Income-seeking invest-ors faced with a flat yield curve in the Canadian bond market and an inverted yield curve in the U.S. may be tempted to give up credit quality to get more yield. However, this is a risky strategy because, as bond quality declines, there’s more exposure to events that can wreck bond prices — and even lead to default.
Ratings and yield make the point:
> Recently, a Government of Canada 4.0% bond due June 1, 2016, has been priced to yield 4.11%.
> A 10-year AAA-rated GE Capital Corp. 5.1% bond due June 1, 2016, yields 55 basis points over the Canada bond.
> A Yellow Pages (technically, YPG Holdings Inc.) 5.25% debenture due Feb. 15, 2016, with a BBB-low rating from Dominion Bond Rating Service Ltd. pays 130 bps over the Canada, for a net payout of 5.40%.
> Deep in the junk market, a Dom-tar Inc. 10.85% bond due Aug. 5, 2017, has traded to yield 425 bps over the Canada, for a net running yield of 8.5%.
Searching for yield carries obvious risks. Some investors — accustomed to nothing more than the macroeconomic processes that set prices on government bonds — may not realize that corporate bonds carry distinct risks. For example, assets that back bonds can be squandered by special dividends issued to curry favour with stockholders; spent on mergers and acquisitions; or eaten up in stock buybacks. Investors shopping for corporate bonds have to read the covenants, which set the limits on what management can do with its finances.
Typically, covenants specify how much a company can leverage its balance sheet, establish mandatory ratios of coverage of debt with operating income, say what happens to bondholders if the company is sold, etc. The covenants are found in the bond’s trust indenture contained in the offering memorandum (a.k.a. the “circular”) that comes with the bond when it is first offered. Covenants are also available online at Sedar (www.sedar.com) for Canadian issues and from the Securities and Exchange Commission (www.sec.gov/edgar.shtml) for U.S. bonds. Off-line, one can just call the investor relations department of an issuer and ask for the document, or call an investment dealer.
Many bond investors — and some advisors — are unfamiliar with covenants. After all, government bonds don’t have restrictive covenants. The market accepts that the Government of Canada and the U.S. Treasury have the means to raise taxes to pay bondholders. Asset-backed corporate bonds provide explicit security that creditors can seize if a coupon is not paid. But general debentures that just pledge a company’s good faith and credit can be a problem.
In a current case, a deal by Jean Coutu Group Inc. to sell its 1,858 U.S drugstores for US$1.45 billion in cash and a 32% holding in U.S. drugstore chain Rite-Aid Corp. has led to predictions that holders of high-yield Jean Coutu debt will seek to stop the transaction on the theory that the deal puts management in contravention of the bonds’ covenants.
The deal gets Jean Coutu off the hook for its not very successful U.S. operations, which the company bought when it was in a more expansive mood. Rite-Aid gets more scale in the drugstore market, in which size is linked to profit. As well, Jean Coutu gets a piece of Rite-Aid and its relatively high debt, but, in exchange, Jean Coutu can use the cash in the deal to pay down its debt.
The deal, according to New York-based bond rating agency Fitch Ratings Ltd. , could force Jean Coutu to admit there has been a change of control of the company. That would trigger repayment of its bonds under the covenants. Moreover, if Rite-Aid assumes the liability to pay Jean Coutu’s US$850 million in 8.5% senior subordinated notes due in 2014, as required by the deal, Rite-Aid would have a 6:1 debt/operating earnings ratio, compared to the 4:2 ratio Jean Coutu currently has with its US$2.3 billion of long-term debt.
The dispute, which is moving the bonds from spreadsheets to courtrooms, illustrates the need for bond investors to check what they are buying. Jean Coutu benefits by getting rid of money-losing U.S. operations and gaining relatively liquid Rite-Aid shares.
“We want bondholders to be aware of the risks they are taking,” says Jamie Feehely, senior vice president at DBRS in Toronto. His advice: check the covenants in the trust indenture that sets out the rights of the bondholders to see where the debt in question ranks in terms of prior debt; check coverage of interest due; and look at covenants that restrict asset sales and the company’s ability to create additional indebtedness.
@page_break@Buying corporate bonds without reading the covenants is simply not prudent, Feehely says. “Read covenants and become familiar with the language,” he urges.
The value of being familiar with covenants becomes apparent when attempting to cut through marketing chatter to find the truth about offered bonds. The Association of British Insurers — in comments printed in the Financial Times on April 7 pertaining to regulatory proposals a day earlier by several investment groups — said: “If bond investors are told that debt is subordinated, they can be sure it will be. If they are told it is senior debt, however, the same cannot be said. ‘Senior,’ it turns out, is largely a marketing term.”
As a result, investors have to look at the covenants to determine where they really stand if there are problems at an issuing company, Feehely says.
Companies are now holding record amounts of cash following the four-year long recovery from the 2000-02 market meltdown. And in pursuit of corporate piggy banks, takeovers and mergers are unavoidable. Thus, management may try to stop takeovers by issuing special dividends or funding share buybacks. Investors who read the covenants may realize that their peril will either be erosion of balance sheets by management trying to spend cash or a change of management that could take the business down a very different path.
“You can’t just rely on a company’s good name or its current debt rating from a major agency like Fitch, DBRS, Standard & Poor’s Corp. or Moody’s Investors Service Inc. ,” says Craig Allardyce, a bond portfolio manager at Mavrix Fund Management Inc. in Toronto. “If you are buying corporate bonds, read the covenants and know what they mean.” IE
Reading corporate bond covenants a judicious exercise
Investors have to look at covenants to determine where they really stand if there are problems at the issuing company
- By: Andrew Allentuck
- October 16, 2006 October 31, 2019
- 12:54