Cut your reading time and listen to a podcast instead. This week's BondCast looks at the rules put in place to protect bond holders from events such as company acquisitions
Learn more about which bonds are on the move with this weekly podcast. Tune in as our senior relationship manager, Jake Koundakjian and Director of Client Education & Research, Elizabeth Moran, discuss covenants such as change of control and debt incurrence designed to protect bondholders. We touch on speculation of SCT going to an initial public offering (IPO) and analyse the effect of covenants found in Barminco, RSCA, Virgin and Qantas bonds. See the transcript below.
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Director, Fixed Income Sales
Jake grew up in Ottawa, Canada, where he rose from a teenage bank teller to a portfolio manager overseeing more than $600 million in assets for the Bank of Nova Scotia. With over twenty years in asset management he moved to Australia seven years ago with his family.
Director, Education and Research
Elizabeth has been with FIIG for ten years and for much of that time has been a corporate and bank analyst. In recent years her passion for education has seen her role shift, to author/ edit FIIG’s “The Australian Guide to Fixed Income” and an online fixed income course for Financial Advisers. She continues to edit FIIG’s weekly newsletter, “The WIRE”.
In her role as Director of Education, Elizabeth has delivered presentations at conferences across Australia. Prior to joining FIIG, Elizabeth worked as an Editor/Analyst for Rapid Ratings, writing daily press releases for Bloomberg. Elizabeth spent five years in London, three working as a credit rating analyst for NatWest Markets.
[00:00:00] Elizabeth Moran: Good afternoon. Welcome to another edition of BondCast. I have with me today, Jake Koundakjian. Hi Jake, how are you?
[00:00:06] Jake Koundakjian: I'm great Liz, how are you?
[00:00:06] Elizabeth Moran: I'm well, thank you, pleased to be back after a few weeks on the road actually. So today we're going to talk about what happens to bonds if companies are taken over or if there's a change in the company structure. We read in the paper over the weekend about SCT, one of the FIIG originated bonds. SCT is a privately owned company. We read about the speculation of it possibly going to an IPO. You want to comment on that, Jake?
[00:00:38] Jake Koundakjian: There's speculation it's written in the AFR, so who knows. But I think what we're going to talk about is the rules that are put in place on bonds. These are legal debt obligations that have specific rules to protect us as bondholders, so you know we can touch on SCT and a few other names that we've seen in the last several years and how management is influenced by the rules that are put in place. Covenants, is what they're called on bonds. There's two basic types, there's maintenance and incurrence covenants. Maintenance ones are adhered to at all times and incurrence ones are protections, I guess.
[00:01:18] Elizabeth Moran: So what happens when a company takes over another company? We have to go back to the terms and conditions in the original information memorandum to see what happens or what protections there are for bondholders in that instance. So if you get a big company with a fantastic credit rating overtaking a smaller one with a not so good credit rating, often what you'd see is the smaller one, where you have quite a lot of risk, the bond price will rise with that new parent company taking on responsibility for the debt.
[00:01:54] Jake Koundakjian: Yeah totally, that's a change of control protection. And I like it when my bonds are taken over by stronger companies. What I don't want is an acquisition by a weaker company. I think in the 80s the leverage buy out phase was pretty popular. So the change of control clause typically is priced at $101, so you have the right, but not the obligation, to put back the bonds at $101 for every $100 you own. So it's a protection in place an example is Barminco is now in the process of being taken over by Ausdrill. They're in talks right now, specifically talking about the specific rules on that. There is a change of control, but what I understand, the Barminco change of control, only triggers if it's a downgrade - so it protects bondholders if a smaller, riskier company takes over. From what I can see Ausdrill is a stronger company and the credit rating agencies probably will upgrade the overall company. So we’re talking protection in place in case of downgrades. With SCT being the fourth largest logistics train company in Australia. Just hashing through the details… If it does actually occur then the change of control could be triggered, but it would be in our hands, it would be our choice. So if a larger company buys them out, maybe I don't want to be putting it back. Maybe I want to only continue, you know, if the SCT bonds are being paid by a much stronger company.
[00:03:21] Elizabeth Moran: I guess it also depends too where the bond price is trading because if you've got a bond that's already trading at $103 or $104, even if it's taken over, that change of control option, unless the price comes down under the change of control value, if it's $101 or $102 or whatever it is, you're not going to sell it back or want your money back, you're going to hang onto it, aren't you?
