January 13, 2017 / 6:26 PM / 3 years ago

Investors fight back on aggressive covenant terms

NEW YORK, Jan 13 (IFR) - Investors dug in their heels this week on three investment-grade bond deals that tried to include more issuer-friendly terms, signaling that - for now at least - enough is enough.

Borrowers scrapped language in new bond offerings that would have spared them from paying a make-whole premium in the event of a default (from a simple covenant breach to actual bankruptcy).

An uproar from the buyside led chipmaker Broadcom, auto lender General Motors Financial and Brazilian paper company Fibria Celulose to drop the wording mid-execution on Wednesday.

Junk-rated Novolex removed similar language from a bond for its buyout from Carlyle this week, while professional services firm Marsh & McLennan retroactively took it out two days after pricing.

“The investor community got very excited by this,” said Michael Kaplan, a partner at law firm Davis Polk, which helped draft some of the contentious clauses. “Right now it’s hard to see why an issuer would want to brave that.”

Make-whole premiums have long been a cherished clause for bond investors, allowing them to demand all the payments they expected when first buying the securities in question if those securities are redeemed early.

But starting with a handful of junk-bond deals last year - and at least one high-grade trade, from sports giant Nike - some borrowers have inserted language to prevent investors from demanding these payments if a company defaults.

“It’s a classic pushing of the envelope to see how much you can get away with,” said David Knutson, head of credit research for the Americas at Schroders.

Covenant Review, an independent research firm, warned that breaching indentures without having to pay a make-whole premium in effect marked “the end of bond covenants”.


Two US court rulings last year appear to have changed market perception of what is and is not acceptable when it comes to the premiums in question.

In a ruling against pawn shop operator Cash America, the court ordered the company to pay a make-whole premium to bondholders because the sale of the majority of a wholly owned subsidiary violated covenants in its bond indenture.

Later in the year, another court ruled in a case involving Energy Future Holdings that a company must pay a make-whole if notes are repaid in a bankruptcy.

Adam Cohen, the founder of Covenant Review, said the new language sought to “opt out” of those rulings.

“This terrible language will vastly embolden issuers to consider breaching covenants and lead to more risk for bondholders and fewer premium redemptions,” he wrote.

But Davis Polk said in a note to clients on Wednesday that investors have “traditionally understood” they are not due a make-whole premium when faced with a company’s default or bankruptcy.

Davis Polk’s Kaplan pointed to previous cases, such as that of Momentive Performance Materials, in which the courts ruled that investors were not due a make-whole premium after the company filed for bankruptcy.

“We simply codified what had always been market expectations,” he told IFR.

That argument did not distinguish, however, between events of defaults such as covenant breaches (in which case investors clearly do expect to be made whole) and actual bankruptcies (in which investors may have little choice but to accept losing money).


Market participants gave various explanations for how the language had been able to get through the market on junk deals last year but was now facing a fight-back in high-grade bonds.

Raman Srivastava, deputy chief investment officer at BNY Mellon investment company Standish, said the much larger high-grade market necessarily received more attention.

“You have more investors’ eyes looking at bigger deals,” he said. “If you see this happening in, for example, a Broadcom deal, it’s going to catch someone’s attention.”

Larger investors also have more sway over an issuer’s behavior, said Justin Cooke, a partner at law firm Allen & Overy who was not involved in any of the deals in question.

“I suspect that one or more very large anchor investors pushed back,” he said.

One likely reason is that giving up the right to a make-whole premium is potentially significantly more expensive for investment-grade bond investors.

Missed future interest payments would typically amount to much more when it comes to high-grade paper, which tends to have longer maturities - and no other call options.

“Investment-grade bonds may mature decades after issuance and typically have a make-whole for life, whereas high-yield bonds typically mature in seven to 10 years and have a redemption premium that reduces to par over several years,” said Cooke.

“A high-yield issuer may be able to redeem at or near par in three or four or five years anyway.” (Reporting by Will Caiger-Smith and Davide Scigliuzzo; Editing by Marc Carnegie, Natalie Harrison and Matthew Davies)

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