The leveraged buyout boom and the increasing number of companies delaying their reporting of financial statements have led to a higher number of funds trading on the assumption that issuers may breach bond covenants, according to panelists speaking at the Strategic Research Institute's 8th Annual Distressed Debt Investing Forum in Las Vegas Nov 16-17.
There are two main types of covenants that funds are betting on: change of control and financial reporting. Investors are buying into credits they see as candidates for LBOs hoping to cash in once the control of the company changes hands. Investors make money by buying into bonds that are trading under par and receiving par or more if the covenant is triggered. "It is a trading strategy to enforce a change of control covenant if the bonds are trading under par," said Thomas Walper, partner at law firm Munger Tolles & Olson. "Bondholders are getting more organized. They are taking big positions when they think covenants will get triggered," he said.
Recent examples of companies whose debt investors have bought into with the expectation that change of control puts may be triggered are Owens Corning, Masco Corp. and Carlisle Companies.
The other area of focus the breach of financial reporting covenants is also gaining increased attention because of the high number of companies that are delaying filing their financial statements. More companies are finding it difficult to meet provisions of the Sarbanes-Oxley Act, which requires the chief executive and chief financial officers of public companies to attest to financial documents on a timely basis. Furthermore, the options backdating scandal, which has led to increasing numbers of companies restating multiple years of income, has also caused an increasing number of companies to delay filing.
Dan Kamensky, v.p. of high-yield distressed trading at Lehman Brothers, said the quality of covenants can vary by issuer. "Because there hasn't been a big focus on reporting covenants, the way they are written varies and there can be varied outcomes and litigation," he said. "Bondholders are trying to use this to their advantage and are trying to enforce covenants where the language appears weak."
He added that loan investors are also becoming more interested in trading on the assumption issuers will breach covenants. "Increasingly we are seeing more pressure from second-lien holders as well and they may start to take their lead from bondholders," said Kamensky.
Bondholders have become increasingly concerned about the lack of meaningful covenants in bond indentures, according to a Moody's Investors Service report. It said the presence of covenants has declined and appears to be at a cyclical low. But more covenants are being added to bonds because of the increased emphasis being placed on them. "There is definitely more focus on covenants in the new issue market," said Kamensky. Moody's will shortly publish a response to its proposal to implement a more systematic approach to the analysis of indenture covenants and to provide specific commentary on the protection covenants provide.
