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Protective Covenants Of Bond Issues An Evaluation

Abstract

The conflict of interest between bondholders and shareholders and the expropriation of funds, from one stakeholder to another, is well documented in finance literature. There are three ways in which stockholders can expropriate funds from bondholders: through increased leverage, investing in new risky projects, and payments such as dividends to equity holders.

Many protective covenants have been introduced into the bond indenture. This paper examines the covenants that were offered in fifteen recent New Zealand bond issues and their effectiveness. It also looks at strategies bondholders can use to minimise the risks to which they are exposed. To this end, eight types of protective covenants were examined.

The results of the paper suggest that bondholders gain little protection from the protective covenants provided by issuers.

Introduction

After the stock market crash of 1987, companies began to look to bond investors to raise their required funds, because of the tighter credit criteria of banks (Korsey, Hudson & Littler, 1998). Bonds became popular in New Zealand, with investors looking for investments that returned a fixed income. The often-poor performance of the New Zealand stock market also served to increase the popularity of bonds. The first junk bond [1] was issued in New Zealand in 1987 at a rate of 18%. During the three years that followed, there were an estimated 30 junk bond issues, raising more than $200 million dollars (Mcllroy, 2000). We have seen many of these New Zealand bonds, however, result in a loss of wealth for the bondholders.

The expropriation of funds and a conflict of interest between bondholders and shareholders has been well documented in finance literature (Damodaran, 1999). The basis of this conflict lies in the different claims, held by the bondholders and shareholders, on the cash flow of the firm. These different claims on the firms’ cash flow held by the two types of stakeholders provide the opportunity for the expropriation of funds from one stakeholder to another. There are three ways in which shareholders can expropriate funds from bondholders: through increased leverage, investing in new risky projects, and payments such as dividends to equity holders (Damodaran, 1999). Any of these three events may increase the risks to the bondholder, yet there is no corresponding increase in returns that would compensate the bondholder because the bondholder’s returns are fixed. The bondholder, however, can be protected from the risk of future events, which could result in their wealth being transferred to shareholders, through protective covenants.

Many covenants and protective methods have been introduced into bond indentures, however, many investors are unaware of the different protective covenants, and of the effectiveness of these protections. This study analyses the covenants that were offered in fifteen recent New Zealand Bond issues and their effectiveness. It also looks at strategies bondholders can use to minimise the risks that they are exposed to.

Literature Review

As defined by Damodaran (1999), covenants are restrictions that are built into contractual agreements that place restrictions on firms’ investment, financing, and dividend decisions.

Gitman (2000) points out that bonds normally have an indenture deed that contains standard provisions which spell out certain criteria of satisfactory record keeping and business maintenance. The indenture deed also normally contains restrictive covenants, which are contractual clauses that place operating and financial constraints on the bond issuers. These serve to protect the bondholder against increases in borrower risk. Gitman (2000) states that any violation of the restrictive provisions normally gives the bondholders the right to demand immediate repayment of the debt.

In the UK, there is a trend toward better representation of bondholders’ interests (Bream, 2002). Bream notes that, while bondholders play a subservient role as long as interest payments are made, they are pushed to the top of the pecking order when companies are in financial difficulty, thus bringing them into the heart of negotiations, while shareholders are frozen out. Further, Bream (2002) points out that there has been a move to debt-for-equity swaps; this highlights the trend for bondholders to gain power at the expense of shareholders. She believes the power that bondholders have comes from the covenants placing constraints on the companies that issue bonds.

Perumpral, Davidson and Sen (1999) examined the ethical implications of “poison put” [2] provisions included in bond offerings. Their paper focuses on the newer covenant provisions provided by United States firms that came about as a result of bondholders experiencing substantial losses of wealth during the 1980’s. Takeovers, recapitalisation, restructuring, and the downgrading of the bonds by bond rating agencies had triggered these losses. Perumpral, et al (1999) state that a number of firms are now using event-risk protections in bond offerings, in an effort to attract investors, the most common being a “poison put” provision. They show that this serves to protect bondholders because they can take advantage of the “poison put” provisions under those circumstances. The presence of the provision also helps to ensure that management acts in the best interests of debt holders as well as equity holders and that management put the interests of the stakeholders ahead of any personal interests.

