Article 4.8 LBOs and bonds: animal antidote Change of control clauses may offer only limited protection to investors
Lex column
Financial Times February 26, 2013
Leveraged buyouts that load up companies with new debt to pay existing shareholders are bondholder poison. Investors are left with securities in a riskier company, falling prices and ratings downgrades.
After being caught off guard during the buyout boom of 2005-07, investors demanded some protection. Some 22% of US investment grade corporate bonds by market capitalisation, 25% by the number of bonds, now include something called a change of control clause, reckons JPMorgan, versus less than 4% in 2006.Change of control clauses enable bondholders to put their bonds back to the company if there is a change of majority control and that results in the bonds being downgraded to junk. Most, but not all of the bonds that do not have them are from issuers not considered to be LBO targets - banks and companies with market caps exceeding $20bn-$30bn.
Most of the change of control provisions would have the company buy the bonds back at 101 cents on the dollar. But that is cold comfort for investors that bought bonds at big premiums. Plunging interest rates in recent years have driven the prices of many investment grade bonds sharply higher. The average dollar price for the Barclays index tracking them is 112, for example. While change of control provisions can mitigate bondholders’ LBO risk, the extreme market conditions of the past few years mean they are no antidote for potential losses if the animals do get restless again.
FT
Source: Lex column (2013) LBOs and bonds: animal antidote, Financial Times, 26 February.
Interest rate risk (market risk)
The prices of fixed-rate bonds tend to fluctuate according to the current rate of interest. If interest rates rise, the price of the bonds will fall and selling them at the new price could result in a loss. Put provisions may build in some protection for fixed-rate bonds, by placing a floor on the price falls because the holder can insist that the company pay a certain minimum. Of course, floating-rate bonds have more protection against interest rate movements if their coupons are linked to an interest benchmark. Interest rate risk was a hot topic of conversation in 2014. Even the UK regulator warned investors to consider the consequences - see Article 4.9. Also note the hint at liquidity risk, discussed below.