Trap In Store for Bond Investors Who Skipped the Small Print

(Bloomberg) -- Investors of top-tier bonds probably haven’t paid much attention to covenants in recent years. They may want to start.

An era of rising prices has laid a trap for holders of investment-grade notes that carry change-of-control clauses. And a boom in leveraged buyouts is threatening to spring it, according to HSBC Holdings Plc.

The oft-ignored options allow investors to hand their debt back at a pre-determined price, usually close to face value. They ensure a holder of high-grade bonds doesn’t get stuck with junk-rated paper if a private-equity firm saddles debt on the company it’s acquiring. The problem is most investment-grade bonds trade well above their issue prices -- so early payouts at around par would be unwelcome, too.

In fact it would translate into losses of 1 billion euros ($1.14 billion) on bonds of 44 companies HSBC has identified as potential LBO targets, according to Bloomberg calculations.

“Investment-grade investors have less of a tradition of paying attention to covenants,” said Dominic Kini, quantitative credit strategist at HSBC in London. He’s been encouraging clients “to pay a bit more attention” to covenant protection.

Trap In Store for Bond Investors Who Skipped the Small Print

Of course, there are also gains in store for those who choose bonds trading below par before a credit-busting acquisition: a total of 370 million euros on early pay-outs at face value.

Sterling investors had to navigate confusing change-of-control documentation earlier this year when GKN Plc bonds trading below par jumped as Melrose Industries Plc made a bid for the British aerospace and defense contractor. It was also a warning, as GKN’s above-par issues slumped as their change-of-control put was worthless.

As bond prices on the potential targets drift toward their CoC trigger, prospective losses are shrinking. Also, fewer of the notes are left out-of-the-money, where they’re trading above their buyback triggers.

Thanks to October’s selloff, which has pushed investment-grade spreads on euro-denominated debt to their widest levels in more than two years and the average price of in-the-money LBO candidates down a point last month to less than 98 cents, triggering a CoC may let some investors scoop up a jackpot.

“For bonds currently priced between 100 and 105 with CoC clauses, potential losses could turn into potential gains if their price falls through 100,” said Song Jin Lee, a co-author of the HSBC report.

©2018 Bloomberg L.P.