Beware of bond covenants

Read any financial publication—ours included—and you’ll see plenty of articles on how equity fund managers pick stocks. Less often discussed is the bond-picking trade.

Bond indentures contain covenants that spell out the debt’s terms, and they typically contain nuances and loopholes only a trained eye can spot.

“It’s highly unlikely that someone who didn’t spend hours reading covenants would have a good understanding of a bond’s risks,” says Heather McOuatt, a portfolio manager at Franklin Bissett Investment Management in Calgary. Covenant analysis is especially important in the high-yield space, given the higher risk of default. But it’s still essential when dealing with investment-grade issues, says McOuatt. “The default risk is low; but it does happen, so you want to make sure you know where you sit on the creditor ladder.” Here’s what McOuatt’s watching for when she analyzes covenants.

Change of control

Say you buy a bond in Opco, which gets sold to Newco. The assets that backed the debt you bought are no longer owned by the company that issued it. Does your bond have the same priority in the event of the new company’s liquidation? “We would examine the covenant to make sure any successor company supports the debt obligations of the issuer,” says McOuatt.

And sometimes, when a company is acquired, it gets downgraded as a result. To account for this, some bonds have a clause stating you can then sell your bond back to the issuer for $1 more than its issued face value (the coupon stays the same). Bond managers refer to this as a $101 put; the rating downgrade, notes McOuatt, has to be from investment grade to non-investment grade.

But there may be loopholes that keep you from getting that extra insurance. First, for a formal acquisition to have taken place, “all or substantially all” of the company’s assets have to be transferred to another corporation. But, does that phrase mean two-thirds or more of assets? Three-quarters or more? “It’s not always adequately defined,” says McOuatt, adding the question still comes before the courts.

Assuming there has been an acquisition, a precise list of conditions can limit when the $101-put clause kicks in. “They get that language as tight as possible,” says McOuatt. For instance, the covenant may specify that certain ratings agencies must state explicitly that the downgrade resulted from the acquisition. So, if all required agencies downgrade due to the acquisition, but they don’t state it explicitly, bondholders don’t get the option to sell back to the company at $101.

The covenant may also specify the number of ratings agencies that have to downgrade. Say one ratings agency exits the Canadian market between the time the bond is issued and the buyout. It may now be impossible to have the required number of downgrades specified in the covenant. That means the $101-put clause won’t apply.

Negative pledge

Many bonds have a negative pledge covenant, which restricts the amount of additional debt that can be issued senior to your bond. When this happens, McOuatt notes it often doesn’t cover what’s called “structural subordination.”

Say you buy a bond issued by a holding company that has several operating subsidiaries. Those subsidiaries may have had no debt when you bought the holding company’s bond, but if there are no restrictions on the subsidiaries’ ability to issue their own debt, it can undermine the security of Holdco bondholders.

“Opco owns the assets and gets the cash flow. So its debts are paid before it can pay dividends up to Holdco,” explains McOuatt. If Opco has a lot of debt and interest to service, there’s less available to funnel into Holdco, and that can mean Holdco’s bondholders don’t get all their money.

That’s why McOuatt prefers to buy Opco bonds when possible. But if she buys Holdco debt, it’s because she’s comfortable with the company’s dividend strategy and Opco’s limits on issuing bonds. She also ensures “there’s adequate compensation for holding a bond that’s a step away from the assets and cash flows.”

Definitions

McOuatt says a covenant’s technical terms can seem familiar, but that doesn’t mean their definitions are standard. It’s important to understand how the issuer defines “Consolidated EBITDA” because it factors into calculations determining whether a company can issue new debt or distribute dividends. “It can be defined virtually any way a company chooses,” she says. The definitions could appear on first mention, or in an appendix. Other terms to watch for:

• Fixed Charge Coverage Ratio
• Leverage Ratio
• Consolidated Fixed Charges
• Total Consolidated Debt
• Consolidated Interest Expense

These are more likely than Consolidated EBITDA to be standard, McOuatt notes. Still, check their definitions to determine “situations in which incremental debt can be added.”

Demystifying covenants

The Canadian Bond Investors Association (CBIA) has proposed a model covenant package based on straightforward language and definitions.

If widely adopted, it would streamline the issuance process, says Heather McOuatt, a portfolio manager at Franklin Bissett Investment Management and CBIA board member. It would also reduce the time-consuming detective work fund managers currently have to do when evaluating covenants, and make covenants more accessible to non-specialists.

McOuatt says this wouldn’t penalize managers who are adept at spotting loopholes in a covenant. “I’d rather have my skills go toward analyzing the company, understanding management’s calls and developing my macroeconomic forecast, than figuring out how the placement of a comma in a covenant makes a difference.”

Dean DiSpalatro is a Toronto-based financial writer.