A revolt by bond buyers has slowed the recent trend of issuer-friendly deals, but market participants say that will not last without big changes to the way investors scrutinise new deals.
Several issuers scrapped controversial terms in deals last month after investors refused to buy them unless they were removed – and the furor is still a hot topic weeks later.
Some described the scale of dissent as unprecedented – but investors clearly thought enough was enough and won the battle.
“There is a huge change in mindset among new issue buyers who have been buying billions of dollars worth of bonds in the last few years without raising any fuss,” said Adam Cohen, founder of research firm Covenant Review.
Covenant Review, set up in 2006, focuses on bond and loan covenants and provides institutional investors with perspectives on their rights as bondholders.
Cohen, a corporate finance lawyer, brought the new covenant change to the attention of the buyside and urged investors not to buy the deals unless the terms were taken out. That triggered the huge investor backlash.
“They (investors) are now drawing red lines and saying they won’t cross them,” said Cohen.
Companies such as Broadcom, General Motors Financial and Fibria Celulose had to withdraw language from bond documents that would have spared them paying an expensive make-whole premium in the event of a default triggered by several actions including a simple covenant breach or bankruptcy.
Marsh & McLennan retroactively removed language from its bonds as the backlash intensified.
Days later, investors were emboldened to push back in a bond exchange offered by Verizon, asking the issuer to add step-up coupons after talk surfaced that it was acquiring Charter Communications.
It declined to do so, but investors tendered far fewer bonds than it had initially hoped.
Companies, for now at least, are hesitant about rocking the boat and bankers are being careful to engage the buyside early.
Discussions about possible new covenants that would protect issuers in the event of major tax changes, for example, have been ongoing over the past few weeks.
“There appears to be a bigger focus on covenant language at the moment from top institutional investors who have recently been flexing their market power,” said Eddie Best, the co-leader of the global capital markets practice at law firm Mayer Brown.
“It seems to be coming from a perception that issuers have been chipping away at provisions in bond documents which were considered to be standard bondholder protections and that, at least in some instances, issuers may have gone too far.”
STICKING TOGETHER
Many are sceptical, however, that investors have the tools to remain as disciplined as they have become in recent weeks.
The buyside has limited time to read through hundreds of pages of bond documents due to the rapid fire-rate at which bonds are sold – and that is unlikely to change in the near term.
“It’s always hard to read every line in the covenant before you buy and there is a presumption that the indenture package is similar to the previous one and no changes are being made,” said Jason Shoup, a senior analyst at Legal & General Investment Management America.
“Especially with IG bond packages, we are not really afforded the time to comb through them to the degree required.”
They often have to commit to buying and prices, on average within just an hour or two after bonds are announced.
The Credit Roundtable, an investor lobby group, complained to regulators in 2015 that buyers were not given enough time to properly analyze new deals.
But the practice of buying and selling still did not change.
The frantic pace of supply – the US investment-grade market saw its sixth straight year of record issuance in 2016 – and the rise of passive investors such as exchange-traded funds and index-trackers has also given more power to issuers.
“Investors are less discriminating in strong markets, so issuers can get away with more,” said David Knutson, head of credit research for the Americas at Schroders.
“As passive investors become more prominent, there is not as much active research going on or discriminating between a good indenture and a weak indenture.”
OVER THE TOP
Many borrowers – and their legal counsel – still believe that they will be able to insert issuer-friendly terms on the off-chance that investors might not object, or indeed notice.
“There are instances when an issuer would want to insert a covenant in page 23 of the indenture, which probably was not that investor-friendly,” said one senior banker.
“We would advise against it, but they would insist on leaving in, and that if someone objected they would remove it. The deals would go through.”
If investors want to have more say over the long haul, some say they need to be better organised in groups and pressure issuers to standardise covenants – a difficult thing to do when companies’ credit profiles and overall businesses are so varied.
At the very least, issuers should highlight any changes in their traditional covenant packages in the risk factors of bond documents to make them more visible.
Best at Mayer Brown said issuers know they need to foster good relations with institutional buyers – and that some of the uproar was overblown.
“Recent covenants changes proposed by issuers are being framed as some sort of conspiracy against investors or a ‘war on covenants’,” said Best.
“[But] these proposed covenant changes are just testing the boundaries of what investors will accept.”