Indentures are the governing legal document for bonds. They detail all the provisions associated with a bond issuance and the obligations of the issuer and the bondholders. For high-yield bonds, the indenture contains a number of specific covenants that are intended to protect investors while preserving the issuer’s ability to smoothly operate its business. While the high-yield covenant package is tailored to a specific issuer’s circumstances and the industry in which it operates, there are a number of common features in high-yield covenant packages.

Only entities in the credit group, or that fall within what is referred to as the “credit box”, are subject to the covenants package. The credit group is typically composed of the issuer and its restricted subsidiaries. Foreign restricted subsidiaries can also fall within the credit box, although they usually are not guarantors of the debt due to tax and regulatory hurdles. All subsidiaries of the issuer are deemed to be restricted subsidiaries unless they are expressly called out as being unrestricted subsidiaries. When calculating financial ratios under the covenants, the financial results of unrestricted subsidiaries are typically excluded. Since unrestricted subsidiaries are outside of the credit box, their activities generally do not impact compliance with the covenants.

The limitation on restricted payments (RPs) covenant is designed to control the amount of cash and other assets that are permitted to flow out of the credit box. The RP covenant must balance the issuer’s desire to pursue new financing and investment opportunities with the desire of the bondholders to limit the distribution of cash and other assets “out of the system” so that the issuer preserves its ability to repay its indebtedness.

The RP covenant in a high-yield indenture contains three parts:

• The definition of “Restricted Payments”;
• The conditions that must be satisfied under the Net Income Basket, also known as the Restricted Payments Builder Basket, and how to calculate it; and
• Exceptions to the limitation on restricted payments

The definition of “Restricted Payments” often includes the following activities of the credit group:

• Payment of cash dividends and other distributions;
• Redemption or repurchase of the issuer’s capital stock
• Repayment of subordinated debt prior to its scheduled maturity date;
• Making restricted investments outside the credit group, which include investments not listed in the definition of “Permitted Investments” in the indenture

The Net Income Basket, or the Restricted Payments Builder Basket, aims to facilitate the issuer’s growth by allowing it to allocate some of its net income towards making restricted payments. The issuer can negotiate a “build up” or starter amount, which enables the issuer to build up its capacity for restricted payments.

The Net Income Basket is generally calculated as follows:

• 50% cumulative Adjusted Net Income, minus 100% of any consolidated net loss; plus
• 100% of the net cash proceeds from issuances of equity; plus
• The amount of debt converted into common equity; plus
• Net reductions in restricted investments that have been made under the Net Income Basket

The issuer can negotiate the right to make certain restricted payments regardless of whether it has built its capacity under the Net Income Basket. Some common exceptions to the limitation on restricted payments include repurchases of equity from management, pro rata dividend payments to third parties, and redemptions of subordinated debt under certain conditions.