We've Moved!

To increase the functionality of the blog, we've moved to:

financialtrainingpartners.com/comments-on-credit

or

commentsoncredit.com

Your subscriptions will be automatically transferred to the new site.  Come see us there for new posts on credit analysis and debt structuring!

Loan - Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond's cost is 50 basis points higher than the loan's cost.  Since both debt instruments were issued by the same borrower, shouldn't they cost the same?

Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).

Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. "high yield") bonds is typically higher than the yield on non-investment grade (i.e. "leveraged") loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:

1. Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds.
2. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have "bullet" maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time.  This longer maturity and lack of amortization make bonds more risky to own than loans.
3. Covenants:  Loans have more (and more restrictive) covenants than bonds.  Thus, as a company's operating performance begins to deteriorate, the loan will default long before the bond.  This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.

Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.

Issuer: Risk vs. Cost
As with Jarden,  for non-investment grade issuers, bonds typically have a higher all-in-cost than loans.  This is because bonds are less risky for issuers and provide issuers additional flexibility.

1. Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it.  If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk.  Companies can reduce their refinancing risk by issuing debt with longer maturities.  The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
2. Flexibility: Bonds place few restrictions on a borrower's operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.

Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.

Loan-Bond Relative Value

When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis.  In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.  

• If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.  
• If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.

Jarden Compares Loan and Bond Costs

Jarden Corporation (Ticker JAH) is a diversified consumer products company whose brands include First Alert, Holmes, Mr. Coffee, and Sunbeam.  On June 30, 2009, it had approximately $2.7 billion of debt outstanding, half of which was in the form of Term Loans due through 2012.  Management was eager to begin refinancing these term loans in order to gain additional covenant flexibility and extend maturities.  Over the next 7 months, it completed two transactions.

August 2009: "Amend and Extend"

• In August 2009, the company extended the maturity of $600 million of Term B loans ("TLBs") from January 2012 to January 2015 through the creation of a "Term B4" tranche.  This new tranche was priced at LIBOR + 3.25%.  The remaining $724 million of term loans remain due through 2012.
• Along with the TLB extension, the company extended the maturity of $100 million of its (unused) revolver from 2010 to 2012 and amended the covenants on its loan facilities to allow for additional securitization and other indebtedness.

January 2010: Senior Subordinated Notes

• In January 2010, the company completed an offering of 7.5% Senior Subordinated Notes due 2020.  The offering consisted of two tranches: $275 million offered in the U.S. and EUR150 (approximately $217) offered in Europe.
• The company used a portion of the proceeds from this bond to repay a portion of its term loan, presumably those maturing through 2012.
• The U.S. tranche was priced at 99.139, for a yield of 7.625%, or a spread of 385 basis points over the 10-year treasury.

So which is cheaper?

With LIBOR at 0.25%, the cost of the loan is 3.5% (i.e. LIBOR + 3.25%), while the bond's effective cost is 7.625%.  So the loan is a cheaper source of capital than the bond?  Not so fast!  The loan is floating rate - if LIBOR goes up, the company's interest cost will go up with it.  The bond is fixed rate - no matter what happens to interest rates, the coupon on the bond will not change.  So we cannot just compare the current loan cost of 3.5% to the bond's cost of 7.625% - that would be comparing apples to oranges.

Combining a Loan and a Swap

In order to compare the cost of a fixed rate instrument (i.e. bond) to a floating rate instrument (i.e. loan), you must put them both on the same basis: either convert the bond to a floating rate or convert the loan to a fixed rate.  This is done using an interest rate swap.  Let's swap the loan to a fixed rate, as follows:

• Step 1: The company borrows at LIBOR + 325 basis points.
• Step 2: In a separate transaction, the company agrees to make a periodic fixed rate payment to a bank, in exchange for which, the bank agrees to make a periodic LIBOR payment to the company.  
• The current quote for such an interest rate swap is about T+10: 
• The company will pay the bank a fixed rate of 3.875%, or 10 basis points over the current 10-year treasury rate of 3.775%
• The bank will pay the company a floating rate of LIBOR, which will vary over the life of the contract. 
• These transactions can be expressed as follows:

We can now calculate the effective fixed rate cost of the loan-swap combination:

• Payment to loan holders:          LIBOR+325 basis points
• Received from the swap bank:   LIBOR
• Payment to swap bank:            Treasury +10 basis points

The LIBOR received from the swap bank offsets the LIBOR paid to the loan holders.  The net outflow from the company is the T+10 paid to the swap bank plus the 325 basis points paid to the loan holders, or T+335.  The 10-year treasury is 3.775%, so the effective fixed rate cost of the loan-swap combination is 3.775% plus 335 basis points, or 7.125%.

