Laying down the law

The debate surrounding the publication of market reform proposals by a group of leading bondholders – the so-called Group of 26 – is hotting up. Issuers have reacted negatively to what has in effect amounted to a series of ultimatums. Laurence Neville reports

The comfortable world of the sterling and euro market has been stirred up following the publication last October of reform proposals by 26 leading bondholders, dubbed the Group of 26. Privately, some issuers and investment banks are seething, and warn of the dire consequences of the proposals. Publicly, even some investors are questioning whether they have any chance of success.

The debate erupted most pertinently at the Houses of Parliament in London, where JPMorgan held an event at the end of November to gauge reaction to the proposals. Given the strength of emotion exhibited at that event, there are now fears that the leading lights of the Group of 26 – most notably Gartmore – could be getting a name for themselves as troublemakers.

Bad omens

Whatever the ultimate repercussions of the publication of the bondholders’ proposals to reform the sterling and euro market, the omens appear bad. The Association of Corporate Treasurers (ACT) issued a stark response to the discussion paper. The International Primary Markets Association (IPMA) is half-hearted in its support. So why has the non-investor world reacted so badly to the proposals? Does apparent rejection by the ACT scupper the investors’ plans?

On December 15, the ACT published its response to the Group of 26’s proposals. It is unlikely to have made comfortable reading for the group. The ACT represents around 3,000 individual members in the UK, including treasurers from most of the Ftse100. That its response is so resolutely unaccommodating to the bondholders’ demands – it is broadly speaking against the notion of change in the market – will concern those who seek change.

Martin O’Donovan, technical officer at the ACT, who helped draft the response, says that while the committee spent time looking at the individual points raised by the investors to ascertain whether they made sense, its response is not a blow-by-blow analysis of the proposals.

“We don’t feel it appropriate to enter a negotiation with bondholders on these proposals,” he says. “That is because our general feeling is that the market does not need new rules or practices. The document raised some very pertinent issues but they should be resolved between issuers and investors on an individual bond-by-bond basis.” O’Donovan says that there is no need to legislate for change even with a code of best practice; the market should be able to ascertain what is required.

This view is backed up by Robert St John, managing director, debt capital markets at Royal Bank of Scotland. He points out that it is unlikely that issuers of the quality of BP and GlaxoSmithKline would be prepared to accept a change of control clause, nor would investors expect one. But at the other end of the spectrum, issuers rated in the triple-B category that might be vulnerable to a leveraged takeover could be expected to provide event risk language to protect investors against this eventuality.

St John also provides a practical example of how the market is able to resolve its problems on a bond-by-bond basis. RBS recently lead-managed a 15-year bond for Brixton plc rated BBB+ by Fitch. The company had an outstanding bond due 2010 and it wanted to use the same package of covenants for its new issue.

Although there was plenty of demand for a new issue using the existing package of covenants, selected investors said they wanted a change of control clause inserted otherwise they would not buy it. The issuer was prepared to add this additional clause but, understandably, was only prepared to do so if it achieved a lower credit spread for that additional protection. “This was achieved through negotiation, which is what happens for most deals,” he says.

Peter Matza, senior manager, treasury at energy group RWE, who was a member of the ad hoc committee which drafted the response, says that the majority of issuers he has spoken with are of the opinion that these proposals are unacceptable and the manner and style in which they were presented is wrong.

Matza believes that the Group of 26 is not representative of all bondholders and its demands are too proscriptive. While he welcomes debate he feels he was not given the chance to contribute before the proposals were published. “I do not think that any group of investors will enhance its cause by publishing a specific list of demands. You can’t ask for a general comment on specific demands.”

The crucial point of the ACT’s response appears to be that it cannot see what benefit reform would bring to issuers. “We are unable to see clearly that the market differentiates in pricing between bonds that have what these investors would describe as adequate covenant protection, and bonds that don’t,” says the ACT’s O’Donovan. “The only conclusion to draw is that perhaps these covenants are not as important as these investors believe.”

Peter Walburg, global head of fixed-income research at DWS/Deutsche Asset Management, who has yet to sign up to the proposals, retorts: “We would like treasurers to be able to reflect on whether being unrated or having strange carve-outs is really worth the extra cost.” He explains that while the market already prices in such factors, that pricing might not be accurate because the details are not always transparent.

