On the Fritz

martin fridson

Try this self-test of your financial acumen:

You are in the market for a new car. With auto sales slumping, one of the manufacturers offers a long-term extended warranty at no extra charge

Do you:

a) Grab the deal?

b) Buy, but decline the warranty on the grounds that you believe the manufacturer will lose money by throwing it in for free?

My guess is that the majority of high yield bond managers will take only a fraction of a nanosecond to reject option ‘b’. Strangely, though, many of those same managers will probably condemn the next issuer that exploits a supply shortage by including a covenant more advantageous to itself than the norm. Some portfolio managers will go so far as to declare the indenture unfair to bondholders.

Even more paradoxically, the denouncers of the ‘greedy’ company will include many professed champions of the free market. Their cardinal principle is that nobody should interfere with contracts involving lawful actions, as long as the parties involved are mentally competent adults who are not acting under coercion. On what grounds then can they possibly object to a bond offering that has investors fighting for allocations? Surely, there are not that many underage, deranged high-yield managers being held at gunpoint. The ordinary assumption about a blowout deal is that the buyers, as well as the sellers, judge it beneficial to participate.

Perhaps recognizing that fairness does not really enter into the equation, portfolio managers sometimes try to wise up an issuer to its own self-interest: “Don’t insist on this nonstandard covenant. Bondholders will punish you next time you come to market.”

This argument assumes that there will be a next time for the issuer. Even if the company’s owners do intend to tap the high-yield market in the future, they may be betting that there will always be occasional windows of opportunity for disliked issuers. They may be mistaken in that judgment, but an error is different from an ethical lapse. Investors are better off reserving their indignation for actual misdeeds, such as self-dealing and dishonest financial reporting.

A related argument involves the notion of ‘negative spillover’. The argument runs thus: “You’re spoiling it for future issuers. Their borrowing cost will be higher because your investor-unfriendly deal will damage the high-yield market’s reputation.”

Granting the premise, one must ask why an issuer would not want the other fellow to pay, if it could get away with it. When a financier proposes to inject equity into a distressed company, high-yield investors do not protest at the windfall they are about to receive as the default risk of their bonds diminishes. On the contrary, they protest at the terms of the accompanying exchange offer, by which the company’s savior attempts to recapture a portion of the windfall.

Negotiating vigorously on exchange offers is certainly a rational, self-interested response. That makes it all the more surprising that many bond investors expect issuers to act irrationally by ignoring the opportunities that arise when the supply/demand balance veers lopsidedly in their favor.

Then again, a few charitable souls probably exist who would never dream of accepting an extended warranty, merely because they have the other party over a barrel.

Martin Fridson is a veteran of high-yield analysis and founder of FridsonVision, a high-yield research firm (www.leverageworld.com).

Comments to onthefritz@creditmag.com

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