The Loan is Cheaper

The effective cost of the bond is 7.625% while the effective cost of the loan is 7.125%, so the loan is cheaper by 0.50%, or 50 basis points.

Why is the bond more expensive?  And why would the company issue the bond if it is more expensive than the loan?  Watch the blog for answers to these questions.

Using Subordination to Define Intercreditor Priority

The November 2009 issue of The RMA Journal, The Journal of Enterprise Risk Management, includes an article entitled "Using Subordination to Define Intercreditor Priority" by Ron Carleton and Tim Delaney of Financial Training Partners. The RMA Journal is published by the Risk Management Association, a leading organization of professional credit, market, and operational risk managers.

Today, with credit portfolios under growing stress, minimizing losses is more important than ever. "Using Subordination to Define Intercreditor Priority" explains the different types of subordination and how lenders can structure debt to protect themselves in case of a default. For a free copy of the article and more information on

Financial Training Partners, visit www.fintrain.com/publications.

Amend and Extend or Amend and Pretend?

In the last 6 months, we've seen a number of "amend and extend" transactions. Typically they involve:

• The extension of the maturity of a term loan and/or revolver (typically for syndicated, non-investment grade loans). This is only for lenders who agree to the extension (i.e. some lenders may keep the original maturity).
• Increasing loan pricing for lenders who agree to extend (to reflect current market conditions and the higher credit risk of the borrower) and an amendment fee.
• Covenant relief for the borrower (reflecting operating performance below original the targets).

Why an Amend and Extend?

During normal economic times, a borrower would do a new syndication as the maturity date for an existing facility approaches. So why are we seeing amend and extend agreements rather than new facilities? Because many of these companies would have a hard time getting a new syndication done. The loan market is much more selective for high risk credits, and many of these companies have high leverage and weak cash flows.

Amend and Pretend?

It is clear why a borrower would want an amend and extend (despite the higher cost) - they get covenant relief and one or two more years to turn around the business and generate cash for debt repayment. But why are lenders agreeing to these transactions? Do they really

believe the borrowers will be able to repay the loans 2 years later, or are they just deferring the day of reckoning - the day when the borrower will need to do a major financial restructuring (or even a bankruptcy) and the lenders will have to write down the value of the loans? Is it an "amend and extend" or "amend and pretend" (that the loan will actually be repaid some day)?

Wrangling Term Loan B Investors

According to Bloomberg.com, American Airlines is asking its lenders for a covenant waiver. A conference call was held on June 22 and responses are due by June 25. Why the rush? The covenant would be waived for the quarter ending June 30, so the company wants the amendment done before the end of the quarter.

As we have discussed in earlier entries, many companies are amending their credit agreements to reflect lower than expected operating performance driven by the recession. Airlines have been especially hard hit by the downturn, so the pressure on American's covenants is no surprise. The interesting element of this amendment is the lending group - institutional investors.

Term Loan B

A Term Loan B ("TLB") is a term loan structured for sale to institutional investors, such as collateralized debt obligations (CDOs) and prime rate mutual funds. Traditional term loans, called Term Loan A's, are typically originated by and sold to banks. Here are the main differences between the two:

Negotiating Amendments with Institutional Investors

Amendments to corporate loan agreements happen all the time. When the lenders are banks (as is typical for revolvers and TLAs), the relationship between borrower and lender often goes back many years and may include other business, such as cash management or bond underwriting. As a result, banks are often willing to work with borrowers towards a long-term solution (i.e. banks are more willing to grant waivers). TLA banks are often referred to as "relationship lenders."

Institutional investors are "transaction lenders" - their relationship with the borrower often goes no further than the individual loan. As a result, they are often less inclined than banks to grant waivers or agree to amendments.

American Airlines "Pays Up" for its Amendment

American's proposal to its TLB lenders is to waive the fixed charge covenant this quarter and cut it through the loan's maturity in 18 months. In exchange, the spread on the loan would go from 200bp over LIBOR to 400bp, and there would be a new LIBOR floor of 2.5%. This would immediately increase the interest rate on the $435 million loan by about 3.9%, increasing interest expense by over $16 million per year. In addition, the lenders would get a 75 basis point amendment fee, costing American over $3 million. These terms are not unusual in today's market for "B" rated companies like American.

What Happens After a Default?

