Investor Group Seeks Bond Protections

By SERENA NG December 17, 2007; Page C2

Tired of seeing their bond investments decline in value when the underlying companies undertake leveraged buyouts or large stock buybacks, around 50 large debt investors are banding together to lobby for more and stronger protections to be written into bond contracts.

A recently formed investor group called the Credit Roundtable, whose members include pension funds, insurance companies, mutual funds and other money managers, will release a white paper today that maps out problems with current protections in contracts governing investment-grade bonds. The paper also details covenants they would like companies to begin including. Covenants are contractual provisions in bond agreements that issuers are required to fulfill if certain events take place.

In the past year, as many companies announced buyouts, special dividends or share buybacks financed by large sales of debt securities, holders of their existing bonds sometimes were on the losing end. The additional debt increased the companies' risk of default and sometimes ranked higher than existing bonds, making the latter riskier. In some cases, prices of the existing bonds fell more than 10% overnight as investors anticipated that credit ratings on the debt would be downgraded to "junk" from investment grade.

The problem for bondholders was that many high-grade bonds didn't have covenants that enabled investors to recover the full value of their securities in the event of a buyout or recapitalization. Many of these bonds were issued years ago, when the prospect of the issuing company getting acquired in a buyout was remote.

The white paper lists provisions that investors want companies to incorporate in future bond issues. These include a "change-of-control put" that gives investors the right to sell their bonds back to companies if the companies are taken over, and "step-up coupon provisions" that would compel issuers to pay higher interest on the bonds if the ratings are downgraded.

"The LBO boom may have stalled temporarily, but it's not over. While the financing market is challenged now, we expect it to reopen at some point," said Tara Innes, a research analyst at AIG Investments, a unit of American International Group that is part of the industry group. "We're trying to plan ahead for issues that may come up over the next few years."

Dana Emery, an executive vice president at Dodge & Cox, which also is part of the lobbying group, says investors have been working together to develop strong covenants for months. The initiative gained traction after a group of bondholders successfully fought back against what they saw as an inequitable deal in the takeover of Equity Office Properties early this year. The 50 firms supporting the white paper include BlackRock Financial Management Inc., Loomis Sayles & Co., Fidelity Investments, and MetLife Inc.

In 2007, roughly 30 U.S. companies with billions of dollars in outstanding debt had their credit ratings cut by Standard & Poor's to junk from investment grade. They included such companies as Alltel Corp., First Data Corp., TXU Corp. and Kinder Morgan Inc. that were taken private in leveraged buyouts, and Health Management Associates Inc., which paid out a big debt-financed dividend to its shareholders.

Write to Serena Ng at serena.ng@wsj.com1

QUESTIONS:

1.) Who are the members of the Credit Roundtable? In general, what is the purpose of this group getting together? What document are they issuing?

2.) What factors influence the rate of interest required of any corporation by investors in its bonds?

3.) When companies issue debt, there may be a difference between the coupon or face rate of interest on the bond and the market rate of interest associated with the bond. What factors lead to that difference?

4.) Which interest rate is used to calculate bond interest expense according to an effective interest amortization schedule?

5.) As time passes, the differences among the bond coupon rate, the initial market rate of interest on a bond, and current market rate of interest can change based on both market factors and factors related to the bond issuer. Provide examples of each of these types of factors.

6.) How do bond covenants influence the changes described in answer to questions 3 and 5?

7.) What accounting implications might arise from changes in bond covenants proposed by the Credit Roundtable? In your answer, provide a definition of a "put" and comment on the implications of imbedded derivatives in a corporation's securities.