship’ includes relationships between Portuguese companies where one company holds, directly or indirectly, the majority of the share capital or the voting rights in, or the right to appoint the majority of the members of the board of directors or supervisory board of, the other company. A group relationship includes relationships between Portuguese companies where one is 100 per cent owned or controlled, directly or indirectly, by the other; or between companies that are bound by a group agreement or a subordination agreement, whereby one company is subject to the instructions or management of the other.
In the absence of a controlling or a group relationship, the validity of a guarantee or security interest could be challenged if there is no justified corporate interest.
In addition, the obligations under the high-yield note guarantees or collateral granted by the Portuguese guarantors shall not extend to any use of the proceeds of the notes for the purpose of acquiring shares representing the share capital of such guarantor or shares representing the share capital of the parent guarantor, or refinancing a previous debt incurred for the acquisition of shares representing the share capital of such guarantor or shares representing the share capital of its parent guarantor. This would constitute unlawful financial assistance pursuant to article 322 of the Portuguese Companies Code.
In this respect, guarantee limitation language is included in such high-yield notes guarantees or collateral to ensure that in no case can any high-yield notes guarantees or collateral granted by a Portuguese guarantor secure repayment of the above-mentioned funds.
Finally, we also outline that, for tax reasons, the obligations under high-yield note guarantees or collateral granted by the Portuguese guarantors are typically limited to an agreed maximum amount. As a result, the Portuguese guarantors will not have a direct obligation to repay any amounts once the relevant maximum secured amount has been reached, as applicable.
What is the typical collateral package for high-yield debt securities in your jurisdiction?
In Portugal, the typical collateral package for high-yield debt securities includes pledges over the issued share capital, plant and equipment (this refers to manufacturing plant and machinery, trucks, generating sets, drilling rigs and similar items), bank account pledges, and security assignments of receivables, among others.
The typical collateral package for high-yield bonds granted by Portuguese entities in connection with high-yield debt securities depends on the type of assets owned by the issuer and subsidiaries and its sector of activity. Usually it comprises:
- share security (namely, a financial pledge over the issued share capital);
- bank account security (namely, a financial pledge over the bank accounts);
- assignment of receivables (including intercompany receivables);
- security over fixed movable assets (namely, a pledge over stock, equipment or inventory); and
- assignments of, or pledges over, insurance policies and, in some cases (although less commonly), intellectual property rights.
In very few issuances, security is taken over real estate.
Are there any limitations on security that can be granted to secure high-yield securities in your jurisdiction? Are there any limitations on types of assets that can be pledged as collateral? Are there any limitations on which entities can provide security?
The limitations on the granting of guarantees are those already mentioned above for upstream, downstream and cross-stream security granted (see question 19).
If the assets of the Portuguese issuer or guarantor are covered by the immunities legally set forth - which include, but are not limited to, assets that are part of the public domain of the Portuguese Republic or allocated to public service purposes - it will be entitled to claim for itself immunity from suit, attachment or other legal process in respect of its obligations under the note guarantees.
We also note that, as a general rule, under Portuguese law, any guarantee, pledge or mortgage must guarantee or secure another obligation to which it is ancillary, which must be identified in the security agreements. Therefore, the guarantee or security follows the underlying obligation in such a way that the invalidity of the underlying obligation entails invalidity of the guarantee or security and termination of the underlying obligation entails termination of the guarantee or security.
Describe the typical collateral structure in your jurisdiction. For example, is it common to see crossing lien deals between high-yield debt securities and bank agreements?
There is no typical collateral structure in Portugal, which will depend on the issuer and guarantors and its credit profile risk, capital and financial structure.
Crossing lien structures (where lenders benefit from first ranking security and bondholders benefit from second ranking security) are not very common but we have seen them being used. This concept can be implemented in practice, although it can be more complex in relation to certain types of assets, such as real estate.
It is also common to regulate this type of issue (ranking and priority of debt and security) in the intercreditor agreement through waterfall provisions.
Finally, we have also seen structures where there is a mixed issuance of senior secured notes and senior unsecured notes.
Who typically bears the costs of legal expenses related to security interests?
