Clients who invest in bonds will have to be a lot more careful in the wake of the Supreme Court of Canada’s decision concerning the leveraged buyout of BCE Inc., rendered on June 20. The decision, which reversed a Quebec Court of Appeal ruling that LBOs of the BCE variety could not rip the rug of security out from under bondholders, affirmed the primacy of stockholders.

The focus of the case was the planned LBO of BCE by several private-equity firms, which would have turned some of the corporation’s bonds that were formerly considered investment-grade debt into deeply subordinated obligations with subinvestment-grade ratings. That process would have eviscerated what the holders of the bonds thought were good security. The SCC held that BCE did not have to compensate owners of bonds that would drop in value when the LBO turned them into lower-rated debt.

The decision’s implications for debt markets are slowly emerging. Clearly, the SCC spoke to the issue of bond quality — that is, the ability and willingness of companies to treat debt with respect. At the very least, the BCE decision took bonds off any pedestal of respect higher than that accorded to equities.

“We always knew we did not have a lot of rights,” says Chris Kresic, senior vice president for investments with Mackenzie Financial Corp. in Toronto. “Equity holders have the vote, and the BCE decision just solidifies that view.”

All corporate bonds are potentially affected by the BCE decision. Moreover, the ruling came at a moment at which stock prices were down in financial services. Low share prices are opportunities for companies to buy others whose prices put them on what amounts to deep-discount sales.

Bond covenants are changing in anticipation of more LBOs to come. And clients — at least, those who do not want to see their bonds shrivel in value at the prospect of subordination — can shop for old issues with relatively strong covenants.

A traditional, relatively strong change-of-control provision is in Great-West Lifeco Inc.’s 6.74% bond issued in November 2001 and due Nov. 24, 2031, which states: “So long as any of the debentures are outstanding, the corporation will not create, assume or suffer to exist any security interest or any of its assets to secure any obligation unless, at the same time, the corporation shall secure or cause to be secured equally and rateably therewith all the debentures then outstanding and the corporation will not merge, amalgamate or consolidate with or into any other corporation or sell, convey or dispose of all or substantially all of its assets to any other person unless the successor company assumes all of the obligations of the corporation.”

There are ways around this covenant in the language referring to the “successor company,” but the intent and the reassurance is obvious.

Bonds issued in anticipation of the BCE decision and those issued subsequent to it have vastly changed takeover covenants.

“Covenants were getting lighter and lighter as the year went on,” says Craig Allardyce, vice president for fixed-income with Mavrix Fund Management Inc.in Toronto. “It used to be that there was hard language that would protect you. Not now. Covenants are no longer highly protective to the bondholder concerned about subordination.”

For example, the Thomson Reuters Corp. 5.70% bond due July 15, 2015, issued in June, has language designed to scare off any suits from debtholders miffed that a takeover of the company or perhaps by it might impair the standing of the bonds: “No implied cov-enant, agreement, representation or warranty will be read into the trust indenture against us, including any covenant, agreement, representation or warranty pertaining to the protection of the reasonable expectation of holders. For greater certainty, representations, warranties and statements made by us or on our behalf will not give rise to, or form the basis of, any reasonable expectations of holders pertaining to the notes.”

The covenant goes on to say that even if bondholders assert a theory of default or omission or some other inconsistency, the holders cannot make such assertions. In other words, even if the company is wrong in some fashion, bondholders will have to climb a very high wall to make a case that they were hurt in ways that they did not anticipate.

Clearly, bond issuers have been emboldened by the BCE decision. They can now say “that the only right you have to sue is if you are not paid,” Allardyce says. The new style of covenant would seem to reduce the rights of bondholders to the most elemental one of the debt contract, he adds.

@page_break@Other bond managers agree that the BCE ruling does nothing to support bondholders in the event of buyouts, material change of control or, for that matter, anything else that a company may do.

“Bondholders are disadvantaged, so investors will have to do their homework,” says Edward Jong, senior vice president, fixed-income, with MAK Allen & Day Capital Partners Inc. in Toronto and manager of frontierAlt Opportunistic Bond Fund. “Old bonds had the safety of not being like equities. Now, the Supreme Court has said that bondholders don’t really have special rights apart from the right to be paid. It’s buyer beware.”

The implications of the SCC decision for bond investing are broad. Nevertheless, it’s hard to prove that new-style covenants have expanded the yield spread of new corporate bonds over government issues. After all, as Allardyce notes, the ongoing credit crisis is probably the stronger force in determining spreads. Today, bond investors who want to know how borrowers are using their money should stick to issues from banks, which have elaborate disclosure procedures and ratios to maintain; and bonds from insurance companies, which are also highly regulated.

Government bonds do not have credit issues and are not part of the concerns raised by the BCE case. Those bond buyers who want higher yield, Allardyce adds, will have to give up some expectations on disclosures of ratios and other leading indicators of security.

So, will the BCE decision last? In law, the SCC has spoken. In the market, there may be increased pressure on issuers.

“In the future, bondholders may demand stronger covenants,” says Randy LeClair, senior vice president and bond portfolio manager with AIC Ltd. in Burlington, Ont. “There could be pressure for standardized covenants, although there is no sign of that for now.” IE