Junking Your Bonds

{Q} Is this risk heightened by the fact that bond prices have been driven up by the credit markets in general, relative to the Treasuries?

{A} Yes, the yield differential that you earn over treasuries has narrowed over the course of the year. That’s because if you take out the leveraged-buyout factor, the corporate market is in very solid shape. Balance sheets, in terms of corporate borrowing, are about as low as they’ve been in 15 years. There is more cash on corporate balance sheets than there has been in a long time. Profits since 2002 have been very strong, averaging double digits quarter over quarter now for the past four years, and default rates are as low as they’ve ever been. It’s a very strong story right now.

{Q} Do you hedge your portfolio with derivatives?

{A} Yes, but not extensively. It would be very expensive and will hurt your returns. [Derivatives are like insurance, and] insurance is a cost, lowering the yield you are getting on the rest of your portfolio. If you’re not right in a particular insurance purchase, then that’s a cost you won’t recover.

{Q} What are you doing instead?

{A} In the last year or so, we’ve been purchasing bonds with other forms of protection in terms of, for example, a change-of-control provision, if you will. Such a provision gives the bondholder an option, in the event a company comes in (like a private equity firm), buys a company that you own, and the debt subsequently gets downgraded to below investment grade, or junk rated. In the absence of this protection, the value of your bonds would drop. But with this protection, you can sell your bonds back to the company. The issuing company is required to buy its bonds back, typically at their original value, or par. This provision protects you in the case of a leveraged buyout.

{Q} Is this applicable only to newly issued bonds?

{A} Yes, and it’s dependent on investors’ reception to the bond offering—not every bond has a change-of-control provision. A company may or may not have to offer this change-of-control provision. We’re seeing it more, but it’s basically a pushback from investors saying they will not buy this particular issue unless a change-of-control provision is in there, because they see this particular company as vulnerable to a leveraged buyout transaction.

{Q} Can you give me some examples?

{A} Lab Corporation Companies (NYSE: LH) was one of the first ones, at the end of December 2005. Wyndham Hotels, now publicly traded as Wyndham Worldwide (NYSE: WYN), also recently issued bonds with a change-of-control put. Wyndham is a hotel management and timeshare management company that until recently was part of Cendant Corporation—a company not afraid of going to the capital markets to try to engineer something to the benefit of shareholders. From a bondholders’ perspective, we demanded a change-of-control provision for the Wyndham bonds.

{Q} Is the private equity industry slowing down?

{A} No. I see 2007 being more active than 2006.