The negative pledge problem

Edward Eyerman, senior director, corporates at Fitch, notes that the European credit market is still at an early stage in its development, and management remain dependent on banks for much of their debt capital. Even in the UK where the capital market for corporate debt is more established there is still a prevalence of bank debt in corporate funding.

“A negative pledge which effectively prevents a company from accessing more debt isn’t realistic in many situations,” says Eyerman. “Short-circuiting access to rescue financing is unlikely to help bondholders where a company is in distress.”

The ACT points out that lending to a corporate through bonds cannot be compared with bank lending because if, with a bank deal, a company gets in trouble then it can renegotiate its terms. “That can’t happen with bondholders – not least because corporates have no list of bondholders,” says O’Donovan. “And there is no pressure from corporates to change that arrangement. As with all these proposals our position is that if it isn’t broken, don’t fix it.”

Con Keating, founding member of The Finance Development Centre, a financial research think-tank, and analyst at Sutherlands Research, an independent research firm, agrees that the proposal ignores the fundamental issue of coordination of bondholders in the event of a corporate needing to amend covenants or seek greater flexibility.

“There is no attempt to address the problem that bondholders are a disparate group compared with banks,” says Keating. “If you are a corporate treasurer and allow a covenant on a bond, it is almost impossible to renegotiate or waive it. Therefore, it will be objected to by treasurers – and indeed it should be.”

If the markets start to depend on a universal and tight level of covenants, this introduces the possibility of destabilising the market if a borrower ever gets into a debt restructuring situation, according to O’Donovan. A tight and specific set of covenants could put more power into the hands of vulture funds, who may push a troubled company into insolvency when it would be in the better interests of the borrower and its long-term and core bond investors (who invested at full price) to go through a restructuring and recovery programme.

Clifford Dammers, secretary general of the IPMA, agrees that if a company has a liquidity crisis the only people willing to put up the money to bail out that company are the banks. “But the investors are asking for the banks not to be allowed to become senior to their holdings,” he says. “How is that fair? The banks will not commit under those circumstances and the companies will go bankrupt. Is that what the investors want? I don’t think so.”

“The feeling among the sell side about these proposals is that they are slightly naive,” says Dammers. “They completely ignore the impending prospectus and transparency directive from the EU for a start [see feature, page 22] and also the fact that 80% of issuance is off medium-term notes programmes, which are clearly documented. I have met with the leaders of the investor group and they said they were aware of these discrepancies. Their arguments were considerably more sophisticated than the proposal they have written.”

Clearly, investment banks are in a difficult situation as intermediaries between investors and issuers. Most have paid lip service to the proposals; HSBC has sent a copy of the proposals to all its clients, while JPMorgan has cautiously embraced them “to show that they have their finger on the investors’ pulse”, according to one investor. Other banks such as Deutsche Bank and Goldman Sachs have adopted a ‘no comment’ approach.

But privately investment banks are giving a different message to their clients. One major European issuer, which came to the euro market during the fourth quarter, says all the investment banks that pitched for the deal mentioned that “investors are flexing their muscles” with the Group of 26 proposals. But he adds: “They all said we could comfortably ignore them.” The same issuer says that the proposals are viewed as a sterling market idea. “Nobody – not even investors who have signed up – mentioned it during our euro roadshow.”

There are areas where investment banks have some sympathy with investors. The IPMA’s Dammers says it is clearly indefensible that investors should not have access to a prospectus during a bond issue, for example. Dammers also acknowledges that investors are not trying to dictate what covenants bonds should have, just that they want them to be honestly labelled and to clarify seniority, negative pledge and other issues so that they can price them.

“But there is also a disingenuous element as most of the bondholders admit that rather than pricing things like structural subordination into bond issues, they would simply stay away from issues that didn’t have the features they want,” says Dammers.

Investor dissent

The ACT’s O’Donovan raises a point made by every issuer and investment bank that Credit magazine spoke to on this issue. “We wondered how universal the concerns raised by these proposals are among investors,” he says. The level of debate has certainly wrong-footed some investors.

