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Business Review 2006 from
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A new trend in the bond world
Peter Smart
Brewin Dolphin Securities Ltd
The buyback of debt announced by Sainsbury's a short while ago was undoubtedly the beginning of a new trend - the initiation of asset protection through company balance sheets.
This has important ramifications for bond investors and the bond sector in Jersey.
Companies like Sainsbury tend to be rich in specific assets - that is a large property portfolio. In this instance they are by and large unencumbered and not assigned to a specific creditor as security for a loan. Being in this enviable position they are the target of leverage buyout specialists, who, among other things, seek to realise the value of these unassigned assets.
If we look at the example of Sainsbury, we can see that, very broadly, the company has issued subordinated unsecured loans (its eurobonds) and of course equity to raise capital. Equity holders, of course, own the business and can determine the future ownership of the company by accepting or declining any potential bid offer.
In the past it has been a relatively simple matter to make an approach to the equity holders with an offer to which it is hard to say no.
This leaves the question of where does this vast amount of funding come from to finance the bid. The answer is from loans secured on the company's property or other tangible assets. This debt by dint of its securitisation leapfrogs all other unsecured debt in terms of capital seniority.
Effectively this action moves the existing investment grade debt - mostly eurobonds - to the bottom of the debt pile.
Most importantly for bondholders the company is not financed by equity any more but by debt - and a lot of it. An increase in debt levels or gearing will generally mean a downgrade in the credit quality of the non-secured debt.
Scary
Thus, for the bond investor, what was once a nice, investment grade bond providing, say, a regular 5.25% annualised income with little capital fluctuation is suddenly a rather scary piece of high yielding equity trading at a large discount to issue or purchase price.
Sainsbury has sought to avoid this happening. The bond buyback has been financed by the issuance of asset-backed bonds with the assets backing them being secured on specific pieces of their property portfolio.
This action is double edged in its effect. Thinking positively, Sainsbury are to be congratulated for taking steps to make their balance sheet more efficient, preventing themselves becoming LBO targets and the buyback terms at these relatively buoyant market levels are perhaps not too bad.
Thinking negatively, it is generally felt that the real terms of the buyback were not particularly generous and that bondholders in fact got a poor deal.
Tying this in with the re-investment risk of buying new bonds when yields are so low makes the action grate somewhat with the goodwill of the bond holder. However, the bond buyback scenario is hugely preferable to that of the leverage buyout.
As bond investors what we have to look to now is who will be the next candidate - either as a bond buyback scheme or the subject of an LBO. Most of the retailers are under pressure here, as is virtually any corporate bond issuer except financial companies. At the time of writing any non-financial that is not a member of the top 20 FTSE 100 club is a potential LBO target. Other bonds to exclude this risk will of course be government, government agencies bonds and supranational issuers.
Perversely, the high yield market puts up an excellent defence to this problem; the bond covenants are investor friendly and they frequently come armed with poison puts and clauses which prevent subordination and even repayment clauses in the event of an aggressive action that pushes their credit ratings lower.
When all is considered it is perhaps better to be looking to the ubiquitous bond fund for exposure to this important investment sector.
The typical investor will invariably be better served using a bond fund. There is a bewildering number of bond funds and investors should seek the services of a professional investment manager for advice in this regard.
Not only should they recommend a wide a wide range of options in this area, but they will also provide investment into funds at the most competitive terms - that is those with no front-end fees - while providing access to fund classes which have the lowest annual management fee.
In addition to the normal bond fund, investors are being offered to opportunities that provide access to the secured loans - the bank loan market. This is the market predominantly used by LBO specialists to obtain finance for balance sheet restructuring exercises.
Traded bank loans - or leverage loans as they are commonly referred to - are not available to the private client investor. They trade in a large institutional only market and the professionals in this space benefit from investing in senior, secured investments that derive their returns from an interest rate that is floating.
Definitions
Senior: Your investment cannot be moved down the company structure by having more senior lending placed above it.
Secured: Your money is lent on a secured basis, so should things turn out nasty the investment has a right over a particular piece of a company.
Floating rate: The interest returns will be cast at a specific yield differential - or spread over short-term interest rates, generally three or six-month LIBOR.
This also means that interest rate risk, as far as losing value from rising interest rates is concerned, is considerably lessened, and in fact completely obviated.
It should be noted here that leverage refers to an increase in borrowing at the company level and not that of the investment vehicle.
The title leverage loans therefore refers to the fact that companies that are issuing bank/leverage loans are increasing gearing or leverage on their balance sheet.
Funds investing in this area will currently be able to pay an annualised dividend of approximately six to 6.5 per cent although there are some funds which escalate the return by gearing up the fund structure to increase returns to ten per cent plus.
Investing in the leverage loan market will increase risk diversification in so many ways - interest rate and credit as well as asset class - and the market is set to post strong growth in terms of size, which, in turn, can only be good news for the investor.
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