Debt-Driven Deals Shake Up Holders of Highly Rated Bonds

By KAREN RICHARDSON and SERENA NG

February 8, 2007; Page C1

The flurry of debt-driven corporate mergers, spinoffs and buyouts is putting a normally staid group of investors -- investment-grade bondholders -- on the defensive.

[Bulleted List] Typically a genteel bunch populated by life insurers and pension-fund managers, these risk-averse investors are learning the hard way that their bets on high-quality corporate bonds, some of the safest debt around, are more vulnerable than believed.

Holders of highly rated bonds in companies like casino operator Harrah's Entertainment Inc. or energy firm Kinder Morgan Inc. have seen their investments dropped in value overnight after private-equity shops launched bids for the companies.

The bids came with plans to load the companies up with new debt. The heavier debt burden meant existing bondholders became more exposed to default. They had added exposure, because the new debt would be paid off first if a default actually occurs. In both cases the credit rating on the existing bonds tumbled from investment grade to junk.

"The whole culture of high-grade bondholders for a very long time was lackadaisical, where nobody was ever worried," says Robert Haines, a bond analyst in New York at CreditSights, an independent debt-research firm.

That might be changing as buyout shops search out more big, high-quality companies to take over.

In a rare show of solidarity, some debt investors are fighting back. Blackstone Group's purchase of Equity Office Properties Trust, the nation's largest office landlord, for $23 billion is one example.

EOP's shareholders voted yesterday in favor of a buyout deal, concluding Blackstone's bidding war with Vornado Realty Trust.

The deal came with significant gamesmanship between existing bondholders and the company.

On Dec. 26, before Vornado appeared on the scene, EOP and Blackstone announced plans to buy back all of EOP's $8.4 billion in bonds as part of the Blackstone buyout. The offer covered short-term bonds due within the next 10 years and longer-term bonds due as late as 2031. But debt investors rallied against it, rejecting the terms as too little for the long-term bondholders.

"It was an impressive effort, especially the way bondholders seemingly looked out for each other," says Sid Bakst, a bond manager at Robeco Weiss, Peck & Greer who wasn't involved in the EOP affair.

In that case, bondholders had some leverage against the company. They were protected by provisions in the debt, known as covenants, that limited the amount of new debt EOP could take on in a buyout. Without the consent of existing bondholders, in other words, Blackstone might not have been able to finance the deal.

AIG Global Investment Group, which held both long-term and short-term bonds, banded other investors against the offer. By Jan. 11, EOP and Blackstone agreed to boost the offer to long-term bondholders by about 20%, paying nearly $950 million for the $725 million in outstanding bonds.

For the remaining $7.6 billion in debt, EOP and Blackstone agreed to pay about $8 billion. In total, bondholders will be paid about $9 billion for their $8.4 billion in bonds.

Bondholders in Tyco International Ltd., which is undergoing a restructuring that will split the conglomerate into three separately traded pieces, are bracing for a potential replay of the EOP situation, says one Tyco bondholder. Like EOP bondholders, investors in Tyco bonds have covenants that allow them to get their money back in a merger.

In many other cases, high-grade bondholders don't have these protections, making them especially vulnerable, even targets. Without covenants, they have little negotiating leverage with buyout shops. And because the bonds are high-grade and pay relatively low interest rates, they are appealing to buyout shops looking for companies that can bear more debt.

Now more investors are demanding these provisions. Home Depot, Federated Department Stores, and Black & Decker were among the companies that included such provisions.

"It's one of the first things we ask for nowadays," says Mr. Bakst of Robeco Weiss. "It's an insurance policy that protects against the worst-case scenario." If companies choose not to include covenants, they may have to commit to higher interest rates before investors will buy their bonds.

Even with the provisions, some bond investors are finding themselves vulnerable. This week, some bondholders in junk-rated Lear Corp. found themselves on the losing end of a buyout offer by Carl Icahn even though their bonds contained change-of-control provisions.

Lear had issued $900 million in bonds last November with terms that ensured the bonds would be paid off in full if ownership of the company changed -- but not if certain "permitted holders" took control of it. These holders were defined elsewhere in the bond agreement as Mr. Icahn, his affiliates and funds controlled by him. As a result, prices of the newly issued bonds slumped on news of the buyout bid.

Junked

How recent LBOs have hurt corporate bonds

Buyout Target	Price Change of Longest Bond on Day Buyout Announced*	Price Change Three Months Later	S&P Rating Action
HCA	-8%	-7.6%	"Watch negative" note added to junk rating
Univision	-3.8%	-1.6%	Cut to junk
Kinder Morgan	-9.1%	-6.5%	n/a
Neiman Marcus	No change	-1.2%	Cut to junk
Freescale Semiconductor	-0.4%	-0.15%**	Cut to junk
Harrah's Entertainment	-0.8%	-1.3%***	Cut deeper into junk territory

*Or day after, if there was no trading on announcement date

**Price data from slightly more than three months later

***Price data taken from Feb. 6, 2007 (most recent available)

Sources: MarketAxess, Standard & Poor's

Treasurys Increase

Treasury prices rose , as new supply entering the market this week as part of the government's quarterly refunding did little to pressure the market.

The benchmark 10-year note was up 5/32 point, or $1.5625 per $1,000 face value, at 99 2/32. Its yield fell to 4.745% from 4.765% Tuesday, as yields move inversely to prices. The 30-year bond was up 9/32 point at 94 18/32 to yield 4.852%, down from 4.870%.

---- Deborah Lynn Blumberg

Write to Karen Richardson at karen.richardson@wsj.com1 and Serena Ng at serena.ng@wsj.com2

URL for this article: http://online.wsj.com/article/SB117089750546101690.html

QUESTIONS:

1.) Define terms "bond covenant" and "bond indenture". Why do bondholders ask for covenants to be included in the indenture? What are some common covenants, and what risks are they intended to control?

2.) Why might covenants be more common for lower-rated bonds than for higher-rated ones? Support your answer.

3.) What is a "change of control" covenant? Why might a bondholder require one to be included in the indenture?

4.) Companies are typically bought out at a premium to the firm's existing stock price. Assume there are two firms: firm A's bonds have a change of control covenant, and Firm B's bonds do not. What are the likely differences in a) their probability of being acquired, b) the takeover premium if they experience a takeover bid, and c) the effects of a takeover bid on the prices of their bonds. Support your answers.