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Tantalising takeover targets

by Elizabeth Moran | Oct 07, 2014

Mergers and acquisitions have surged in Australia this year so this is a good time to consider the impact of these events on bondholders.

What usually happens in the event of a takeover is the new owner of the company typically provides implicit or direct support for interest and principal repayments on bonds, so the bond often takes on the credit rating of the new owner.

If the new owner’s credit rating is higher, then generally the price of the bond will rise, delivering a windfall to existing owners but reducing the yield on offer to new buyers.

By contrast, a lower credit rating would likely see the price of the bond fall as new investors demanded higher returns to compensate for higher risks.

A recent example is the takeover of gas pipeline operator Envestra by Hong Kong based Cheung Kong Group. The Envestra bond included some more complex terms and conditions to protect bond holders in the event of a takeover, but in the end they weren’t needed.

Credit rating agency, Standard & Poor’s viewed the Cheung Kong takeover of Envestra as positive, given its view that Cheung Kong would run the business with a more conservative approach and upgraded Envestra’s credit rating by one notch.

Envestra has issued a number of bonds which benefited from the upgrade but also an inflation linked bond that matures in 2025 that is already rated some notches higher than either Envestra or Cheung Kong’s credit rating.

This is possible because the bond has a special feature, known as a credit wrap. It is insured by a company that will pay interest and principal in the event Envestra fails to make a payment. So, the takeover had no impact because the bond already had a high credit rating based on the company that insures the bond.

Envestra retains primary responsibility for all of the bonds it has issued but with the backing of the larger Cheung Kong Group as majority shareholder.

The story is far more interesting if a much higher credit rated company takes over a lower rated one. Do you remember when Bear Stearns was near failure and JP Morgan Chase stepped in to save the bank? Bear Stearns bonds became the responsibility of JP Morgan Chase, a much larger, more secure bank with higher credit ratings overnight.  The price of the Bear Stearns bonds jumped and the yield moved lower, reflecting the much lower risk of JP Morgan Chase.

An investor recently posed the takeover question in relation to Qantas bonds. They were contemplating a change in government rules that would allow foreign ownership of Qantas. There are lots of “ifs” here but if a government owned airline became a majority shareholder of Qantas, the value of the bonds would rise and return fall reflecting the new, lower risk profile of the owner. Bondholders would likely be sitting on significant gains and a higher than expected return.

Investing in bonds in companies that may be subjected to takeover can be a way to speculate in the market in a similar fashion to shares.

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