“I am surprised at the level of controversy this has generated in the UK but then it is the world’s oldest democracy,” says DWS/DeAM’s Walburg. “The language used during the debate arranged by JPMorgan at the Houses of Parliament was very passionate. Before I came over to the UK I thought that the proposals would be easily adopted but I am not so sure having witnessed the debate.”

O’Donovan argues that investors should want diversity in the market because it enables them, through careful analysis, to increase returns. “No one is going to benefit from a more standardised and more homogenous market,” he says.

Investors such as Lucy Speake, head of credit management (specialist) at Insight Investment, are also concerned at the likely impact on yield levels. “There is no such thing as a free lunch,” she says. “Companies won’t sign up to these ideas for nothing. We’re in the camp of those who prefer a more flexible market for issuers. It gives us the opportunity to price the value of whatever covenants an issuer chooses to include or not include in their issue.”

Karl Bergqwist, head of research, credit investment at Gartmore Investment Management, says that he has “a real problem” with the argument that the proposals will make the market less volatile and therefore make it harder to outperform. “If badly structured bonds make up a significant part of the index, it becomes a question of investment managers having to pick the least toxic. That in my mind represents a systemic problem and is not good for the orderly development of the asset class. We have a fiduciary duty to our clients to look after their interests. Ensuring that bond investors get treated fairly is very much in the interest of our clients.”

Insight Investment’s Speake says that while there is no evidence that these proposals have directly contributed to the recent decline in sterling credit issuance, there is a danger that issuers could look to, for example, the US private placement market if they feel that they are being restricted in the sterling market. Many investment bankers agree.

“The strong growth of the sterling euro market in the 1990s was in large part due to the unregulated nature of that market,” says Speake. “It has been good for issuers and investors alike. The current market presents no major concerns. Covenants are not an issue in the vast majority of cases.”

Speake also has specific concerns about the proposals. “With regard to change of control provisions we support coupon step-ups rather than forcing the company to buy back its bonds,” she says. “These have been used in a number of deals recently and don’t restrict the company unnecessarily. We need to get the balance right between giving investors protection and incentivising issuers to use the Eurobond market.”

Walburg at DWS/DeAM says that his concerns focus on what happens with regard to issuers who decide not to comply with the ideas in these proposals and how they should be treated by signatories to the proposals. Will those investors take a stand and refuse to buy bonds from those issuers? “We can’t do that because we have a fiduciary duty to our clients to buy the best bonds for them,” he says.

“We must be able to retain the freedom to, for example, buy unrated bonds – and be paid accordingly for doing so,” he adds. “Because we have the largest credit research team in Europe we have the capacity to look at a wide range of bonds and we would want that to continue.”

“There are no planned boycotts at the moment and, of course, that is one of the problems with these proposals,” says the IPMA’s Dammers. “There are clearly a range of voices represented in the grouping – some more hawkish than others – and some members of the gang of 26 would like to see these words backed up by action. But any action would be questionable under competition law and it also raises the problem of fiduciary duty. Can they take a short-term hit for a long-term benefit to the market? It is unlikely their current clients would welcome that.”

One of the principal signatories to the proposals concedes – off the record – that the Group of 26 cannot enforce them through a buying strike because they have a duty to their clients to work in their interests in the short term as well as the long term. “But,” he adds, “if we put pressure on the right issuer at the right time then we can achieve our goals.”

“The answer to whether the bondholders’ proposals will be effective was made clear by the success of Heineken’s unrated bond recently,” says RWE’s Matza. “Of the 26 investor names on the proposal document, perhaps six of those could not buy it because it was unrated. Around 75% of those who could buy it did – even though it was unrated and an important element of their requirements is for a bond to have at least one rating. What does that tell us about the intentions of those bondholders and their reasoning behind this document? Well done to them for sticking their heads above the parapet and raising a stink. But what is there to back this up? Little or nothing.”

However, Gartmore’s Bergqwist says that failure is better than not trying in the first place. “Unless we do something, nothing will change,” he says. “We have to take a risk to back this.”

Nice ideas, poor timing

“The timing of this document is unfortunate for the investors because the market is so strong,” says Dammers. “It could have worked 18 months ago – which is when the bondholders began work on it. But now it is a seller’s market. Many of the things that are being suggested here are radical changes to the way in which our members do business. They are not going to be changed easily.”

