When Angels Lose Their Wings
Are investment-grade European corporate bonds an alternative form of cheap, preferred equity? The notion may not be as absurd as it may sound. In stark contrast to corporate bonds issued in the United States, where effective covenants and restrictions in bond indentures are supported and maintained by the US legal and regulatory framework, European corporate bonds lack practical contractual protections in standard Eurobond or EMTN (European Medium Term Note) documentation as well as effective legal and regulatory support of EU member state regimes. The relative creditor rights of investors holding unsecured notes from European issuers may potentially be diluted, via future secured financings, to the point where they are the lowest-ranking creditor in the capital structure.
In this report on Europe’s “Fallen Angels” (corporate issuers that have witnessed their credit ratings fall from investment-grade to sub-investment-grade), we review and comment on how European corporate managements regularly take advantage of lax protections in investment-grade bonds and resort to secured loan facilities from relationship banks to stabilise a deteriorating financial position. Fitch’s analysis focuses on the position of bondholders as corporate stakeholders in light of market and legal frameworks in Europe that may no longer be sustainable:
In 2003, investors in the corporate bonds of such Fallen Angels as ABB Ltd. (“ABB”), Vivendi Universal (“Vivendi”) and Royal Ahold (Koninklijke Ahold NV or “Ahold”), among others, have benefited directly from bank-led London Approach rescues, notwithstanding the structural subordination they endured in the process. Other London Approach-style rescues such as Heidelberg Cement (Heidelberger Zement AG or “Heidelberg”) and the current plan under negotiation with French chemicals company Rhodia have yet to generate the same degree of market confidence in rehabilitation. Bondholders in these credits may be potentially vulnerable to ongoing structural subordination and unable to prevent erosion in enterprise value. More worrying for all creditors and stakeholders, however, are the Fallen Angels that fail to arrange London Approach rescues, as there may not be practical alternative market or legal mechanisms to foster rehabilitation.
Recent changes to the insolvency regimes in France and Italy, in the aftermath of the Alstom Affair and the Parmalat crisis, towards more formal Chapter 11- style debtor-in-possession frameworks, suggest that policymakers are being forced to recognise that current market and legal frameworks are not adequate for rescuing or rehabilitating otherwise viable companies. As they develop new insolvency frameworks in the aftermath of corporate crises, however, Europe’s policymakers are focused on protecting local constituent interests. The question for the Gang of 26 is whether its efforts to achieve stronger market standards continue to focus on exercising market leverage over arrangers and issuers in new issues; or whether it takes its case directly to policymakers and influences the development of formal insolvency frameworks such that managements are no longer disincentivised to agree to their covenant demands and European courts recognise their rights as corporate stakeholders.
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European Corporate Debt Issuance
 Excludes Converts, Asset-Backed & CDs Source: Thomson Financial |
European Corporate Debt Issuance
 Excludes Converts, Asset-Backed & CDs Source: Thomson Financial |
The appetite among European corporations for flexible, long-term debt capital, and the corresponding demand for fixed-rate assets among European institutional investors, has grown dramatically since the launch of the euro in 1999. Indeed, the development of a single market for European fixed-income products has led to a rapid rise in new issuance of European corporate bonds such that they now rival US levels. The depth, diversity and size of available funding in the international capital markets as well as the relative cost and flexibility benefits of corporate bonds compared with traditional bank loans have persuaded many European companies to embrace bonds as a preferred source of debt capital. However, the supply of new corporate bonds is struggling to meet considerable demand. Institutional investment managers and a rapidly growing European fund industry have attracted substantial capital from pension funds and insurance companies as well as retail investors seeking additional yields in fixed-income credit products. However, investor emphasis on the total return and relative yield pick-up available in corporate bonds contrasts sharply with secular trends in issuer credit quality towards the lower end of the investment-grade credit scale, as well as weak structural characteristics in the corporate bond instruments themselves.
