Debtholder Relations in a Pandemic: Are You Prepared for What Comes Next?
Debt is top of mind for just about everyone these days: consumers (who hold mortgage and credit card debt), governments (which float bond offerings) and public companies (which rely on debt for expansion in good times and for general corporate purposes).
With COVID-19 dramatically reducing the revenue-generation capabilities of many organizations, the potential for covenant breaches that can result in defaults has never been higher.
Given the importance of debtholder relations, IR focus has chosen to delve into the topic, with a practical focus on what bondholders want and expect from public companies during the pandemic. As debt ranks higher than equity in the capital stack, secured and unsecured creditors receive preferential treatment under law, which puts them firmly in the driver’s seat during periods of financial distress.
As interest rates tended to move ever lower over the past 40 years, the abundance of cheap money (and interest deductibility for tax purposes) caused many issuers to opt for debt to finance their growth.
Generally, companies borrow money to match the terms of their assets with the terms of their liabilities and to take advantage of borrowing costs that are lower than the after-tax returns they expect to make from a debt-funded asset purchase.
Companies also arrange revolving credit facilities for liquidity. These facilities can be drawn whenever there is a need and are especially useful when a business experiences sharp cash flow fluctuations and low cash balances. In today’s environment, credit facilities are a lifeline for many companies.
Revolving credit facilities charge interest on drawn amounts only. There can also be a commitment fee paid to compensate the lender for keeping the line open even if it is not used. Conversely, bonds and debentures are term debt and incur interest on the full amount at the prescribed coupon rate, which must be paid at regular intervals. Floating rate debentures have coupons that automatically adjust to changing interest rates. Depending on market conditions, this may make floating rate debentures easier to market.
While the terms are used interchangeably, bonds are often secured by a specific asset such as a plant or machine, while debentures are often unsecured and offer protection to investors through various restrictive covenants and by the issuer’s general creditworthiness (as reflected in its credit rating).
Credit ratings are generally divided into two buckets: anything at or above BBB- (also called Baa3) is considered investment grade; anything starting at BB+ (or Ba1) and below is high yield or “junk,” to use the colloquial definition. Lower-rated bonds offer higher yields to compensate investors for additional risk.
The margin a company pays its lender for assuming risk is typically calculated as the spread between the yield on a benchmark (Government of Canada bond, for example) and the corporation’s bond. The bigger the risk, the higher the credit spread.
Ratings assigned by DBRS, S&P, Moody’s and Fitch will have a significant influence on the cost of borrowing. In its commentary from April 9, one of those rating agencies, DBRS, noted that COVID-19 has “considerably dislocated the world economy and drastically altered the course of most industries and companies through, among other things, forced shutdown of operations, sharp declines in demand for products and services, altered consumer behaviour, as well as supply chain and labour supply shocks.” As a result, the agency noted it had revised the ratings of “many” corporate issuers to incorporate the expected impact of the pandemic and indicated, somewhat ominously, that it expects its process to lead to more “negative rating actions” in the coming months. Other agencies have issued similar thoughts.
That said, debt investors can still profit from downgrades. This might happen when, for example, a holder proactively divests an investment-grade security before a downgrade and buys it back on the prospect of an upgrade.
There are various characteristics that may be built into the return of principal, including a call/redemption right that gives the issuer the right to pay off the bond prior to maturity to take advantage of a lower interest rate. Other common terms include:
- bonds with sinking fund provisions that require the issuer to set aside earnings each year to provide for repayment at maturity;
- bonds with purchase-fund arrangements that require the issuer to retire a specified amount of the outstanding bond/debenture when the price reaches a stipulated level;
- extendible bonds typically issued with a short maturity term but with an option for the holder to exchange the debt for an identical amount of longer-term debt at the same or slightly higher rate of interest;
- retractable bonds, which give the holder the option to force the issuer to repay the bonds earlier than their final maturity date; and
- convertible bonds/debentures that allow the holders to convert their debt into common shares of the issuer.
There are also different credit facility types. Revolving facilities are so named because they allow for a revolving cycle of withdrawing, spending and repaying until the arrangement expires.
Debt can be privately placed directly with institutions such as pension funds and insurance companies (same for credit facilities) or publicly floated on a fixed-income market. Fixed income markets dwarf equity markets in value, demonstrating the popularity of debt instruments.
On public markets, bond prices are quoted with a base of 100. If the bond trades at 100, it is trading at face value; if it trades above or below, it is trading at a premium or a discount. Bond pricing principles are tough to summarize in the confines of this article but involve the calculation of present value using an appropriate discount rate (which depends on the level of risk).