When a leveraged buyout occurs, bondholders tend to suffer a loss of wealth, while stockholders enjoy an increase in wealth. This transfer of wealth, however, is avoided when the bond contract includes a “poison put”, thus protecting the bondholders from wealth loss during restructuring of a firm.

Crabbe (1991) found that about 40% of bonds in 1991 contained protection from major restructuring of firms. The types of covenants that protected bondholders from losses due to restructuring are mostly “super poison puts”, which give investors the right to sell their bonds back to the issuer at par in the event of a leveraged restructuring.

Kahan and Tuckman’s (1993) paper, which documents United Stated firms that change the covenants of their public debt, states that covenants that were optimal when debt was issued, will not necessarily remain optimal over time, because of the changes in a firm’s economic environment and investment opportunities. They suggest that the renegotiation of covenants may be desirable. According to Kahan and Tuckman (1993), covenants that restrict a company’s ability to pay dividends, to incur additional debt, to engage in transactions with a controlling shareholder, or to sell assets without forcing the purchaser to assume the company’s obligations with respect to the bonds, will protect the bondholders’ wealth from being expropriated.

Datta and Iskandar-Datta (1996) found that a large proportion of asset sell-offs by United States firms resulted in the transfer of wealth between bondholders and shareholders. However, they found that dividend restriction covenants were effective in protecting bondholders from this wealth expropriation.

According to Harikumar (1996) managers in the United States have risk-shifting incentives. When risky debt is present, managers are motivated to shift business and financial risk away from shareholders to bondholders, if management is fully aligned with stockholders. The risk-shifting incentives of a manager can be eliminated through the use of stock options and compensation packages that are designed to align managers’ interests with those of the bondholders as well as those of the shareholders. Most studies that evaluate bond contracts assume that managers act in the interest of the shareholders, and that therefore, bondholders require complex indentures to mitigate wealth transfers, such as sinking funds, dividend restrictions, and call and convertibility clauses. Risk-shifting incentives can be eliminated using a non-stock based compensation, designed to align managers’ interests with those of bondholders.

Korsey, Hudson and Littler (1998) state that risk that affects the market as a whole is called systematic risk, whereas risk that affects a particular investment is known as unsystematic risk. Through diversification, an investor can eliminate unsystematic risk without reducing expected returns; if an investor holds enough different investments and one is affected by a factor particular to that investment, there is little effect on the rest of the portfolio.

Bondholders can reduce the conflict of interest by owning an equity stake in the firm, by attaching warrants to the debt or through the use of convertible options, because the source of the conflict of interest between shareholders and bondholders lies in the nature of their claims (Damodaran, 1999).

It can be seen from the above literature review, that a number of authors have discussed the rationale for protective covenants in bond issues. However, very little research has been undertaken to assess the effectiveness of covenants. Therefore this study attempts to examine the effectiveness of covenants by studying a sample of recent bond issues in New Zealand.

There are, however, other mechanisms available to bondholders to protect themselves from expropriation. These will be briefly discussed below but the effectiveness of these mechanisms have not been tested in this study:

Aligning managers’ interest with both bondholders and shareholders

Bondholders should be aware of the compensation received by the management of the firm they intend to lend money to and gain an understanding of where the manager’s interests lie.

They need to be aware of this because managers have risk shifting incentives, if they are fully aligned with stockholders, when risky debt is present. The risk-shifting incentives of a manager can be eliminated through the use of stock options and compensation packages that are designed to align managers and bondholders’ interests (Harikumar, 1996).

