low-level engagement on corporate governance and poor protection for covenants are sited as major issues that need addressing
When Philip Green gave up on his takeover campaign for UK retailer Marks & Spencer recently, its bondholders breathed a huge sigh of relief. The company's bond prices had plummeted when Green first revealed his plans for taking over the troubled retailer.
Why bond prices should fall while the share price rocketed highlights some interesting differences between equity and credit analysts' views on a company. Additionally, the case of Marks & Spencer helps highlight the weak position that bondholders currently have in their dealings with firms - and in particular their low level of engagement on corporate governance.
The Philip Green effect
To shareholders, Green's bid was good news. Simply put, their shares would be worth a lot more and so the share price leapt up. But to bondholders, the bid was, for a number of reasons, extremely bad news. Firstly, the 'new' privately-owned Marks & Spencer would have a lot more debt in its financial structure that would rank ahead of the bondholder's debt - effectively a massive reduction in credit quality that would result with the debt being downgraded from high-quality investment grade status to junk.
To make matters worse, as a private company there was a significant reduction in the level of information available to bond investors. No surprise then that bond prices fell sharply to reflect this scenario.
What might be surprising to investors is that bondholders could be so badly impacted by such a move - why was there so little protection? For bondholders, protection is normally given in the form of covenants when the bonds are issued. Covenants are legally enforceable clauses in bond issues that look to protect the bondholders from potentially financially damaging actions that may be taken by the company issuing the bond. Typical covenants can relate to:
• A change in ownership of the company
• A limit to the level of financial leverage the company can undertake
• A restriction on the company disposing of assets that generate the income to pay bondholders' coupons.
So given this, why were bondholders so badly exposed? It is widely recognised that investors in European corporate bonds currently operate in an environment of weak covenant protection. This position has been exacerbated by the fragmented voice of bond investors when things have gone wrong in terms of their direct dealings with companies and their bankers.
Bondholders have no ownership voting rights and therefore often only limited means to make effective engagement with companies to effect change or seek redress.
Bondholders fight back
However, bondholders are looking to level the playing field. Recently the bond committee of the Association of British Insurers (ABI), backed by some major bond investors, launched a position paper that looks to improve the lot of the humble bond investor.
Members of the ABI are large institutional investors controlling funds worth some £1 trillion. This includes substantial holdings of both sterling and euro-denominated bonds, managed to deliver returns to pension fund, retail and high net worth investors. It is therefore appropriate that the ABI should seek to promote higher standards to look after the interests of such a wide group of investors.
The paper is concerned with principles and best practice rather than with prescription. In particular it emphasises the value investors place on timely access to information, transparency and clarity with regard to their entitlement to security. The ABI now intends to seek to collaborate with like-minded European investor groups in promoting discussion with issuers on these subjects. A more united voice from bondholders is seen as the best way of getting a better deal.
So what would have been the ideal scenario for bond investors when Marks & Spencer issued its most recent £400m bond issue in March?
Well, firstly, a change of control provision that would have given bondholders proper protection against the risk of Marks & Spencer being bought by a third party (such as Philip Green, for example) that would result in a materially weaker company from a credit perspective.
Secondly, a covenant committing the borrower to continuing disclosure whether or not it was taken private, merged with another company or just plain taken over. Such a covenant would set out how the issuer would ensure continued communication with investors, for example through an annual bondholder meeting, and commit to timely publication of price-sensitive developments on the same basis that would apply to equity issuers.
All in all, a fairer deal for bond investors.
Corporate governance is important to a credit investor, given the strong correlation frequently seen between poor governance and credit deterioration. Parmalat, Enron, Ahold and Worldcom are all part of the litany of recent credit disasters that have the mark of poor corporate governance.
Many corporate failures have exhibited similar patterns of management behaviour sufficient to be useful to help predict or, at the very least, alert investors to vulnerabilities to credit deterioration.
Bond investors have an asymmetric risk profile inasmuch as the upside is capped but downside losses can be significant. They must be vigilant to satisfy themselves that a weak record in corporate governance is not just the tip of the iceberg. In this regard, it is surprising that bondholders have not been as vocal in the debate on corporate governance issues as equity investors, but again times are changing.
In terms of day-to-day dealings in credit markets, more investors are now formally incorporating key indicators of poor corporate governance into their internal credit assessments for many companies. For example, incomplete or poor financial disclosure, major accounting re-statements, regulatory investigation, an aggressive management culture towards the treatment of off-balance sheet liabilities and acquisitions are all areas that deserve attention.
Warning lights start to flash when we see the presence of these factors and we need to be satisfied that this is not symptomatic of a heightened risk profile. Corporate governance issues are being more formally and explicitly looked at by the ratings agencies as witnessed in the production of corporate governance assessments.
The equity/ credit link
To understand and properly weight the risks, it is critically important for investment firms to have joined-up thinking between debt and equity investors and well-established corporate governance teams.
Our corporate governance team look at various issues including the functioning and independence of the board, compensation practices, independence in supervision and oversight, and they alert us whenever they have material concerns in these areas. The philosophy employed is not to look at these issues against a rigid set of rules but rather to establish best practice guidelines from which a case by case approach can be taken.
The key to success is an integrated approach between the insights generated by bond and equity teams and the active engagement with the management of companies in which we invest. Investors should seek a relationship of constructive engagement. In addition, the corporate governance team can help clarify the position in instances where bondholders and equity holders' interests may not be fully aligned.
The outlook for bond investors, in terms of better protecting their investments, is improving but there is a long way to go. While the ABI has been actively engaged in facilitating bondholder and company negotiations in the sterling market for many years, similar arrangements are not generally available to investors and issuers in the euro market.
As Rod Paris, director and head of Global Fixed Income at Standard Life Investments and chairman of the ABI Bond Committee, says: "More and more institutional investment is going into corporate bonds. ABI members are part of this trend but there has been little opportunity for dialogue with issuers, especially in the euro-denominated market."
The ability for bondholders to get better protection on their investments will depend upon their ability to work together to promote higher standards. The very mention of Philip Green in the future should not cause bondholders' knees to shake.
Partner Insight Video: Advisers have had to adapt to the changing investment landscape.
Investment trust savings scheme