Be Protected: Know Your Covenants

In the world of bond investing, risk mitigation is critical, hence bond covenants serve as important safeguards of investor interests. These contractual agreements outline the terms and conditions of bond issuances, providing a framework to protect bondholders from potential risks and uncertainties. Among the myriad of bond covenants, change of control restrictions, ratings restrictions, and sale of assets restrictions stand out as key provisions aimed at fortifying the position of bondholders. Let's explore how these provisions work and how they seek to shield bondholders from adverse circumstances.

Change of Control Restrictions

Change of control restrictions are contractual provisions that empower bondholders to act in the event of a change in the ownership or control of the issuer company. This change can occur due to mergers, acquisitions, or other corporate restructurings that may significantly impact the issuer's financial stability and creditworthiness.

Bondholders may become concerned about the issuer's ability to meet its debt obligations following a change in control. Change of control restrictions grant bondholders the right to demand early repayment of their bonds or negotiate new terms with the acquiring entity to safeguard their rights and interests.

Corporate mergers and acquisitions introduce uncertainty and volatility into the market, potentially affecting the issuer's financial performance. By activating change of control provisions, bondholders can mitigate the risk of default and preserve the value of their investments. Many bonds typically have a “change of control put provision” struck at a level of 101. This gives investors the option to demand principal repayment of their bonds from the issuer at a price of 101.00 if the control is triggered.

Ratings Restrictions

Ratings restrictions are provisions that limit the ability of the issuer to undertake actions that may negatively impact its credit rating. These restrictions are designed to maintain the credit quality of the bond and protect bondholders from potential downgrades that could erode the value of their investments.

Ratings restrictions prevent the issuer from engaging in activities that could weaken its credit profile, such as taking on excessive debt or engaging in risky financial transactions. By upholding credit quality standards, these provisions help mitigate the risk of default and maintain investor confidence in the bond.

Additionally, ratings restrictions promote transparency in corporate decision-making by requiring the issuer to adhere to certain financial and operational benchmarks. By providing bondholders with visibility into the issuer's financial health, these provisions enable investors to make informed investment decisions and assess the credit risk associated with the bond. Like change of control triggers, some bonds have imbedded ratings triggers at a level of 101. As an illustration, if an investment grade rated company engages in financial activities (including mergers and acquisitions) that cause the company’s credit rating to be lowered to non-investment grade status, then a bondholder can demand principal repayment at a price of 101.

Sale of Assets Restrictions

Sale of assets restrictions are provisions that restrict the issuer's ability to sell key assets without the consent of bondholders. These restrictions are intended to protect the collateral or security backing the bond and ensure that bondholders' interests are not compromised by asset sales.

These restrictions also assist in ensuring that bondholders' claims are prioritized in the event of default. By preventing the issuer from disposing of key assets without bondholder consent, restrictive sale of asset provisions help preserve the value of the bond and mitigate the risk of loss for investors.

They also provide bondholders with assurance that the issuer will not take actions that could weaken the security supporting the bond. By limiting the issuer's ability to sell assets, these provisions enhance the security and stability of the bond, thereby protecting bondholders from potential losses.

In summary, bond covenants such as change of control restrictions, ratings restrictions, and sale of assets restrictions play a crucial role in safeguarding the interests of bondholders. Investors are also empowered to take affirmative action in the event these protective mechanisms are breached. However, it is worth noting that not all bonds contain protective covenants. Therefore, consult with your financial practitioner to learn what covenants your bonds possess and how they help to protect you.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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