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Structural weakness

24 February 2015 By Neil Unmack

The rulebook is being rewritten in Europe’s high-yield boom. This is a seller’s market and returns are already slim: junk bonds yield just 3.97 percent on average, Barclays says. Now deal structures are also increasingly tilting in the issuer’s favour. That stores up trouble.

Picard, the French frozen-food chain, is a good example of what’s happening. Its recent 770 million euro bond lets owner Lion Capital take about 600 million euros out of the business, lifting debt to a racy 6.1 times EBITDA. These so-called “dividend recapitalisations,” while divisive, have been around for a while. But what’s just as notable here is how other protections, built into the bond covenants that govern a deal, are also being eroded.

First, in future Picard can pay Lion unlimited dividends as long as debt stays below 4.5 times EBITDA. Traditionally, sub-investment-grade deals impose tighter limits on dividends, so companies use excess cash to repay bank debt. That means bondholders end up with securities in a more creditworthy company. This way, leverage may instead stay higher for longer even if the company performs well.

Second, after 18 months Picard can buy back debt without fully compensating investors for forgoing future interest payments. Typical “non-call” periods would ensure investors enjoyed at least 3 years’ worth of payouts.

Third, a “portability clause” means if Picard is sold, its bonds might stay in place, rather than being bought back at a premium.

Elsewhere, investors are also letting others jump to the front of the repayment queue. Allowing companies to raise more debt secured against property and other assets would leave less for unsecured creditors in a default. Moody’s, the rating agency, says recent deals let companies raise up to 1.4 times EBITDA in new secured debt, up from 0.4 times in 2012.

As central banks suppress rates and print money, bond investors have a weak hand. Europe’s market is particularly susceptible to aggressive terms, because it is young. That means legal and financial structures are more flexible than they are in the United States. Theoretically buyers could go on strike, or ask regulators to get involved. For now, neither seems likely.

 

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