Looming leveraged buyout crushes BCE bonds’ value

But not all BCE bonds are equal; the bonds’ covenants have turned the issues into “Hell’s Bells” and “Good Bells”

The looming leveraged buyout of BCE Inc. by U.S. private-equity firm Cerberus Capital Management LP and possible allies (the Canada Pension Plan Investment Board, New York-based buyout firm Kohlberg Kravis Roberts & Co. and the Caisse de dépôt et placement du Québec) has pumped up BCE’s stock price by a third of its value. However, it has also put the company’s bonds into limbo.

As a result, bondholders — suddenly faced with the possibility that the cost of making BCE pay for its own demise as a public entity will devastate the credit rating of its outstanding bonds — have been hit hard. For instance, long BCE bonds, such as those due in 2035, have dropped by 20% in market price.

BCE bonds have traditionally been investment vehicles that kept widows solvent and orphans fed. They are among the most widely held bonds in Canada. Yet, those widows and orphans now have good reason to worry. BCE’s bellwether 5% bonds due in 2017 lost $15 per $100 of face value when the potential LBO was announced.

However, not all BCE bonds are equal. The bonds’ covenants have turned the issues into what the Street has been calling “Hell’s Bells” and the “Good Bells.” Moreover, it’s not just the particular issues but also the domicile of the holders. For instance, in the U.S., BCE bonds have dropped by just a few percentage points, thanks to legislation — the Employee Retirement Income Security Act of 1974 — that puts money managers in the shoes of fiduciaries required to protect the interests of their beneficial owners. The ERISA has had the curious side effect of making the Canadian bonds a cheap deal because no legislation here will force money managers to litigate on behalf of clients.

Credit-watchers have placed the ratings of BCE and its operating company, Bell Canada, under review. DBRS and Moody’s Investors Service Inc. have warned that the LBO and the resulting inflation of BCE debt could push the BCE bonds into junk territory. If that were to happen, many institutional managers would be forced to dump BCE debt. The vultures would feast as widows and orphans — who have counted on BCE to be a bulwark for their fortunes — suffer potentially massive losses.

However, a bond buyback could be in the cards for the “Good Bells,” according to Harry Koza, a senior market analyst for Thomson Financial in Toronto. Holders would also get accrued interest and an extra $1.5 billion for early retirement of the debt, he suggests.

Bell bonds issued with a 1976 indenture have covenants requiring minimum limits for interest coverage and a maximum for debt/tangible property. Those conditions limit the ability of a buyer of the company to add too much age to the balance sheet. There is also a clause that requires any transaction not to be prejudicial to the interests of bondholders.

Meanwhile, Bell bonds issued under a later, 1996 indenture do not have the limitation on debt to assets ratio, but they do have the restriction on acts that may hurt bondholders. The market has read the covenants as meaning that the 1976 bonds are effectively immunized against LBO-generated mayhem and thus has put premium prices on those bonds.

As a result of all this speculation, the outlook for BCE and Bell Canada bonds is cloudy. On May 26, DBRS issued a ratings statement indicating that although the obligations of both the holding company and the operating company continue to have investment-grade ratings, there would be a review with negative implications: “DBRS notes that there is a potential that all or some of the bonds could remain in place and subject to a significantly higher financial risk profile. While DBRS acknowledges that there are certain covenants protecting senior unsecured bondholders at the Bell Canada level, which may lead to these bonds being called, there is no certainty at this stage that this will occur.”

In other words, holders of all BCE and Bell Canada bonds could wind up with a lot less security.

Koza suggests that the bonds with strong protective covenants will be redeemed, leaving the less protected debt subordinated to other debt.

@page_break@But the covenant protection is better because of the older indenture, says Peter Kotsopoulos, executive vice president for fixed-income at McLean Budden Ltd. in Toronto.

“If you come to the market to borrow, then you have to respect the debt on your previous lenders,” he says. “If they leverage up the Bell name and all bondholders lose, the next time, there will be premium yield spread.”

KKR may figure that there is so much fat at BCE that it can cut costs and get more free cash to pay its bills, Kotsopoulos says. The risk remains that if the bonds fall below a BBB rating, there would be a cascade of bonds onto the market.

“If the company stops paying interest, it is because it is in big trouble. And if the company is in big trouble, it might have to stop paying interest,” he says.

Institutional managers are not rushing to buy discounted BCE and Bell Canada bonds. The potential for a major gain once the smoke clears has been offset by the possibility that an LBO could trigger a downgrade to junk status. The risk to bondholders, especially those that are not permitted to hold high-yield bonds, is substantial. The outcome depends on the manner in which the transaction is consummated, says a Bay Street money manager.

DBRS has taken what it admits is a critical view of a potential outcome, says Chris Diceman, the rating agency’s senior vice president. As well, he notes, the lack of a high-yield market in Canada implies that if the bonds do go below BBB (low), the lowest investment-grade rating, to a speculative BB rating, there could be a lack of buyers to soak up the flow.

“Canada does not have a substantial high-yield market. So, if the bonds’ ratings decline, there would not be a lot of money rushing to buy them,” he suggests.

Limbo is not a good place to be when your mandate is to hold only investment-grade bonds or when clients plan to start living on their investments. If private equity wins BCE, individual investors could wind up footing much of the bill. IE