By Mitch Reznick and Fraser Lundie
Investors should read the fine print before reaching for more yield. Wellknown bond structures, such as 10-year maturities with five-year “non-call” periods in which issuers can’t refinance the securities, are gone for now. Instead, maturities are getting shorter, call dates closer and investor protections weaker as the legally binding agreements in bonds, known as covenants, are being relaxed in companies’ favour.
Some of these deal features are more common in the loan market, and as companies continue tapping credit investors for debt rather than banks, they are being applied to bonds. Issuers are also exploiting investors’ strong appetite for yield, the market’s scarce liquidity and record-low interest rates to issue debt on terms that better suit them.
This isn’t nefarious in itself. However, as investors we must gauge how much additional risk these changes create and calculate whether they are factored into bond prices. This means spending more time reading the back pages of offer documents and digging into covenants to accurately price deals that give more flexibility to the sponsor and potentially lower returns to investors.
Comparing new bonds with existing issues – and not buying the most recent simply because they are more liquid – in search of better value is also important.
The bond issued by SBB/Telemach shows how bond structures are changing. The Serbian cable and satellite operator’s seven-year, €475m senior-secured bond will partially finance private equity group Kohlberg Kravis Roberts’ (KKR’s) acquisition of the company. KKR contributed about €590m in equity to support the deal – at more than 50%, this exceeds the normal amount for such financings.
We believe the deal has been structured to enable KKR to reduce the size of its equity commitment more quickly than past bond structures have allowed. For example, the conditions restricting SBB/Telemach from allowing cash to leave the legal borrowing entity, called the restricted group, are more relaxed than in previous high yield bonds. This lets the company use capital more freely and may affect its ability to repay bondholders, and should be considered in pricing.
Some of the more liberal aspects of SBB/ Telemach bond covenant are:
• Being able to more easily raise the allowance from the restricted group to release cash to entities other than bondholders. This is achieved by growing the allowance, known as the restricted payments basket, at full EBITDA minus 1.5% interest, compared to the 50% of net income applied in previous high yield bonds
• Exceptions that allow company cash to be used to service the debt of a business outside of the restricted group
• Permitted stock dividends if leverage falls below three-times EBITDA
• A change-of-control put option, called a “portability” feature, allowing the company to shift its capital structure to a new owner under certain conditions in a takeover
These conditions suit the issuer’s interests. In addition, SBB/Telemach can redeem 10% of the bond at 103% of its nominal value during the three years prior to the first call. This feature limits the potential upside of the bond.
We liked SBB/Telemach’s credit fundamentals. But we considered its latest bond to be over-valued given the weaker covenants and call structure. Immediately after being issued, it rose two points above its re-offer price of 100 in the secondary market. Now it trades about 50 cents below par. We could not have forecasted this price movement, but suspect that the risks of its weaker structure are now being priced-in more accurately.
High yield bond covenants and structures are changing as European banks pull back from the lending market. Investors must pay close attention to how returns may be influenced and their protections weakened, and decide whether they are getting paid for these risks. This, plus the ability to compare new issues with existing debt, will help investors find value.
Mitch Reznick and Fraser Lundie are co-heads of Hermes Credit
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