Companies with below investment grade issue ratings may decide to issue high-yield bonds. The high-yield bond indenture memorializes the terms and conditions of a particular high-yield bond issuance. It contains a number of common financial tests that must be satisfied in the covenants section. These financial tests include the Fixed Charge Coverage Ratio, Total Net Leverage Ratio, and Consolidated Net Income. The tests usually apply to the issuer and its restricted subsidiaries, which are the subsidiaries that are included in the credit group.

The Fixed Charge Coverage Ratio (FCCR) measures the issuer’s ability to meet fixed payment obligations such as paying interest, rent, and debt payments. It is calculated by dividing the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by its fixed charges. The FCCR is found in the merger covenant and the limitation on indebtedness covenant of the indenture. The indenture usually requires the FCCR to exceed a 2:1 ratio. The ratio is calculated on a pro forma basis after giving effect to the incurrence of additional indebtedness.

The calculation of Consolidated Net Income (CNI) is important to understand in the context of the limitation on restricted payments covenant. The limitation on restricted payments covenant is designed to prevent leakage of value in order to preserve the issuer’s ability to repay its existing debt obligations. The term “Restricted Payments” is typically defined in the indenture to include paying cash dividends, stock buybacks, repaying subordinated debt ahead of the maturity date, and investments that are not “Permitted Investments” as defined in the indenture.

The limitation on restricted payments covenant includes a Net Income Basket, also called a Restricted Payments Builder Basket. This basket allows the issuer to engage in certain restricted payments as long as there is capacity under the basket. In other words, the basket provides an exception to the general restriction on restricted payments. The Net Income Basket is typically based on 50% of the company’s Consolidated Net Income. The next step in the calculation is to add to that amount the cash proceeds from certain equity issuances by the issuer and capital contributions to the issuer. After that, the calculation takes into account net reductions in investments made pursuant to the Net Income Basket.

The Total Net Leverage Ratio (TNLR) measures how much debt the issuer has relative to its earnings. TNLR is calculated by first taking the issuer’s total debt outstanding and subtracting cash and cash equivalents. This net debt amount is then divided by the issuer’s EBITDA. The TNLR, or a similar leverage ratio, is typically seen in the limitation on indebtedness covenant.

Other ratios that may appear in the covenants section of a high-yield notes indenture include the First Lien Leverage Ratio and the Consolidated Secured Net Debt Ratio. The First Lien Leverage Ratio is calculated by taking the secured indebtedness amount and dividing it by EBITDA. The Consolidated Secured Net Debt Ratio is calculated by taking the consolidated total indebtedness secured by a lien on collateral and dividing that amount by EBITDA.