In a recent special report by Fitch Ratings entitled “Jumping the Queue” (available at www.fitchratings.com), the agency examined many of the loopholes in standard sterling and eurodenominated Eurobond documentation and EMTN programmes.2 Among these are Negative Pledge clauses that exclude bank debt and where the definition of relevant indebtedness often excludes debt in the issuer’s local currency. Ineffective Negative Pledges and weak covenant packages allow corporate managements to change business strategy, restructure balance sheets or spin off assets to the benefit of shareholders and detriment of bondholders. A potential acquirer has few constraints preventing the layering of secured debt on existing unsecured creditors to effect a take-private transaction, such as a leveraged buyout or a management buyout, while leaving the unsecured, once investment-grade bonds on the balance sheet as an involuntary contributor to a new owner’s leveraged bet on the company.
Moreover, a review of how European corporate managements and European legal frameworks respond to corporate financial or economic distress reveals a systemic disregard for unsecured bondholders’ creditor rights. Indeed, in practice, once an investment-grade company becomes sub-investment-grade, the securities purchased by fixed-income investors, often subscribed as “senior” notes, may in fact have become the lowest-ranking debt instrument in the debtor’s capital structure.
The lack of adequate protections in European investment-grade bond documentation translates into greater vulnerability to event risk in the European corporate bond market compared with its more mature US counterpart. Although prices for investment-grade European corporate bonds as reflected in their spread over benchmark government bonds remain near historically tight levels, concern about the structural risk characteristics of publicly dispersed corporate bonds is beginning to generate serious debate about the nature of European corporate bonds as an investment asset class. Specifically, a group of 26 investors from the UK and Europe (the “Gang of 26”) has recently issued a public paper calling for specific improvements in sterling and euro market standards in structural features, documentation and market practices. Citing ineffective Negative Pledges and Change of Control provisions, poor reporting and disclosure practices among other market shortcomings, these investors recognize that their rights as creditors are easily compromised by borrowers, which, together with their arranging banks and advisors, are intent on maintaining maximum flexibility for minimum cost in operations and financings.
The public airing of long-held complaints about the trends in the sterling and euro corporate bond markets raises fundamental questions about the adjusted risk/reward profile of European corporate bonds. Although many market practitioners and observers have sympathy with the views of these investors regarding current European corporate bond market standards, few offer optimistic hints as to the prospect of real reform, particularly in current market conditions. Nonetheless, the Gang of 26 remains intent on spreading its influence among UK and European investing institutions, and is having success with many continental investors burnt by recent event-driven deteriorations in credit quality. However, an analysis of how and why managements resist bondholder demands for greater protection from event risks suggests that it will take much more than market leverage to produce meaningful reform.
European corporations with investment-grade credit ratings issue bonds in the form of notes with maturities that typically range from five to ten years, although in some cases maturities have reached up to 30 years, particularly in the sterling market but also recently in the euro market. European investment-grade corporate bonds are marketed as ranking “senior” unsecured and are widely believed to enjoy pari passu ranking status with all other unsecured note issues or creditors lending to the same corporate group. Although they account for an increasing share of the total capital consumed by European corporate borrowers, investors in unsecured notes of European issuers, unlike their equity-investing counterparts, have no vote or input in matters of corporate governance and limited exposure to sharing the potential value appreciation that might accompany any improvement in a company’s profitability. Instead, investors in unsecured notes receive fixedinterest coupon payments on a fixed schedule over the life of the notes and 100% of the principal amount of the notes repaid at maturity.
