Don'y be taken for a ride
Sterling corporate bond investors are wising up. Having had their fingers burned one too many times, they are now increasingly insisting on ensuring that the bonds they buy are safe-guarded in terms of covernants, and Eurobond investors on the continent may want to take note.
The sterling corporate bond market is clearly more mature than its Euro counterpart. Not only is it much older, but negative experiences have made participants wiser. Cases such as MEPC, Thorn Plc and Lucas Varity have left investors wary. The absence or weakness of covernant structures in these cases and others have resulted in shocking scenarios such as the following.
Imagine, in 1990 you buy a 30-year corporate bond issued by British Single A-rated industrial company X. Several years later this is taken over by US company Y – a Triple B credit. In the late 1990s company Y is taken over by company Z, an aerospace manufacturer that decides that an auto company does not fit into its plans. Company Z then rids itself of company X to a buy-out company, which executes a leveraged buy-out. Now in 2003 you find yourself having bought a Single A British industrial company X bond which is now junk – and you still have 17 years until maturity. “Caught with a 20-year bond that goes from investment grade to non-investment grade can kill you,” says Karl Bergqwist, Gartmore, who believes that deterioration of credit is a much bigger risk than a default. “Investors would sell out of a bond before it defaults – that’s not the risk. The greatest risk is when a credit deteriorates and the massive impact it will have on the price and liquidity.”
It has happened, and lack of protection in the form of covernants means bondholders have lost serious amounts of money. Whether they have seen their bonds pushed down the capital structure so that they have become so deeply subordinated that holders in equity have more power, or whether companies have stripped assets out leaving bondholders with little remaining value, UK corporate bondholders have been hurt.
Now, however, they are increasingly making a stand and demanding appropriate covernants from the companies to which they lend their money. In terms of company acquisitions resulting in credit deterioration, UK investors are trying to enforce a ‘change control clause’ which will protect their bonds in such an event.
One other change that is increasingly being demanded by the industry regards the negative pledge clause, whereby the company agrees that it will not pledge any of its assets “if doing so would give the existing lenders less security.” Most bonds contain this clause already, but UK investors are now calling for a standardisation of the wording, which has often been doctored to the corporate’s advantage. Bergqwist gives one example of a British company with all its assets in the UK and a cashflow in sterling. Tagged on to the negative pledge clause of one of its sterling-denominated bonds was the sentence – none of the above applies if the company issues in its domestic currency. In other words, unless an investor read the small print carefully, they could have unwittingly bought what seemed a protected domestic bond from a UK company, only to be left with nothing if the company embarked on asset-stripping. “And this is not an isolated example,” says Bergqwist. “If you want to subordinate bondholders then say so. Call a spade a spade. This is not an orderly market and bondholders are being taken for a ride.”
But the protection isn’t only advantageous to the investor. For the issuer offering significant protection enables them to borrow at a cheaper level. “It’s a win-win situation. Investors enjoy less volatility, and companies can achieve funding at a cheaper level, “ says Bergqwist. There are also cases of where bond covernants can protect a company in the event of market rumours. At the end of the 1990s Rank Group was rumoured in a Sunday paper as being in the sights of US buy-out company KKR, and saw its bond prices fall dramatically. The inclusion of a change of control clause would have prevented the dramatic spread widening and loss of liquidity.
Discussions are currently taking place between large institutions in the UK market on how to formalise covernant documentation and disclosure, but Euro investors need to take note. Admittedly the Eurozone enjoys a natural protection as its bonds tend to be five- to10-years in tenor, compared to the much longer-dated sterling corporate market, but covernants should not be overlooked, particularly as the number of longer-dated bond issues are increasing. “You just wouldn’t be able to issue a 30-year totally uncovernanted corporate bond in sterling – UK investors wouldn’t buy it. But in euros it could happen,” says Bergqwist. “The way the Euro market will grow up is when something goes horribly wrong. Continental European investors should sit up and pay attention, and learn from the mistakes in the sterling market.”