On 21 June 2010, The Bond Covenant Group (TBCG) launched a set of model bond covenants designed to reduce event risk in investment grade Eurobonds and promote documentary standardisation. TBCG is an ad hoc group of investor bodies comprising The Association of British Insurers (ABI), the Investment Management Association, the National Association of Pension Funds and the Bundesverband Investment and Asset Management.
Covenants in investment grade Eurobonds have traditionally been light – often extremely so. Many have only a negative pledge and some (particularly by financial institutions but also some strong corporate credits) not even that. Any change is, therefore, likely to face some issuer resistance, but these proposals from TBCG have received a particularly cool reception. The Association of Corporate Treasurers for example, while supporting the concept of standardisation, has stated that it regards the proposals as more suitable for a non-investment grade bank loan than for an investment grade Eurobond. In fact, as we shall see, the proposals are in some ways more restrictive than those typically found in non-investment grade (high yield) bonds.
This initiative is not a new idea but does represent a significant step-up in the efforts of investor groups. As long ago as 2003, investors were collectively calling for greater and more standard protections in investment grade Euro bonds. In 2004, the ABI published a paper focusing on change of control, negative pledge and call options. In 2005, the leveraged takeover of cleaning group ISS served to focus the market's mind on event risk. The price of the previously investment grade ISS Eurobonds fell significantly after the bonds were downgraded below investment grade as a result of the increased ISS leverage. Many investors were surprised at their lack of covenant protection in these circumstances and intensified their clamour for event-linked put rights. To date, the most concrete effect of this investor agitation has been the widespread (though far from universal) adoption in the investment grade market of change of control put rights, typically linked to a rating downgrade.
Nevertheless, many investors still feel that the event risk protections are too often insufficient. The TBCG initiative shows that, in the aftermath of the financial crisis, those investors sense an opportunity to address this on a market-wide basis.
There was only limited consultation with participants on the sell side prior to publication of the model covenants and, perhaps as a result, the model, as published, has been regarded by many as overly investor-friendly. At the launch, TBCG spokesman John Hale was, however, at pains to point out that the model covenants should be regarded as a base from which investors would not, in future, expect to see major deviation but which he accepted would need to be modified in detail for the particular circumstances of each issuer.
Restricting debt and disposals
However, there is little sign so far of these covenants gaining market acceptance even as a base. It is unhelpful that, when looked at in detail, some of these covenants do appear more restrictive even than their equivalents in traditional high yield bonds. Looking at two of the model provisions:
Priority borrowings, ie secured and subsidiary (structurally senior) borrowings, are restricted. For many groups which raise or guarantee debt at subsidiary levels, this is a significant restriction. In high yield, indebtedness covenants usually permit priority (and pari passu) borrowings that don't cause the group to breach a particular coverage, or sometimes a gearing, ratio and there are long lists of exceptions. The TBCG covenant is an absolute prohibition with only a limited number of permitted exceptions. Acquired secured debt, for example, is only permitted if discharged within a fixed number of months. In high yield, acquired debt may be permitted provided the enlarged group's new leverage is either no worse or is within the ratio headroom for further debt.
Borrowings for these purposes include, in the model form, the mark-to-market value of derivative positions even if they arose for genuine hedging and non-speculative purposes. Many borrowers, in the current interest rate environment where rates are much lower than when those borrowers, perfectly sensibly, signed large interest rate swaps for genuine hedging purposes have seen the dangers of covenants that may be tripped by the negative mark-to-market values of derivative positions. Most post-IFRS covenants do recognise that these negative balances are accounting rather than real phenomena for most companies and carve them out accordingly in respect of non-speculative hedging instruments.
Non-ordinary-course disposals are restricted in the model form to a maximum percentage, over a fixed period, of consolidated net worth or assets although any proceeds that the issuer re-invests in its business are added back to this headroom. In high yield, disposals are permitted but the issuer must use the proceeds in a particular way. Like in the TBCG model, proceeds can be re-invested in the business but in addition they can be used to pay down debt or if not so used within a year, to make a tender offer to bondholders. In this model, issuers can safely make disposals without fear of default even if it does not make business sense to re-invest the proceeds in the business. Of course, this may not matter if the headroom is set sufficiently high but it is a shame that the authors of the TBCG model chose such a restrictive structure.
The change of control model clause, on the other hand, compares well enough with its high yield equivalent. It includes an optional rating downgrade limb which is not always present in high yield. However, the requirement (common in current standard investment grade change of control clauses) for there to be a causal link between the change of control and the downgrade has been removed. TBCG explain this on the basis that rating agencies will often not expressly link the downgrade to the change of control making the clause unworkable. However many issuers consider this link to be very important.
Reasonable issuers
The TBCG initiative is about event risks and the dispassionate observer of the investment grade Eurobond market might well conclude that currently investors are relatively unprotected from such risks – compared to the coupon that those risks carry. This initiative is not about protecting investors against a deterioration of creditworthiness caused by business deterioration. It is not a call by TBCG, for example, for maintenance covenants to be standard in Eurobonds.
It is also true that, given the way in which bonds are sold – ie fast, if the market does chose to move towards more event-risk protection, a degree of standardisation would enhance the smooth operation of the market.
Given the understandable concerns of investors, the initiative could, in principle, have won more supporters among reasonable sell-side participants. However, it remains to be seen if this particular model gains widespread acceptance. Of course if a major pricing incentive were to emerge, issuers may see things very differently.
Finally, it is perhaps ironic that, in many high yield bonds, the equivalent covenants to those in the TBCG model are suspended entirely if the bonds rise to investment grade. Maybe a model covenant set could be developed for investment grade Eurobonds which was similarly suspended until the bonds fell below investment grade (a feature occasionally seen in emerging markets bonds). Issuers may still be resistant, of course, arguing that the rating agencies may consider an issuer with such a covenant set at greater risk of default on downgrade and find that fact itself to be a reason to downgrade. The question is beyond the expertise of a mere lawyer but one the market would need to consider very carefully.
By Andrew Carey, partner at Hogan Lovells in London