Fitch: U.S. leveraged transactions challenge existing bond covenant packages

By Angela McDaniels

Seattle, Dec. 14 - Fitch Ratings said the role of covenants in indentures has become increasingly significant to bondholders because some of those issuers could be likely buyout targets and the risk of credit deterioration may be substantial.

With an increasing number of leveraged buyout, recapitalization, merger and acquisition, share repurchase and special dividend transactions being completed, the agency said the role of existing covenant packages in protecting fixed income investors has been severely tested.

The effect of leveraging transactions also extends to credit default swap market participants who are exposed to "successor events" and changing default or recovery prospects following such transactions, according to an agency news release.

"Low default rates and robust access to capital have fueled investor appetite for financing leveraged transactions," Amol Joshi, a director in Fitch's high-yield team, said in the release.

"It is likely that many of the existing investment-grade and cross-over indentures did not foresee the current scenario of cash-rich private equity buyers and investment banks willing to finance debt deals supported by deep liquidity from institutional investors in completing large leveraged transactions."

Fitch said it analyzed the covenant protections of three issuers who have brought event risk to the forefront of bondholder concerns - HCA Inc., The Jean Coutu Group (PJC) Inc. and Clear Channel Communications, Inc. - and identified certain key provisions that, if present, could have benefited bondholders.

The agency said it will, from time to time, examine significant transactions in the marketplace that challenge existing covenant restrictions or benefit from the absence of critical covenants, while being primarily debt-financed.

Although event risk is certainly present for investment-grade companies when there is an absence of covenants such as change of control and limitations on debt incurrence, restricted payments, anti-layering, etc., high-yield companies with all of such covenants present are not immune to event risk, Fitch noted.

The agency suggested that investors painstakingly analyze covenant packages to minimize investment losses related to the significant event risk prevailing at this time and said investors appear to be recognizing such risk and demanding additional protective measures.

Investors may, in fact, be willing to pay more for bonds that offer additional protection, the agency said. For example, bonds with a change-of-control put may trade at a premium to the company's other debt, even though such bonds are pari passu to the other debt with respect to all other provisions.

Ultimately, as additional analysis is done in studying existing indentures, more differentiation in bond pricing is likely to occur, Fitch predicted.

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