FIIG - The Fixed Income Experts

News and Education

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.

Copyright The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Disclaimer Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at
www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.