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Understanding Bond Guarantees

Bond terms become increasingly important as we move from an investment grade bonds to a non-investment grade bonds. The non-investment grade bonds are usually less liquid compared to investment grade bonds. Therefore, it becomes cardinal to understand the terms and covenants applicable on a high yield issue before going ahead with an investment. In order to understand the terms and conditions associated with a high yield bond the primary source has to be its prospectus. A prospectus is a very important document with representations and warranties by the company and therefore makes it an important tool in making an investment decision. In a prospectus, the summary terms are usually shown in the first few pages and further detailed information is provided in the later pages. The summary terms are useful but that shouldn't be treated as the final information. There are certain provisions that are called "carve outs", which can be understood only after reading the detailed terms of a high yield bond issue.

To begin with, it is necessary to understand the issuer and its position within the corporate structure. In case the issuer is an operating subsidiary, then it is generally beneficial to the bond holders as they are closer to cash generating assets. In case, the issuer is a holding company or a financing subsidiary then we need to know whether the issuer owns any operating assets. If the issuer doesn't own any assets, then the next thing to check is the presence of any guarantee structure. For a holding company or a financing subsidiary, there could be guarantees from operating subsidiaries. These guarantees are referred to as upstream guarantees. Even in case of an issuance from operating subsidiary there could be guarantees from the parent company and other subsidiaries. A guarantee from the parent entity is referred as downstream guarantee. If a guarantee is present then it may be further helpful to know what percentage of revenues or earnings before interest, tax, depreciation and amortization (EBITDA) is attributable to the guarantor group. A high percentage is expected to support the bond price as investors generally likes to stick with a bond with strong terms owing to safety of capital.

There could be subsidiaries that are not governed by the bond terms. These subsidiaries are called unrestricted subsidiaries as against restricted subsidiaries, which fall under bond terms. If the unrestricted subsidiaries represent a major portion of revenues and assets, then it could create troubles for the bond investors during a distress situation of the bond issuer. In case of a default, the obligations of non-guarantor and unrestricted subsidiaries are treated as structurally senior, and therefore there could be losses. Therefore, it is very important to understand guarantee structure in a bond prospectus. That said, one should understand that guarantees, even if present, could be a weak guarantee and detailed research is warranted in that case.