In addition to the corporate issuer’s contractual obligation to pay the coupon on fixed dates set out in the notes’ terms and conditions, investors in corporate bonds have historically demanded covenants in the agreement, an indenture or trust deed, which served to prevent management or an acquirer from potentially abusing their debt capital in the interests of other stakeholders, particularly equity shareholders. After all, investors in notes agreeing to a long-term contract with the company – up to 30 years in some cases – want to keep management disciplined in maintaining the credit quality of the company over the life of the instrument. Typical among these covenants are:
In addition, investors often require covenants restricting asset sales, to prevent asset stripping, as well as restrictions on payments to shareholders or affiliates, unless certain financial and cash flow thresholds are maintained. Finally, in the event that the issuer cannot meet its obligations under the notes, bond investors retain the right to declare an event of default and accelerate and enforce their contractual claims over the company. However, such enforcement may lead to the insolvency of the borrower. As a result, resolution of these claims may include a capital restructuring, where bondholders accept a “haircut” on their potential recoveries, although the company remains a going concern; or the sale of the company and/or its assets in order to repay outstanding interest and principal. These negotiated rights imply senior creditor status, and rank the bondholders’ claims above or at least equal to other unsecured creditors. The combination of covenants and favourable ranking in the capital structure are the principal factors that contribute to the lower risk/lower return profile associated with “senior” unsecured corporate bonds compared with subordinated debt instruments and equity financing products.
The absence of adequate bondholder protections in Europe is, in part, the legacy of issuing mechanisms in the UK and Europe. In the UK, a market with a long history of capital market intermediation, long-term bonds were principally issued in the form of debentures until the 1980s. Debentures were fixedrate bonds that were often privately held until maturity. They were also secured over assets and included covenants relating to specific investment projects. Increasing investor demand for fixed-rate products eventually led to the development of unsecured corporate bonds in the UK. By the 1970s UK companies were able to access cheaper and more flexible unsecured bonds: first in the form of unsecured loan stock, which included borrowing limits tied to capital and reserves; and later in the 1980s and 1990s via the rapidly developing market for liquid, publicly rated Eurobonds and subsequently EMTN programmes.
Eurobonds were principally sold via banks to retail investors (giving rise to the infamous Belgian dentist) and offered more flexibility and less onerous disclosure requirements than the US bond market. Eurobonds were an attractive funding source for international financial institutions and sovereign issuers in the 1980s and 1990s. Amid growing institutional demand, UK and European companies seeking longer-term fixed-rate debt started issuing
Eurobonds with greater frequency in the 1990s. Initially developed in the US in the 1960s, though not successfully imported to Europe until the late 1980s, Medium Term Note programmes (“MTNs” or “EMTNs” for European issuers) are set at a specific total programme amount and drawn as issuers deem necessary given funding needs and market conditions. The EMTN programme represents one set of documentation for the entire programme (which can be altered and updated annually) augmented by separate issue pricing supplements, which represent a summary of pricing terms, amount issued out of the programme, coupon dates, and other standard information.
Historically, Eurobonds and EMTNs were issued by ‘AAA’ and ‘AA’ rated companies, where bondholder protections in documentation were often limited and generally insignificant given the high credit quality of the borrowers. The high credit ratings reflected a legacy of tight regulation, low gearing, and strong visibility in cash flow generation, which underscored the ability of corporate borrowers to repay debt given their respective industries.
Over the past two decades the confluence of trends towards economic liberalisation, deregulation of protected industries and an evolving shareholder culture in Europe have altered the market environment for European companies and industries. By employing greater leverage in their balance sheets, equity-incentivised managements could achieve higher returns on equity and drive shareholder returns. Deregulation in many industries as well as the removal of protective trade barriers also contributed to reduced visibility of market positions and cash flows, further undermining the credit profiles of many borrowers.
Combine these structural changes to balance sheets and market environments with the advent of the euro in 1999 – fundamentally altering the nature of fixed-income investing in Europe by removing interest rate and currency differentials – and suddenly the supply of and demand for lower-rated investment-grade corporate bonds were leading to a boom in issuance. Critically for bond investors, however, the demand for additional yield did not account for the underlying structure of weakly covenanted Eurobonds and EMTN programmes. As a result documentation standards have not changed materially to reflect the deterioration in issuer credit quality.
