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Bond holders may get steamrollered by runaway M&A

Bond holders may get steamrollered by runaway M&A

This looks to be a bumper year for M&A activity, with a number of FTSE 100 firms experiencing transformative deals.

Sky and Shire are being courted by foreign suitors, while Sainsbury’s and SSE are looking to merge with competitors. And an activist investor’s efforts are splitting Whitbread in two.

M&A is traditionally considered an equity shareholder story, as takeovers tend to push prices higher. However, debt still has a sizeable part to play in corporate financing and the experiences of creditors and bondholders in M&A situations can be very different to those of shareholders, thanks to a quirk peculiar to bond markets.

Most listed companies have one or two share classes at most, and the legal distinctions tend to be clearly marked.

However, a large company can have a range of bonds in issue, all with different features and characteristics, such as covenants, maturity dates and positioning within the firm’s capital structure. Outcomes can differ depending on which of a company’s bonds the investor holds.

The takeover bid for GKN from Melrose provides a good example of the impact M&A can have, through the views of credit rating agencies. When the deal is completed, the credit rating of the combined entity is likely to be lowered to sub-investment grade.

Such a move is typically negative for existing bondholders as it tends to push prices lower and yields higher. Indeed, for GKN’s bonds maturing in 2022, this is already playing out, with the bonds trading below their face value.

However, investors holding GKN’s 2032 debt can sleep far easier, thanks to features in the bond documentation that benefit existing investors; if the bonds are downgraded (as is expected), then investors can choose to either sell the bonds back to the firm at face value or receive a 125bps step-up in coupon payments.

Some takeovers can end up as positive stories for well-secured debt, as bondholders in Punch Taverns discovered when Heineken pushed to acquire the business.

But when bonds lack such security, it can easily go the other way.

Elliott Advisors’ push to split up Whitbread has helped to contribute to a widening in spreads since rumours first appeared last year, while the yields on bonds issued by Japanese firm Takeda pushed higher as the firm’s creditors digested their attempts to acquire Shire.

Unsecured bondholders do not automatically get a say on a takeover deal. And, in such a frothy environment for deal makers, bids and mergers can come from unexpected quarters.

For bond investors looking to shield themselves from M&A risks, it is not about just avoiding certain issuers. The most effective defence will be found in the bonds offering investors protection against the risks.

Avoiding the devils requires an understanding of the detail.  

Ewan McAlpine is a senior client portfolio manager at Royal London Asset Management

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