Diversification

Through diversification an investor can eliminate unsystematic risk, which is risk that is firm specific. Diversification allows the investor to reduce this risk without reducing expected returns. If an investor holds enough different investments and one is affected by a factor particular to that investment, there is little effect on the rest of the portfolio (Korsey, Hudson & Littler, 1998).

Taking an equity stake in the firm

Bondholders can reduce the conflict of interest by owning an equity stake in the firm, because the source of the conflict of interest lies in the nature of the bondholders’ claims (Damodaran, 1999). If wealth is transferred from bondholders to shareholders, for example, if a new risky project is undertaken, the share price might increase while the bond price decrease. However, a bondholder that has an equity stake in the firm will not ‘lose’ from this transfer of wealth.

Knowledge

Bondholders need to be informed and need to understand the risks associated with a bond, before investing in that particular bond. In an efficient market, “the higher the risk, the higher the return”. For a market to be efficient, all information must be known and acted on. In the New Zealand bond market the more informed investors are, the better protected these investors are from their wealth being expropriated, as, in an efficient market, lenders are protected against expropriation because they are compensated with a lower price/ higher yield.

Method and Sources

A detailed analysis of fifteen recent bond issues in New Zealand was undertaken to determine the degree of protection against the transfer of bondholders’ wealth, provided by these bonds. The following eight main protective covenants were studied for this end:

Restrictions on Investment Policy

Restrictions on Increasing Leverage

Restrictions on Dividend Policy

Required Minimum Levels of Liquidity

Prohibitions on Selling Assets

Call Options

“Poison Puts”

Security

The investment statements of the bond issues were analysed in detail; first to identify if they offered these covenants, and second to determine the effectiveness of the covenants offered. The methodology and the analysis used to determine the effectiveness of the above eight covenants are different. For example debt to equity ratios were computed and compared in a objective manner in order to assess the covenant on increasing leverage. On the other hand, there is no single reliable quantifiable measure to assess the effectiveness of the covenant on prohibition to selling assets – as several unmeasurable, subjective but important factors need to be considered. However, close study and comparison of the bond issues in regard to prohibition on selling assets is sufficient to preserve the consistency of judgement.

A brief summary of the fifteen issues that were studied is shown in Table 1 below. Codes are used in order to preserve confidentiality. The names of the fifteen companies are found in Appendix 1, listed in alphabetical order, which is different to the order of the codes in the following table.

Table 1 Summary of Bond Issues Studied

Issuer

Coupon rate

Year of issue

Time to maturity

Size of Issue

 

(%)

 

(Years)

('000)

B1

10.00

2002

7.75

10,000

B2

7.04

2002

10

300,000

B3

10.75

2002

6.75

2,670

B4

8.50

2001

10

45,000

B5

10.25

2003

5.25

100,000

B6

8.40

2002

Indefinite

50,000

B7

10.75

2001

3.75

100,000

B8

9.30

2001

5

30,000

B9

8.65

2002

Indefinite

15,000

B10

8.25

2002

4

5,000

B11

9.25

2001

2

5,000

B12

10.00

2001

3

100,000

B13

12.00

2000

1

8,900

B14

8.50

2002

9

150,000

B15

10.75

2000

4

300,000

Findings

It can be observed from table 2 that the bond issues B13, B15 & B4 contains most protective covenants and B2 on the other hand is least protective. The degree of protection provided by each covenant is different. Therefore, direct comparison is difficult and to some extent subjective. Nevertheless, when all eight covenants are considered in a holistic manner using the following two criteria, some objective assessment on protection can be made.

