Bondholders Scarred by Busted Mergers Push Banks for Change

(Bloomberg) -- Some of the world’s biggest debt investors are demanding better terms to lend money for corporate takeovers, after $42 billion of failed deals left them nursing losses.

The money managers are pressing Wall Street banks to shield them from losses that occur when a failed merger prompts a company to buy back debt at a price below market value, according to people with knowledge of the matter. The discussions heated up after the failure last month of Lam Research Corp.’s $10.6 billion deal to purchase KLA-Tencor Corp., which cost bondholders $86 million, the people said, asking not to be identified as the discussions are private.

Investors who have enabled $1.2 trillion of mergers this year are nervously staring down a growing pipeline of debt that needs to be sold for deals that may never see the light of day. Among them are AT&T Inc.’s $85 billion merger with Time Warner Inc. and Bayer AG’s acquisition of Monsanto Co. Those companies have already lined up a combined $97 billion in bridge loans from banks, which typically offload the debt to investors in the bond market before a transaction is completed.

Fair Compensation

"The whole M&A wave is being driven on the back of bondholders providing cheap financing," said Bill Parry, a managing director of capital markets at Seaport Global Securities who advises bondholders. "So why not give them fair compensation if a deal falls apart?"

The Credit Roundtable, a group made up of some of the world’s biggest money managers, is preparing to discuss the matter when members meet in Chicago this month, according to Schroder Investment Management’s David Knutson, a co-head for the organization. Vanguard Group Inc., Prudential Financial Inc. and Loomis Sayles & Co. are among the members.

What’s frustrating bondholders is an obscure clause in credit agreements, known as a special mandatory redemption, that typically allows companies to buy back bonds at 101 cents on the dollar if the deal goes kaput.

The problem? Many of the bonds have risen much more, in some cases as high as 113 cents, crystallizing losses for investors when deals are canned and the notes called at 101 cents. The debt has climbed in large part because it trades in line with underlying U.S. government bonds, which have returned 4 percent this year as central banks around the world hold interest rates near record lows. 

Given the correlation between investment-grade credit and Treasuries, it makes sense for investors to try to eliminate any rate-related risks, said Rick Rieder, chief investment officer of global fixed income at BlackRock Inc.

Call For Change

One option investors are discussing is a change in how that redemption price is determined, the people said. Instead of getting a premium to face value of the bond, they want the call price to be measured in spread, which is the extra premium over a fixed Treasury rate at the time of sale. Spread is already a common measure investors use to value bonds and fixing it to a benchmark means they don’t have to be interest rate forecasters to figure out if they like the deal.

"People are more sensitive to the 101 call than ever before,” said Knutson, who leads credit research at Schroder. "Price-based call is an old piece of financial technology that doesn’t reflect how investors trade and manage risk now.”

Sysco Corp.’s failed bid last year for US Foods sent the first big jolt to investors, with its longest-dated bonds called after trading as high as 113.3 cents on the dollar. The deal was terminated in June 2015. Investors who bought at the peak lost more than $309 million.

Bondholders Scarred by Busted Mergers Push Banks for Change

This year, Halliburton Co. and Lam called back a total of $4.1 billion of notes they sold to support busted mergers. Investors were left with losses of more than $100 million from peak trading prices for those bonds.

“Investors have been burned by a couple of these special mandatory redemption bonds," said Travis King, head of investment-grade credit at Voya Investment Management. "You’ve had such interest rate volatility this year that that option becomes significantly less valuable. It can actually constrain the performance of the bonds.” 

Investors are bracing for more pain, with about $10 billion of Aetna Inc. bonds to be called if the insurer fails to close its deal to buy Humana Inc. by the end of the year. And there’s potential financing down the road for deals with a lot more funding on the line, including AT&T, Qualcomm Inc. and Bayer.

“It’s definitely a risk you have to consider," said Mark Kiesel, Pacific Investment Management Co.’s chief investment officer for global credit. "Some of these deals have a 50, 60 or 70 percent chance of going through but there’s also a 30, 40 or 50 percent chance they don’t.”