In Canada, the FTSE Russel Canadian High-Yield Bond Index and in the U.S. the Bloomberg Barclays High Yield Index are two of many well-referenced benchmarks. In the case of the U.S. benchmark, it was down 20% in March as the world woke up to the realities of COVID-19.
Debtholders require certain safeguards to be included before they will invest. Common protective provisions include:
- working capital requirements that may prohibit common share dividend payments if those payments would cause the issuer’s working capital to fall below a stated minimum (this provision has already triggered a number of Canadian issuers to cut their dividends since the pandemic began);
- sale of asset and merger restrictions and prohibitions or limits on the divestiture of shares in a subsidiary;
- prohibitions on prior liens meaning that no bonds in future can be issued that rank higher than the existing bond on offer; and
- negative pledge provisions, which prohibit subsequent debentures from being secured by all or a part of the company’s properties unless the existing debenture is similarly secured.
A Bondholder’s View
When bondholders invest, they analyze the 5 Cs of credit: character, capacity, capital, collateral, and conditions. In simple terms, they all add up to the same thing: will the issuer be able to make its scheduled coupon payments, and will the issuer be able to repay the debt in full and on time?
With COVID-19 halting or slowing production and the provision of services by many companies, and in so doing greatly reducing revenue (not to mention productivity), bondholders that IR focus talked to moved quickly to reassess the business models of the issuers whose bonds they own, with a focus on cash burn. As one debtholder put it: “We choose to take debt in companies with strong, positive operating leverage; those who can grow revenues without the same growth in their cost base. Now, with COVID-19, we’re looking to see how quickly companies can reduce costs – and by how much – so that negative operating leverage doesn’t impact the issuer’s ability to service their debt to us.”
Bondholders pay close attention to the issuer’s cash conversion cycle in order to forecast the likely amount of time it will take a company to convert its investments in inventory to cash. A longer cycle means greater risk of non-repayment and greater use of credit facilities.
The message to IROs from bondholders interviewed is to have a strong sense of your company’s business model, revenue annuity stream (if any), variable and fixed costs, plans for cost reductions and projected cash burn. In this environment, bondholders expect a company to employ a variety of operating and cash flow preservation measures, including:
- cost reduction in both operating structures and capital expenditures;
- elimination or pullback of inventory buying; and
- suspension of share buybacks or suspension of planned dividend increases.
Companies with some form of prepaid revenue annuity are likely to be rewarded in this environment because their revenue is effectively in the bank. Even then, the potential for the annuity revenue stream to reduce is heightened as customers prepaying for a service face their own cash shortfalls.
ESG risk is typically on the list of factors bondholders consider. COVID-19 can be viewed through the ESG lens and, unsurprisingly, some debtholders are now looking at corporate policies/practices related to providing financial support to customers/workers, business continuity costs/risks and provisioning costs for worker safety. Executive compensation is also top of mind with many investors (debt and equity) and some expect the C-suite and Directors to share in the pain caused by COVID-19 economic disruptions.
Some companies devote specific pages of their investor websites to bondholder communication. The institutional bondholders IR focus interviewed generally did not use these sites as they found them “perfunctory” and “too basic.” According to them, a useful website portal contains:
- a four-column table listing all outstanding debt, rate, face value and maturity date with hyperlinks from each security to its prospectus and/or governing indenture where contractual obligations/restrictions are listed;
- a separate table showing credit ratings assigned by all rating agencies for all relevant debentures, notes and commercial paper;
- recent bondholder presentations; and
- issuer contact information.
Best-practice IR programs also consider debtholder outreach, including participation in debt investor conferences.
IROs working in the banking, REIT and telecommunications sectors are more likely to engage with bondholders than other IR practitioners, due to the debt-intensive nature of their industries.
Outside these sectors, it is common to spend far more time with equity investors than bondholders. This is reflected in CIRI surveys that typically list ‘debtholder relations’ at or near the bottom of responsibilities assumed by IR. For their part, bondholders we interviewed said they tend to bypass investor relations officers by going directly to CFOs/treasury departments for in-depth discussions.
That said, bondholder relations is critically important to every company that uses debt – and that’s just about every company. Accordingly, it is valuable for IR practitioners to have a good handle on who owns the debt of their companies (a process that can be aided by third-party market intelligence services), the key protective provisions in their debt securities outstanding and the plan for generating cash to service debt during this pandemic.
Whether or not you engage with bondholders directly, how these bondholders – and rating agencies – react in the weeks ahead may have a significant impact on your equity owners and your company overall. So be aware!
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