In early October 2003, in response to the kind of event risks highlighted in “Jumping the Queue”, a group of 26 UK and European investors published a document calling for improved market standards in documentation for sterling and euro corporate bonds. The “Gang of 26”, as it has come to be known, noted the deterioration in bondholder protections in both sterling and euro corporate bond documentation as well as many other deficiencies in the markets relating to the potential volatility that these unattended structural issues can have on secondary market prices. The market standards paper also noted inadequate secondary market liquidity, attempts by arrangers to bring unrated transactions to the market, and inconsistent and, in many cases, inadequate reporting and disclosure practices. The members of the Gang of 26 correctly note that their status as “senior” creditors is too easily compromised, that they are involuntarily supporting potential take-private transactions, and that some issuers are abusing lax reporting and disclosure practices.
Notwithstanding widespread sympathy among many practitioners in Europe’s corporate bond market, few believe that the Gang of 26 will be successful in achieving meaningful reform in the near term. The principal reason centres on the current market environment and the corresponding lack of negotiating leverage that investors have over issuers as new transactions are marketed. Demand for corporate bonds remains historically strong, with European corporate bond yields near historically low levels and massive liquidity searching for additional yield. Without the ability to identify to issuers any current spread premia for the existing structural risks that they assume, or to explain potential discounts to issuers that agree with the need for tighter standards, the Gang of 26 has very little leverage to see its demands through.
Moreover, with pension funds and insurance companies compelled to shift their portfolios away from risky equity investments towards instruments that match their long-term fixed-rate liabilities, European corporate bonds offering superior returns to government bonds look increasingly attractive to a rapidly growing institutional investor base in fixed-income credit products. Many observers argue that trends in the credit quality and structural characteristics of European corporate bonds are frequently secondary considerations if the instruments carry investment-grade ratings and investors can capture additional yield.
The Gang of 26 recognises that current market conditions do not bode well for making demands of issuers and arrangers, yet it is determined to spread its influence to a critical mass of sterling and euro investors in order to exercise greater leverage at a time when market conditions warrant.
The Gang of 26 has been inspired by its counterparts in the European high yield bond investment community, which successfully lobbied for structural changes to their market in 2003, and which have traditionally enjoyed comparatively tighter covenant packages and more transparent reporting and disclosure practices. High yield investors are more sensitive to credit quality and potential event risk as the higher potential for default inherent in sub-investment-grade ratings focuses their concerns regarding both management discipline and bond structure.
| 1. Change of Control Provision: |
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| 2. Negative Pledge Clause: |
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| 3. Disposal of Assets Restriction: |
Issuers should strike the common wording of “except in the normal course of business” which functions as a “get-out clause” and renders the covenant virtually meaningless. |
Source: “Improving Market Standards in the Sterling and Euro Fixed Income Credit Markets” October 2003
High yield investors appreciate that covenants can be fundamental to preserving value and preventing shareholders from abusing discretion over bond proceeds. Consider the recent example of Kirch Media A.G. (“Kirch”, a member of Kirch Group or TaurusHolding GmbH & Co. KG) and its subsidiary, free-to-air broadcaster ProSiebenSat.1 Media AG (“ProSieben”). Following downgrades to sub-investment-grade in 2002, ProSieben issued high yield bonds that contained effective covenants on change of control, restrictions on payments and transactions between affiliates specifically drafted to prevent an attempt by the distressed parent company from seizing ProSieben assets to stave off the parent’s insolvency.3 Kirch eventually entered administration and was liquidated, while ProSieben has continued to service its bonds as a going concern under new ownership. Contrast the ProSieben case with that of Swiss national airline Swissair, where holders of once investment-grade bonds were essentially helpless as assets were transferred from the distressed Swissair borrower group to an affiliate company. Swissair eventually became insolvent while the affiliate, CrossAir, continued to operate, in part, on the basis of assets that had once formed part of the Swissair borrowing group.
