Page 35 - Newcom

YIELDCURVE
by DEAN DiSPALATRO,
senior editor of Advisor Group
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
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 hap- pens, 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 37
VITALY KOROVIN/THINKSTOCK
“IT’S HIGHLY UNLIKELY THAT SOMEONE WHO DIDN’T SPEND HOURS READING COVENANTS WOULD HAVE A GOOD UNDERSTANDING OF A BOND’S RISKS.”
Change of control
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.
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 obliga- tions 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
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