Table 2 Protective Covenants in some recent New Zealand Bond Issues

Protective Covenant

Issuers

B13

B15

B4

B11

B12

B5

B3

B9

B10

B1

B6

B7

B8

B14

B2

Investment Policy

Y

Y

L

L

L

Additional Leverage

Y

Y

Y

L

L

 L

L

L

L

Dividend Policy

 

L

L

L

L

L

L

 L

 L

L

Level of Liquidity

Y

Y

Selling Assets

Call Option

Y

Y

L

L

 

"Poison Put"

 Y

Y

L

L

L

L

Securities

Y

Y

Y

L

L

L

The following key/criteria were used to summarise the relevant information:

L – Limited restrictive covenants were those where the indenture deed contained a protective covenant, however, the restrictions placed on the issuer provided very little, if any protection for the bondholder. For example issuer B3 bond indenture contained a restrictive covenant that restricted the issuer from acquiring additional leverage, however, the issuer was only prevented from issuing new debt if it caused the gearing ratio to exceed 4.25:1, which was at the time 3.3. Issuer B3’s deed also states that a breaking of this undertaking does not constitute an event of default under the trust deed. Therefore, the restrictive covenant, provided in the trust deed, provides little or no protection to the bondholders. The covenants classified in this paper as “limited” were considered to provide little or insignificant protection for the bondholder.

Y - The issuer has provided restrictive covenants that offered protection to the bondholder, where the covenants clearly place restrictions on the company, preventing the company from taking actions that could affect the bondholder’s wealth, such as, investing in new risky projects or increasing leverage by a significant amount. A restriction that adequately protected the bondholder was placed on the issuer.

Blank – where the investment statement specifically stated that the company has no restrictions in that area or did not mention that type of covenant.

Restrictions on Investment Policy

Protective covenants that restrict the issuer's investment policy protect the bondholder from increased risk from new risky projects. The results of this study found only two out of the fifteen bonds studied contained adequate protective covenants that placed restrictions on the issuer’s investment policy. These two bonds were junk bonds issued to raise funds for a specific project; they contained protective covenants that prevented the issuer from engaging in any other projects. Three of the bonds contained protective covenants that provided limited restrictions on the issuer’s investment policy. No bonds that were issued by larger corporations contained protective covenants that limited their investment policy.

Restrictions on Increasing Leverage

Covenants that place restrictions on the issuer increasing leverage prevent the bondholders from amplified risk from an increase in leverage. Again, it was found that smaller bond issues, that were issued to raise funds for a specific project, normally contain protective covenants that totally restricted the issuer from increasing leverage.

Nine of the bonds studied did contain restrictions on increasing leverage, however, six of these restrictions were very broad and sometimes not well defined. Therefore, these companies were able to increase leverage by such a large amount before violating the restrictive covenant; hence, these covenants provided little protection for the bondholder.

Restriction on Dividend Policy

Covenants that restrict a company’s dividend policy prevent the bondholder bearing extra risk from cash shortages, or increased leverage as a result of payments to equity holders. Dividend restriction covenants are also effective in protecting bondholders from their wealth being expropriated if assets are sold off (Datta & Iskandar-Datta, 1996). This study found that the New Zealand corporations’ bonds, which were analysed, did not provide this kind of protection for their bondholders. Nine of the bonds analysed did contain limited covenants, which offered very little protection to bondholders. Therefore, making payments to equity is a means by which shareholders may expropriate bondholders’ wealth.

Minimum level of liquidity

If a company is required to maintain a minimum level of liquidity, the bondholder is assured that the company will be able to meet its interest payments.

However, only a very small proportion of the bonds studied contained protective covenants that required the issuer to maintain a minimum level of liquidity.

Prohibition on selling assets

A large proportion of sell-offs may result in the transfer of wealth between bondholders and shareholders (Datta & Iskandar-Datta, 1996). In the event of liquidation, these assets would help bondholders recover some or all of the value of their bonds. However, none of the New Zealand bonds studied contained protective covenants that prevented the issuer from selling its assets.