With the weak economy, we are seeing more companies breach covenants in their loan agreements. Such a default typically gives lenders these right:

1. Acceleration (i.e. "call the loan") - declare the principal of the loan to be immediately due and payable. This typically would result in the bankruptcy of the borrower since they do not have the cash on hand to repay the loan.
2. Foreclose on collateral - As with acceleration, this would result in the bankruptcy of the borrower.
3. Stop funding unused revolver commitments. Banks will typically continue to allow some revolver borrowings because cutting off the revolver would often result in a bankruptcy.

After a covenant default, banks typically do not exercise their rights - they do not call the loan or foreclose on collateral, and they often allow the borrower to continue to borrower under the revolver. Banks know that these actions would result in bankruptcy, and it is in everyone's interest to avoid bankruptcy.

So what really happens?

Most covenant defaults result in an amendment (or waiver) to the loan agreement. The financial covenants that were breached are loosened in order to get the borrower out of default. Ideally, the company and banks should see the covenant breach coming and work out an amendment before the default happens.

A good example of this is the recent amendment done by Actuant Corporation (ticker ATU), a diversified industrial company headquartered in Wisconsin. The company was forecasting deteriorating financial performance which could have breached covenants. Before the defaults happened, the company negotiated an amendment which increased its leverage covenant from 3.5x to 4.5x (with future step-downs) and reduced its fixed charge covenant covenant from 1.75x to 1.65x.

What do banks get in exchange?

In exchange for giving a borrower more room under its covenants, banks typically get one or more of the following:

1. Increased pricing and/or a one-time fee - to compensate them for the increased risk,
2. Additional collateral - to improve their loss in the event of a bankruptcy,
3. Reduced exposure - if the company is able to reduce unused amounts on the revolver or repay a portion of the term loan,
4. Additional covenants - to ensure that cash is used to repay debt (e.g. dividend and/or capex limitations) and to better monitor the company's performance.

In the Actuant example, the banks received:

• An amendment fee and increased pricing (spread went from L+250 to L+375; commitment fee went from 40 to 50bp),
• Faster term loan amortization (from $1.5 million per quarter to $10 million), and
• Additional collateral.

Eddie Bauer Can't Step Down

Eddie Bauer did not have a good fourth quarter of 2008.  Reflecting the worsening economy, sales were down 5.7% compared to the forth quarter of 2007.  Still, adjusted EBITDA for the full year 2008 was almost $53 million, up over 25% from 2007.  As for liquidity, the company ended the year with over $60 million in the bank, zero drawn on its $150 million revolver, and with no principal payments due on its other debt (a $193 million term loan and $75 million in convertible notes) until 2014.  What could go wrong?

Covenant Compliance 

The company’s debt agreements contain covenants limiting certain activities and requiring the company to maintain certain ratios.  The most restrictive covenants are in the term loan, which required (as of year-end 2008) senior leverage to be no greater than 5x EBITDA and fixed charge coverage to be at least 0.9x (as well as limiting capital expenditures, dividends, new debt, and new liens).  As of December 31, 2008, the company was in compliance with its debt covenants.

Now For the Step-Down

On March 18, 2009, Eddie Bauer announced it is "seeking an amendment to the term loan agreement to provide covenant relief and flexibility to manage through a recessionary economy."  The problem is not that the company expects leverage to go above 5x or coverage to go below 0.9x; the problem is that the financial covenants in the term loan agreement step down.  As of March 31, 2009, leverage must be at or below 4x, compared to the 5x requirement just 3 months earlier.  The coverage requirement also increases, eventually hitting 1.1x in 2012.  Why did the company and its banks, led by Goldman Sachs and JP Morgan, include these changing covenant levels in the loan agreement?

Covenants Should Reflect the Business Deal

Setting loan covenant levels is an art not a science.  Ideally, covenants should reflect the shared expectations of the borrower and lenders.  In the case of Eddie Bauer, the company and its banks clearly expected the retailer to improve cash flow and bring down leverage, and set the leverage and coverage covenants at levels that both sides thought were achievable.  When a company's performance is materially worse than both sides expected when they did the deal, there should be a covenant default.

What Happens After a Default?

Rarely does a covenant breach in a corporate loan agreement result in foreclosure or bankruptcy; usually the borrower and lenders agree on an amendment.  The borrower gets looser covenants, but what do the lenders get?  It varies, but the amendment can include more collateral for the lenders, higher interest rates, an amendment fee, and additional restrictions on the borrower, all intended to reduce the lenders' risk and increase the return on the loan.

So far, Eddie Bauer has not reached agreement with its lenders, but the amendment under discussion includes an 8% amendment fee (with 5% of that deferred until 2014), warrants for almost 20% of the company's stock, and a significantly higher interest rate.  Quite a cost for failing to step up!