In Portugal, the issuer bears the costs of legal expenses related to the transaction, including the fees to be paid by the initial purchasers to their legal counsel. The issuer also bears any expenses related to security interests, including stamp duty and registration costs.
How are security interests recorded? Is there a public register?
Bank account pledges are subject to registration with the bank with which the account is held, while share security can be subject to registration with the issuer, a depositor or a bank in the case of registered, deposited or dematerialised shares. Mortgages over real estate or registrable movable assets (eg, vehicles, ships, aircraft), as well as pledges over quotas, are recorded in the competent registry office, whose register is in both cases public.
How are security interests typically enforced in the high-yield context?
Portuguese law does not recognise the concept of parallel debt or trusteeship. The indenture will thus provide (along with the intercreditor agreement) that only the security agent may enforce the security documents in its capacity as agent and joint and several creditor, and that usually the holders of the notes will not have direct security interests. Therefore, the holders will not be entitled to take enforcement action in respect of the high-yield notes guarantee or collateral securing the high-yield notes, except through the trustee, who will provide instructions to the security agent in respect of the notes’ guarantee or collateral, or both.
The security interests are thus enforced by the security agent on the occurrence of an enforcement event and following an instruction by the bondholders or lenders in accordance with the provisions of the indenture, the intercreditor agreement and the relevant security agreement. Depending on the type of security, the ways of enforcing security can be very different. Financial pledges over shares and bank accounts allow for an appropriation of the asset by the pledgor and allow for an extrajudicial sale of the asset to the extent the rules for the evaluation of the asset are established in the contract. The enforcement of a mortgage, however, requires a judicial enforcement proceeding, whereas assignment of receivables only requires a notification to the debtor or client of the issuer to make payments directly to the secured parties.
Finally, it is common for the guarantors to grant power of attorney in favour of the security agent to enforce security and sell the assets on the occurrence of an event of default.
Debt seniority and intercreditor arrangements
Ranking of high-yield debt
How does high-yield debt rank in relation to other creditor interests?
The majority of high-yield notes are senior unsecured notes, which means that they rank equally in right of payment with all existing and future non-subordinated obligations of the issuer and rank senior to any existing or future subordinated indebtedness. If collateral is granted (which is often the case), the notes will, in practice, rank senior to any existing or future unsecured obligations to the extent the proceeds of enforcement of the collateral satisfy with priority the obligations of the issuer under the high-yield debt securities.
However, certain guaranteed credits - namely, special statutory liens (eg, real estate special statutory liens such as state credits related with real estate property tax) and movable assets special statutory liens (eg, credits resulting from legal expenses incurred in the interest of the creditors) - may rank in priority to the security of high-yield debt.
If there are privileged credits, which are credits secured by general statutory liens over assets integrated in the insolvency estate (labour, tax and social security debts), they rank in priority to common credits up to the amount corresponding to the value of the assets granted in guarantee or the general statutory liens, which means that they rank senior to senior unsecured high-yield notes.
Regulation of voting and control
Describe how intercreditor arrangements entered into by companies in your jurisdiction typically regulate voting and control between holders of high-yield debt securities and bank lenders?
The terms of the intercreditor agreement governing control of enforcement proceedings depend on the collateral structure and the ranking of high-yield debt in relation to bank debt. Structures involving super senior bank debt with lenders controlling the enforcement are less common and deals with pari passu structures provide for a right of the noteholders to participate in the control of enforcement proceedings by voting as a class.
Offsetting of interest payments
May issuers set off interest payments on their securities against their tax liability? Are there any special considerations for the high-yield market?
Issuers of securities, including high-yield bonds, may generally set off their interest payments against their tax liability. However, there is a general annual limitation to tax deduction for corporate income tax purposes of financial expenses in excess of the highest of €1 million or 30 per cent of EBITDA (as adjusted for tax purposes). Non-deductible financial expenses can be carried forward to the five subsequent years. In the event that net financial expenses of a tax year are below the 30 per cent EBITDA threshold, the difference may be used as an extra deduction on top of the 30 per cent of EBITDA during the five subsequent years.
Is it common for issuers to obtain a tax ruling from the competent authority in your jurisdiction in connection with the issuance of high-yield bonds?
No, it is uncommon for issuers to obtain any tax rulings in connection with the issuance of securities, including high-yield bonds.