[00:03:43] Jake Koundakjian: Yeah absolutely I think, RSCA is another one that is one of the smaller of the FIIG originated bonds that we have outstanding. There was a change of control and in that case we didn't want to put it back, we wanted to continue to own it. But that same change of control can act, I guess, as a dagger dangling over management as they always have to be ready to pay us back if we want to sell it back to them at $101. So it can be an incentive for management. All those covenants are there to make sure that we're protected.
[00:04:19] Elizabeth Moran: That's definitely true and certainly in the case, not that long ago, we had a FIIG originated bond, the Coffey one. That was a company not doing so well here - it had mining services but also aid distribution as part of its services. So it was quite diversified, although it was a smaller company. And you know it was trading in the mid-80s range and fortunately an American aid distribution company bought it out and you know it was such a small amount for them and they overpaid for the bonds
[00:04:56] Jake Koundakjian: I think they paid $106.50 for the bonds so it ended up being a good result overall for holders. But yeah, the change of control, we didn't trigger it at $101. They bought it back at $106.5. So excellent result and that was a few years back.
[00:05:16] Elizabeth Moran: One of the other companies I want to touch on, because it is often speculated, is Virgin. You know, would someone take over the airline and what would happen to those bonds in that instance? You know it’s a B- rated credit so it is very high risk really.
[00:05:39] Jake Koundakjian: It's higher risk and higher yielding of course. There is a change of control on the Virgin bonds from what I've seen and what I can remember. So for stronger companies buying me out in my Virgin positions, I might not want to sell it back at $101 and be happy. You know let's stay with Air Canada, which is a stronger credit, being Canadian. Air Canada came in and said they want to get a foothold in Australia. They want to pick up Virgin under their brand name. You know, I'm just speculating here.
[00:06:03] Elizabeth Moran: Yes, we're just talking through the mechanics of it.
[00:06:03] Jake Koundakjian: Yeah, from what I recall, Air Canada is investment grade. I would love to continue to own all of my Virgin positions because payments would come from a stronger company but I would always have the right to put it back at $101.
[00:06:10] Elizabeth Moran: Exactly, but what you would expect in that instance is the price to go up, it wouldn't go down.
[00:06:10] Jake Koundakjian: Absolutely, because I feel more secure that I will be paid. Virgin is a B- rated, whether it's Qantas, I don't think that would ever occur. Qantas is rated investment grade and is a stronger credit. To be paying the bills makes me more confident that I am going to be earning my 7% or 8% coupon or whatever it is on the Virgin position. Do you think we should also touch on some of the other covenants?
[00:06:43] Elizabeth Moran: For sure, we can do, let's do that. There are a number of other ones, shall we talk through them?
[00:06:51] Jake Koundakjian: Yeah, I think the restricted payments are pretty important, especially for companies that are more equity centric. These are one of their restrictions to restrict payments to pay dividends or buy back shares. I don't want as a bond holder, them paying dividends. I want them to be saving cash to pay me back. And so there are restrictions, restrictive payment covenants, which protect us to make sure that they don't just spend all their money on buying back shares in the marketplace. There are also limitations on indebtedness. They can't just keep on adding more and more debt ahead of me.
[00:07:26] Elizabeth Moran: That's a really big one for me, that debt incurrence. You know you want to make sure you keep your position in the capital structure and you keep the subordination and if they're adding debt in front of you as a bond holder, you have been increasingly subordinated and the bonds are increasing in risk. So I mean it's a fairly standard covenant in any of the FIIG deals.
[00:07:48] Jake Koundakjian: But of course, if you breach any of these that's a default and then we can take over the company. So there are rules in place and if anybody who is a regular investor in FIIG originated bonds, we send around all the details on each deal. You could take a look at the covenants in there and ask your friendly relationship manager for some of the details on each one.
[00:08:08] Elizabeth Moran: So just summarising with SCT, a potential IPO reported in the AFR today, nothing for us or our clients to be worried about, not at this point anyway. It's just a rumored as a possibility and there is a change of control. A covenant in there at $101… But I believe both of those bonds are trading above $101.
[00:08:26] Jake Koundakjian: Well, the floater isn't, but that's because it's very, very short. I think it's February or March next, 2019, from memory, so that one's a little bit under. So you might want to put that back at $101 if that occurs. But who knows if an IPO, is going to occur, it's just a little report in a newspaper, but if it does there are protections in place. In that case, you might not want to put it back, especially if a stronger company is buying them out and you know they IPO'd it and suddenly they've got $50m cash on the books. Maybe you want to hang back or...
[00:09:00] Elizabeth Moran: Just hang on and wait for that maturity date... Well that sums up BondCast today. Thanks for joining me Jake and thanks for listening.
[00:09:07] Jake Koundakjian: Thanks Liz.