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Safeway LBO puts spotlight on need for bond protection

By Danielle Robinson

NEW YORK, March 7 (IFR) - Investors have been put on high alert regarding the need for covenant protection in investment-grade corporate bonds, after being rattled by this week's US$9.4bn LBO of Safeway and last month's scare when Time Warner Cable was saved at the eleventh hour from a hostile bid.

News that Cerberus Capital Management's US$9.4bn acquisition of Safeway, US$7.6bn of which will be in debt, sent the grocery operator's CDS premium gapping out more than 52bp, to close at 344bp on Thursday.

Although most of Safeway's bonds have change of control (CoC) language, its US$150m of 7.45% 2027s and its US$600m of 7.25% February 2031s do not.

Both bonds had already lost several points in dollar price since Safeway started to shop itself around, and have plunged further on news of the Cerberus-led LBO. The 2031s were trading at 93.00, or Treasuries plus 523bp, on Friday, from the high 90s and around 375bp earlier in the week.

That comes just weeks after holders of more than US$20bn of TWC debt, none of which has CoC language, were saved from being junked, after Comcast outbid high-yield Charter Communications for the cable company.

But the two incidences have underscored that CoC language, which has become something of a standard in Triple B bonds, is not widespread enough to protect against the event risk facing bondholders today.

"Time Warner really increased investors' concern about the event risk in the investment-grade market," said Rajeev Sharma, portfolio manager at First Investors Management Co.

"For the longest time we didn't know if Time Warner Cable's bonds would go into high-yield, and all that uncertainty has meant that the first thing you look at in a new issue now is whether it has CoC protection."

CoC language has come back in vogue in the past year, as evidenced by the fact that six out of the eight non-financial corporate deals on Tuesday had CoC language.

They were mostly Triple B, or split between Single A and Triple B, and generally had room to leverage up.

But TWC was a classic case of a Triple B company that traditionally never included CoC language in its bonds when it should have.

With M&A on the rise and LBOs picking up, investors are also worried that more companies will look for loopholes in the wording of covenants to get around the 101 put right in CoC language.


"Not all CoC protection is equal," said Alex Diaz-Matos, analyst at independent credit research firm, Covenant Review. "There is a wide variety of drafting differences and how those provisions are drafted can influence the strength of the put right."

Some covenants, for example, will give a 101 put right to bondholders if a change of control causes ratings to drop from investment-grade to junk. But if they are downgraded to non-investment-grade before a change of control, then companies can argue that the put right does not transfer over to the newly rated high-yield bond.

In its press release, Safeway said it "contemplated" repaying its existing indebtedness, other than the 2019s, 2020s and 2021s, which all have CoC language, as well as the 2027s and 2031s, which do not.

That could be because it will wait for the 19s, 20s and 21s to be put to them, hoping that some investors do not do so. Diaz-Matos thinks Safeway might consider the CoC put invalid at this point, because they had not been downgraded by the ratings agencies at the time of the LBO announcement.

"There are games that can be played with the ownership structure and the timing of the downgrade relative to the 'change of control' which pits the acquirer against the bond investor," said Scott Kimball, senior portfolio manager at Taplin, Canida & Habacht, part of the Bank of Montreal asset management stable.

"Seeing as the investor is presumably the lesser expert when it comes to breaking contractual language, seeking more covenant protection is warranted."

Investors are now looking for things like step-up coupons and prohibition against asset sales, or the divestment of core assets and business lines that account for a large percentage of operating income.

Another problem is the fact that many bonds are trading well above 101, making the put right out of the money.

Step-up coupons are hard to get in today's investment-grade market, however, where the flood of inflows into funds has made it easy for companies to find less sensitive investors to buy their bonds.

All the more reason to go through covenants with a fine-tooth comb and know the credit and sector trends, said Kimball.

"There is no substitute for good credit work, because there are no put options for stupidity," he said.

This story appears in the March 8 issue of IFR Magazine, a Thomson Reuters publication