Two new reports point to shortcomings in Eurobond documents that are leaving bondholders unhappy. They cover a range of complaints, from administrative issues such as the tardy dissemination of prospectuses to legal problems such as the structural subordination of bondholders when companies securitize.
The papers are united in their attention to apparently ineffective negative pledges in Eurobond documents and suggest tighter covenants to protect investors’ interests.
Bondholders feel they are getting a shoddy deal compared with bank lenders. Take the case of global retailer Ahold. Despite a negative pledge in its bond documents, it was able to borrow close to $2 billion within a week of revealing overstated profits in its US food services division earlier this year. To get funding, it pledged to the banks shares in its US and Dutch subsidiaries in the event of insolvency.
This cut the value of Ahold’s assets against which unsecured bondholders would have a claim should it become insolvent. The new loan, and other difficulties, pushed Ahold’s bonds from a Fitch BB rating to single B.
Fitch highlights the weakness of negative pledge clauses in its report, Jumping the queue. John Hatton, its author, says bluntly: “Covenants are not as concrete as people think they are.” Now investors want change. Twenty-six institutions, representing a quarter of the $980 billion Eurobond market, have formed a group to list their demands.
The covenants in question are intended to stop borrowers giving security over company assets to other lenders without doing the same for bondholders. But investors say the exclusions that carve out certain borrowing from the negative pledges in a standard Eurobond are so wide as to make the clause worthless.
Weak negative pledges have allowed companies such as Capital Shopping Centres to borrow heavily on a secured basis when they hit difficulty, with disastrous effects for bondholders. In Capital’s case, the company granted security to banks over property assets in return for billions of dollars of secured debt.
Eventually the amount of unencumbered assets no longer exceeded Capital’s £350 million ($594 million) of bonds and Fitch cut its rating to sub-investment grade. At its height, Capital’s rating had been in A territory.
Carve-outs devalue covenants Carve-outs that are common in Eurobonds, according to Fitch, include allowing secured borrowing in the issuer’s domestic currency, borrowing from banks, borrowing by subsidiaries of the issuer and borrowing that a company inherits through an acquisition.
Yet, despite the damage they can cause, negative pledges are often overlooked. In August last year Fitch itself alerted investors to a change in Guichard-Perrachon’s documents for a e4 billion medium-term note programme that widened the exemption from its negative pledge to include all bank borrowing.
The company had changed just three words in the relevant indebtedness clause, removing the phrase “whether or not” so it no longer excluded all secured borrowing “whether or not represented by notes or other securities” but instead excluded only borrowing that was in the form of securities.
When Fitch examined all the actively traded bonds that it has rated it found just one where the negative pledge was watertight – a deal by UK company Green Property. Even when that company was the subject of a leveraged management buyout, Fitch fielded dozens of phone calls from investors unaware of the terms of the company’s bonds.
Eurobond investors are now adamant that the carve-outs must stop, or issuers must cease to miss-sell the bonds they issue. They say: “In order to label debt instruments ‘senior unsecured’, a maximum of 20% of total indebtedness (on or off the group’s consolidated balance sheet) should be able to rank ahead of the instruments.”
The investors add: “No carve-outs or general exemptions should be permitted that would allow for this limit to be exceeded.” Of course, investors would expect to pay less for bonds that failed to make senior unsecured grade.
Tough markets mean issuers must also take care. Companies cannot afford to be constrained by promises they cannot keep. Issuers are happy to make promises to their banks, but worry about agreeing to covenants in bond documents because these can be harder to work around. Bank covenants are often waived to help rescue a troubled company.
“Treasurers at even the biggest companies have experience of renegotiating bank debt, perhaps for subsidiaries or joint ventures,” says John Grout, technical director at the Association of Corporate Treasurers. At the same time, banks simply will not lend without a better security package than bond investors.
Negotiating waivers on covenants in bond documents is far more difficult. Many bondholders invest through custodians and are hard to track. Organizing an investors’ meeting can take months and issuers cannot be sure enough will show up to form a quorum.
Nor can issuers rely on cooperation. Recent restructurings such as that by communications company UPC have involved US investment funds adopting an aggressive stance in restructuring negotiations in a bid to be paid off at a premium to other lenders. “Issuers cannot assume they will be able to have a reasonable conversation with bondholders if things go wrong,” says Hatton at Fitch. What really troubles companies is the notion that investors might impose a market standard that is unsuitable for many and potentially damaging for some.
But investors seem undeterred and are building strength. The group of 26 aims soon to represent the majority of investors in the Eurobond market and will be hard to ignore.
