The price of protection

The shifting dynamics of supply and demand within the UK corporate bond market have brought about a decline in investor pricing power. To redress the balance, investors are demanding increasingly stringent covenants, as Hardeep Dhillon discovers.

The UK’s corporate bond market has historically been a restrained creature. Fewer bonds and paper-hungry investors snapping up new issues have traditionally kept secondary spreads tight.

But in recent years the market has begun to lose some of its composure. The tendency for companies to issue debt across currencies means the sterling market is more exposed to the euro and dollar markets’ troublemakers. Recently bankrupt US telecom company WorldCom has a £500 million bond outstanding while heavily indebted France Télécom and Tyco, the Bermuda-based conglomerate beset by reports of accounting irregularities, have £1.5 billion and £485 million respectively in sterling bonds.

“The sterling market was previously a parochial market,” says an investment banker at a London-based bank, “with mainly UK companies issuing bonds. But now there are more foreign issuers in the market, after the increase in participation last year. And, as we have seen, those new borrowers have included companies that have since had problems.”

However, while spreads on sterling bonds in the secondary market are now more responsive, that does not mean UK investors are able to demand higher spreads at issue. Ironically the supply and demand technicals that previously kept secondary market spreads tight are still evident in the primary market.

In times of huge demand and slack issuance, like the previous few years, then investors will have less influence in the deal-making process, says Danny McKernan, head of credit at Aegon Asset Management in Edinburgh. “Investor pricing power has varied considerably with their appetite for risk,” he says.

A good deal of that is down to market conditions, suggests McKernan. There are some borrowers who could afford to issue at spread levels where investors feel comfortable and adequately compensated. The insurance sector would be particularly hard-pressed to get what they believed to be a fair-priced deal away, he says. “Pricing does not always have to be cheap. If we like a company, are happy with the covenants and the pricing is fair then the long-term opportunities would deem it a good investment. It is important that we get the fundamentals right,” says McKernan.

Structural shifts in the make-up of the sterling investor base are also weakening investors’ bargaining power. “It used to be the case that a handful of accounts dictated terms, pricing and covenants and were all UK-based,” says Jonathan Hoyle, syndicate manager at JP Morgan. “We have moved to a situation where there are more investors in each tranche and a broader type too. But we have not reached the extremes of the euro market.”

For deals that JP Morgan has lead-managed in 2002, Hoyle states that for a deal size of £250 million, anywhere up to 30 accounts have been involved, rocketing to 100 for German utility RWE’s £1.5 billion transaction. Asset managers and relative value funds have joined the hunt for paper alongside the insurance companies and pension funds, and in some cases can account for 10%-15% of a new issue.

Nevertheless, sterling investors still have more influence over issuers than their counterparts on the Continent where the investor base is even more fragmented. But this greater influence does not necessarily allow investors to dictate pricing, says Aegon’s McKernan, instead it is more often seen in the form of bond protection clauses. In the last 12 to 18 months, he adds, bond covenants have come to the forefront of people’s thinking; they are increasingly being asked for in the UK and that can compensate investors for what they lose in the pricing.

“It takes two, three or even four investors to request a certain form of protection and the banks and borrower will have to listen. The bigger fish in a smaller pond type scenario does help.”

Bernard Hunter, head of investment-grade research at Merrill Lynch Investment Managers in London, says: “We can give something in return if a company puts strong covenants in a bond. Covenants help protect us – as investors – against that very small risk of a very large negative event, like a break-up leveraged buyout. We aren’t paid for taking such risk; we are paid for taking industry and management risk.”

The covenants most demanded, says Hunter, are change of control covenants, which guard against takeovers; floating charge covenants, which stop firms from handing over assets as collateral to other creditors; and anti-securitisation rules, which stop a company from selling assets to special-purpose vehicles. Coupon step-ups are also currently in vogue, a feature JPM’s Hoyle believes is favourable to investors. “On average, investors can get 50bp per notch,” he says, “ but on average the rating differential per notch is only 15bp-20bp, so you could argue that the coupon step-ups are too generous rather than not generous enough.” Not all fund managers are so convinced the compensation is adequate.

JP Morgan’s Hoyle believes covenants can be a double-edged sword for the sterling market. “One year ago there was a lot of talk that sterling investors’ requests for more highly covenanted indentures was doing them harm. It was actively discouraging issuers borrowing in sterling.”

“We can’t dictate to companies how they run their business. It is dangerous to get to a situation where the capital markets are only open to a borrower under certain conditions. You can’t say to a company: you can’t sell or purchase assets, you can’t leverage up and you can’t buy back shares, because that company will cease to use the capital markets. Right now the pension funds and insurance companies are too long equities and need to invest in credit. And companies need to issue credit, but don’t need access to capital on restrictive terms.”

Sterling investors do agree with Hoyle that putting in place restrictive covenants can be counterproductive. “There is the question of whether sterling investors should have more input in the terms of a deal,” says MLIM’s Hunter, “but if we demand covenants that are too tight it could force the company to do something that otherwise would not be efficient. If we demand spreads that are too wide then the company will go to the dollar or euro market and bear the cost of the currency swap. We are in a global credit market and there is a limit to the power that sterling investors have.”

Irish property company Green Property is one issuer that has taken on investor concerns and incorporated more protection for bondholders into its deals. Aegon’s McKernan says the borrower learned from its earlier 2009 deal when it launched its 2016 transaction earlier this year. The deal included protection such as change of ownership, downgrade via a bondholder vote, these were incorporated into the 2009s so they were covered as well.

“In an ideal world all bonds should have covenants,” he says. “But a generalisation would be that industrials and TMT should probably have something in there because there is a lot of event risk. What with Enron, WorldCom and so on, more attention is being paid to pricing and covenants.”

Investors’ commitment to covenants will be tested when the market reopens. Investors have cash but are parking it in Gilts or triple-A paper. “Investors are not on a buyer’s strike,” says Hunter. “But will be especially watchful of the credits that we invest in.”

A £6 billion pipeline a few weeks ago has drained to only £1 billion, but JP Morgan’s Hoyle believes a good issuance could be seen when the markets open again for business in September. “July has been a slow market because of enormous volatility in the equity market but come September, if the equity markets stabilise then I would expect quarter four to be a very busy period.”

The types of deals that investment managers will probably buy will be simple stable credits. The last bonds that Aegon bought were UK supermarket Safeway and Imperial Tobacco. Neither is exciting but McKernan says they were entirely comfortable with the credits’ low volatility and attractive pricing. “The Safeway 2007s tightened 1bp [after issue],” he says. “This is not much, but in the context of the whole market trading wider, I don’t think you can put your finger on many deals that have tightened.”

Hunter puts a reflective mood on events. “It is not a credit crunch; deals are being done but when the riskier names come back we will be aggressive about pushing covenants. We do not want breaches of covenants or restrictive covenants that constrain a company from carrying out a rational strategy. But if they are prepared to include protection for bondholders that reduces asymmetrical risk – risk of a credit cliff, event risk– not only could they do larger deals but also at tighter spreads.”