Private Credit Covenants 101

Chris Lyons

Chris Lyons, CFA

Managing Director and Group Head, Private Credit

Virginia O'Kelley

Virginia O'Kelley, CFA

Vice President, Portfolio Manager, Private Credit

Introduction

Large institutional investors such as insurance companies, pension funds and certain other long-term investors seek specific fixed income assets that provide both long duration and potentially lower losses than other choices. Many of these investors now look to private credits, also known as private placements, to provide the duration they need along with potentially higher returns and lower losses. To foster better understanding of private credit opportunities, Voya presents this overview of typical covenants used to protect the interests of private credit investors.

Private Credit Compared to Public Bonds

Private credit (or private placement) bonds are debt offerings issued by corporate borrowers. They are similar to public bonds in that, for both asset classes, companies pay a fixed rate of interest over a set period.

However, private credit holdings may also achieve additional yield and return compared to corporate public bonds of similar credit quality and duration, due to contractual limitations in each deal.

Contractual Protections for Investors

Private credits are issued under the terms of a written contract — the note purchase agreement — which sets the interest rate to be paid by the borrower and puts limits on a borrower’s business operations intended to enhance the probability that the lenders will be repaid. Such limitations, called covenants, are designed to monitor the financial health of the borrower and limit the borrower’s ability to incur additional debt.

If the borrower violates these covenants, the note purchase agreement gives lenders the right to take certain actions against the borrower, ranging from increasing the interest rate on the note to calling the notes and requiring immediate repayment in full. Covenants are unique to each transaction, can vary widely depending on circumstances and are virtually nonexistent among investment grade public bonds.1 The private credit covenants are designed to maintain pari passu, i.e., equal, treatment with other senior creditors and to force prepayment while the credit is still financeable by its banks or other lenders. When an exit is not possible, lenders can renegotiate terms to increase the yield via fees and coupon rate increases, or improve recovery rates if payment default ultimately occurs. Generally, covenants provide three types of protection:

  • Protect the note holders’ position in the capital structure
  • Protect against credit deterioration (financial covenants)
  • Protect against “event risk,” or the company favoring its equity holders over its lenders

Private credit bonds are callable at any time by the borrower; however, the call is at a “make whole” price. While technically complex, the “make whole” concept allows the investor to maintain the initial yield of the investment over the remaining term regardless of whether interest rates have increased or decreased since funding. Hence, while privates are fully callable, they are not negatively convex. Figure 1 provides more detail on the different type of covenants and their advantages.

Added Value of Covenants

We estimate the long-term excess value of covenants generally to be 46 basis points versus non-covenanted public bonds. Value comes from amendment and waiver fees, pre-payment fees, coupon increases and lower losses in the event of default.

Figure 1. Type of covenants and their advantages

Figure 1. Type of covenants and their advantages

Source: Voya Investment Management

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