Not only do European high yield investors enjoy stronger covenant standards, they also demonstrated in 2003 that they could take effective action to achieve structural improvements in their market. Specifically, in late 2002 and early 2003 a group of influential European high yield investors effectively lobbied for greater credit support and structural enhancements to European high yield bonds. As we discussed in our report “Re-inventing European High Yield” (available at www.fitchratings.com), a spate of European high yield defaults in 2001 and 2002 revealed the depth of subordination and almost complete lack of creditor rights inherent in European high yield bonds issued out of structurally subordinated holding companies. The experience of being shut out from restructuring discussions – by senior secured banks, which lent to entities closer to the cash flows and assets of group operating companies – produced a collective action in the form of a threatened buyers’ strike on new European high yield issues unless future issuance reflected contractual as opposed to structural subordination.
Europe’s high yield investor community was successful insofar as most new issuance in 2003, among sub-investment-grade issues (including many Fallen Angel and crossover credits), included not only standard high yield covenant packages but also upstream credit support from operating subsidiaries in the form of subordinated guarantees and secondary pledges over shares. The inclusion of these credit support features makes it potentially more difficult for senior secured creditors to disregard subordinated high yield creditor claims in default situations, which should result in stronger recoveries for European high yield investors going forward.
The situation for investment-grade investors is all the more urgent given that some recent attempts by Fallen Angels to raise new money bonds from the European high yield market require upstream credit support. As in the case of Heidelberg Cement, the prospect of issuers granting primary security to relationship bank loans and second security to new high yield bonds potentially leaves the once investment-grade and outstanding Eurobond and EMTN issues as the lowest-ranking and most structurally subordinated creditors on the balance sheet. The Gang of 26 recognises that its investmentgrade issues potentially face the same weak ranking position in a default, even below trade creditors, as that encountered by the high yield investors prior to the high yield investor action.
The lessons from the European high yield experience may not be entirely appropriate for the Gang of 26 and the investment-grade market, in view of certain factors specific to the European high yield market. In addition to difficult market conditions, which provided the activist European high yield investors with considerable leverage over arrangers, the threat of the buyers’ strike was directed principally at the issue of structural subordination. Timing was critical, as several arrangers were attempting to refinance contractually subordinated mezzanine bridge loans (arranged as part of the acquisition facilities for leveraged buyouts of the issuing companies) with structurally subordinated high yield bonds.4 In order to satisfy the demand of high yield investors for upstream credit support from operating subsidiaries, the investment bank arrangers were forced to seek waivers from the senior loan group after the senior loans had already been syndicated. The ability to refinance the bridges was therefore dependent on an awkward and ultimately unsatisfactory process of offering substantial concessions (principally in the form of additional fees and margin) to senior bank groups.
In hindsight, the investor action proved effective not because of market leverage per se, but rather because high yield arrangers were particularly vulnerable to the prospect of holding bridge loans for an indefinite time – an intolerable situation for most arrangers due to the potentially large exposure of concentrated and risky credit on their balance sheets. Consequently, all the leading arrangers of European high yield issues were obliged, regardless of stronger market conditions throughout 2003, to provide some form of upstream credit support (principally guarantees and share pledges from operating subsidiaries) to new European high yield bonds, in order to mitigate the risk of “hung” bridges. The structural adjustments towards a US-style contractual subordination template in the European high yield market were therefore a result of arrangers acting out of self interest in response to their vulnerability in providing interim acquisition facilities. The challenge for investment-grade investors is whether they will be able to identify similar self interests among arrangers or issuing companies in order to achieve meaningful and lasting structural changes to investment-grade corporate bonds through market cycles.
Another point of departure for the Gang of 26 in its efforts to produce stronger and more effective standards in European corporate bonds is the example of the US corporate bond market. The US investment-grade corporate bond market is considered to be mature in terms of depth, liquidity, documentation standards, and reporting and disclosure. In addition to the benefits of uniform reporting and disclosure obligations inherent in SEC registration of publicly traded securities, US investment-grade corporate bonds benefit from strong standards in documentation. US indenture covenants include an effective Negative Pledge clause as well as restrictions on liens, disposal of assets, and transactions between affiliates, among other