Prohibition on the company calling the bonds

Bondholders can find themselves at an advantage in certain situations, such as a drop in interest rates, as their returns are fixed. If the company can, however, recall the bonds, the bondholders can find themselves at a disadvantage, having to reinvest at a time when interest rates are low and they may lose some or all of the capital gains on their bonds. However, only two of the bonds studied prohibited the company from calling the bonds. Seven of the bond issues stipulated that the company could call the bonds and two of the issues allowed the company to recall the bonds in certain circumstances.

“Poison Puts”

The findings of this study agreed with Crabbe (1991), who found that approximately 40% of bonds contained protection from major restructuring of firms by way of providing a “poison put” provision. Six out of the fifteen, or 40%, of the bonds studied contained a “Poison Put”, the same result as Crabbe’s study. However, only two of these were considered to give the bondholder adequate protection. Therefore, although “poison put” covenants were commonly found in bond indenture deeds, the conditions of most of these covenants greatly limited the protection that the bondholder would otherwise receive from such a covenant.

Security

If bonds are secured against a company’s assets the bondholder has a greater chance of recovering their investment, in the case of liquidation, as their bonds would rank higher than unsecured creditors. Companies, however, can erode this security through a practice known as company layering, in which they sandwich new debt between existing bank debt and bondholders, thereby putting bondholders at the bottom rung of claimants for payback. Anti-layering covenants were developed in the 1980s. Although, six out of the fifteen bonds studied provided the bondholder with security, only three of these contained anti-layering covenants prohibiting security being given to other parties.

Discussion

Many covenants and protective methods have been introduced into the bond market. Investors need to be aware of the ways available to them to protect themselves, and of the effectiveness of these protections. This study analysed the covenants offered in some recent New Zealand Bond issues and their effectiveness: a detailed analysis of fifteen recent bond issues in New Zealand was undertaken to determine the amount of protection provided by these bonds’ protective covenants. This paper examined the mechanisms available to bondholders to protect themselves from expropriation and the effectiveness of these mechanisms.

Protective Covenants

Protective covenants are restrictions that are built into contractual agreements that place restrictions on the firms’ investment, financing, and dividend decisions.

Gitman (2000) lists the following four restrictive covenants as the most common:

The borrower is required to maintain a minimum level of liquidity. Our analysis revealed only 2 out of 15 bonds studied contained this covenant.

The borrower is prohibited from selling accounts receivable to generate cash. This provision prevents a long-run cash shortage if accounts receivable are sold to meet current obligations.

Fixed asset restrictions are placed on the borrower, as the liquidation or encumbrance of fixed assets could affect the firm’s ability to repay the bonds. However, none of the fifteen bonds studied contained protective covenants that prevented the issuer from selling its assets.

Dividend payments are limited to specific percentage or amounts. Nine of the bonds analysed did contain limited covenants, which offered little protection.

It is assumed that covenants that restrict a company’s ability to pay dividends, to incur additional debt, to engage in transactions with a controlling shareholder, or to sell assets without forcing the purchaser to assume the company’s obligations with respect to the bonds, will protect the bondholders’ wealth from being expropriated (Kahan & Tuckman, 1993). However, this study does not support the assumption that bondholders are adequately protected, through protective covenants, from situations that might increase their risk. Further, it was found that the protective covenants in the recent New Zealand bond issues studied did not, in many cases, restrict companies from increasing leverage, taking on new risky projects, making payments such as dividends to equity holders, undercutting the security that the loans are based on, being involved in leverage buyouts, selling assets, buying back their own shares, or issuing new security. A large number of bonds contained call features advantageous to the issuer; some dividend policies could transfer wealth from bondholders to shareholders; and security provisions and trust deeds were not as attractive as they first appeared.

