Hybrid loan and high yield financing

Europe has recently seen a number of financings in which capital is raised by a combination of secured loans and high yield covered bonds ('covered' bonds are secured by specific assets of the issuer). In these arrangements, lenders and bondholders rank equally in the distribution of assets in any insolvency, as both are secured creditors of the borrower/issuer. This is a relatively new development, as traditionally bondholders hold unsecured debt and are paid in insolvency, if at all, only after secured creditors.

As bondholders in combination financings rank equally with lenders, new issues arise as to who may enforce a security and in what circumstances. In particular, creditors' interests may differ where the borrower/issuer may have defaulted on (for example) its loan facilities, but not on its obligation to pay the coupon on its bonds.

Recent financings have dealt with these issues using provisions such as:

• enforcement against the security being controlled by two-thirds of lenders, giving lenders primary control over enforcement until the loan facilities are reduced below a certain threshold, after which enforcement is controlled by a majority of all secured creditors (that is, lenders and bondholders); and
• to ensure timely decision-making, time limits on voting, after which the debt of non-voting creditors is excluded for the purposes of making enforcement decisions.

The market for combination financings is still evolving and it remains to be seen how arrangements between creditors will develop in light of experience.

It has been reported that the Australian Government is considering allowing Australian banks to issue covered bonds to provide banks with cheaper financing to offset banks' increasing funding costs.