DWS/DeAM’s Walburg agrees that this is not a good time to put forward such proposals. “Every Tom, Dick and Harry can buy bonds and see the spreads tighten and equally every Tom, Dick and Harry can issue a bond and see it snapped up by investors,” he says. Even so Walburg plans to give the proposals a thumbs-up to his investment committee. “But will I die if these ideas don’t get implemented? Of course not. These ideas would make everybody’s job a little bit easier but they would benefit small firms more than larger ones such as ourselves.”

RWE’s Matza has a typically strident view of the likely outcome of this process. “In my view the proposals have academic value only,” he says. “They have little or no chance of succeeding. Investors may well raise their individual concerns with us but most likely in private one-on-one meetings. And what happens in those meetings is private.”

Fitch’s Eyerman remains more sanguine. “The Group of 26 proposals won’t die out just because the ACT says that it’s not interested in addressing the specific proposals in the market standards paper. But the group needs to get the pension and insurance industry associations interested in the issues and co-ordinated on a position if they are going to influence issuers, arrangers or regulators. In the US many modern market standards were set down by pension fund and insurance industry associations.”

At least some of the changes demanded by the Group of 26 appear to have broad support. “The proposals on documentation are valid and provisions do need tightening up,” says John Hatton, managing director, corporates at Fitch Ratings. Says Bergqwist: “There is 100% agreement on some of the issues we have raised, for instance on disclosure of documentation. I am not aware of anyone objecting to that and therefore I hope it will be introduced sooner rather than later. Covenants are a more contentious issue and there is plenty of debate taking place.”

Tim Frost at JPMorgan believes that there are two alternatives open to the bondholder group: it can either persevere with the existing proposals or remove the sections on ratings and covenants in order to garner broader support throughout the investor industry – and indeed the wider financial market.

“Having spoken to investors and issuers there is no consensus on the issues of ratings and covenants and therefore it might be in the best interests of the grouping to drop those ideas,” he says. “We have worked with the investor grouping to refine their proposals but our job is not to lead the charge but to bring issuers and investors together on issues where there is broad support.”

With the Group of 26 planning a gathering in London in January to decide where to take their proposals next, it will be intriguing to see how this debate develops.

Giving rating agencies a bigger role Many of the specific details in the proposals were chosen because they represent market reality, according to Karl Bergqwist, head of research, credit investment at Gartmore Investment Management. For instance, one proposal – that an instrument be labelled ‘senior unsecured’ only if a maximum of 20% of total indebtedness can rank ahead of it – is based on the fact that this is the level used by rating agencies as a trigger for notching down ratings for subordination. Speake finds an increasing reliance on rating agencies in the proposals objectionable. “Rating agencies are constrained in a way in which investors are not: agencies can only make a judgement based on what facts are available at that time,” she says. “For example, S&P took Railtrack down to a junk rating because they believed the circumstances appeared to warrant it. But ultimately investors got all their money back. Rating agencies are not in a position to speculate upon likely outcomes.” Peter Walburg, global head of fixed-income research at DWS/DeAM, argues that this increased dependency on rating agencies and safeguards within the market will reduce the importance and effectiveness of a firm’s internal research capacity. “Some of the covenant suggestions in these proposals are tied to decisions by rating agencies and we do have concerns about that,” he says. “We don’t want to depend to a greater extent on rating agencies because we feel that DWS/DeAM has the research capacity for that not to be necessary.” However, Walburg also has sympathy with the view that reducing market volatility would free up analysts to use their time for fundamental research and finding relative value, “rather than trying to discover bugs that have been written in to bond covenants by the issuer’s lawyer”. Bergqwist concedes that basing triggers on ratings is not ideal as it gives more power to the rating agencies. “[But] the main advantage of ratings-based triggers is that a borrower has to convince the agencies’ analysts that a certain action is not credit negative,” he says. Con Keating, founding member of The Finance Development Centre and analyst at Sutherlands Research, remains unconvinced. “Do [rating agencies] serve by increasing scrutiny?” he asks. “Do they push for greater disclosure? In my experience they make much of the fact that they are privy to inside information over and above that available publicly. The influence of rating agencies is evidence of their possession of control rights, but where is the financial involvement or responsibility?” In short, he believes rating agencies should not be the basis for new market mechanisms in the credit markets.