According to Bream (2002), there has been a trend toward better representation of bondholders’ interests in the past 12 months. While bondholders play a subservient role as long as interest payments are made, they are pushed to the top of the pecking order when companies are in financial difficulty, thus bringing them into the heart of negotiations, while shareholders are frozen out. Bream (2002) notes that there has been a move to debt-for-equity swaps; this highlights the trend for bondholders to gain power at the expense of shareholders. She believes the power that bondholders have, comes from the covenants placing constraints on the companies that issue bonds. The results of this study, however, found that the restrictive covenants contain in the indenture deeds of recent New Zealand bond issues generally place little constraints on the issuers. Thus the protective covenants of these issues provide little protection to the bondholder from the transfer of their wealth to shareholders.

Conclusion

The results of this study found that, only two out of the fifteen bonds studied contained adequate protective covenants that placed restrictions on the issuer’s investment policy.

Nine of the bonds studied did contain restrictions on increasing leverage, however, these restrictions were very broad and sometimes not well defined. While some of the bond issues contained limited protection, bondholders were found to have little protection against issuers making payments to equity holders. Only a very small proportion of the bonds studied contained protective covenants that required the issuer to maintain a minimum level of liquidity. None of the bonds studied contained protective covenants that prevented the issuer from selling its assets. While 40%, of the bonds studied contained a “Poison Put”, only two of these were considered to give the bondholder adequate protection. Although six out of the fifteen bonds studied provided the bondholder with security, only three of them contained anti-layering covenants prohibiting security being given to other parties.

It was found that bondholders gain little protection from the protective convents provided by issuers. There are some strategies bondholders can use to reduce their risks. They should be aware of the compensation received by the management of the firm they intend to lend money to, and gain an understanding of where the manager’s interests lie. Diversification allows the investor to reduce this risk without reducing expected returns. Bondholders can reduce the conflict of interest by owning an equity stake in the firm, because the source of the conflict of interest lies in the nature of the bondholders’ claims (Damodaran, 1999). Bondholders need to be informed and need to understand the risks associated with a bond, before investing in that particular bond. However, to what extent these strategies are adopted by bondholders are not evaluated in this paper. Therefore, this is a relevant extension of the present research work.

It was also found that the information provided in some bond issues is not perfectly transparent and also distorted to some extent. Therefore, the bond market in New Zealand is inefficient – particularly information wise.

Further, the bond market in New Zealand is relatively new and some investors are not financially literate. In view of the above, financially illiterate investors in particular, have to be extremely cautious in investing in bonds.

Further research is needed to assess the role played by the New Zealand Securities Commission in maintaining the integrity of this market.

References

Appin, R., (2002) Dole Bombshell rocks investors: A good deal for shareholders, a nightmare for bondholders? The Investment Dealers’ Digest, 68 (37), 15-19.

Bream, R. (2002, Apr 10). Bondholders wrest power from equities. Financial Times p. 25.

Crabbe, L. (1991). Event risk: An analysis of losses to bondholders and “super poison put” bond covenants. Journal of Finance, 46 (2), 689-706.

Datta, S., & Iskandar-Datta, M. E. (1996). Who gains from corporate asset sales? The Journal of Financial Research, 19 (1), 41-59.

Damodaran, A. (1999). Applied Corporate Finance – A user’s manual. New York: John Wiley & Sons.

Gitman, L. J. (2000). Principles of Managerial Finance (9thed.). New York: Addison Wesley Longman.

Harikumar, T. (1996). Leverage, risk-shifting incentive, and stock-based compensation. The Journal of Financial Research, 19, (3), 417-429.

Kahan, M., & Tuckman, B. (1993). Do bondholders lose from junk bond covenant changes? The Journal of Business, 66 (4), 499-516.

Korsey, K., Hudson, R., & Littler, K. (1998) The intelligent Guide to Stock Market Investment. New York: John Wiley & Sons.

Mcllroy, C. (2000, Mar 7) Developers find intelligent life in growing junk bond market. The National Business Review, P.58.

Perumpral, S., Davidson, D., & Sen, N. (1999). Event risk covenants and shareholder wealth: Ethical implications of the “Poison Put” provision in bonds. Journal of Business Ethics, 22 (2), 119-132.

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