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brings on itself; typically it is considered a positive move for investors. But
if this limitation allows for a holding company to have, say, more than 50
percent of debt relative to servicing capabilities (a rather generous “limita-
tion”), then the value of the covenant is cheapened. Differences between the
spirit and the letter of a covenant may be difficult to distinguish, but taking
the time to dig into the details can be well rewarded, either by avoiding a
risky security that does not offer desirable protection, or by purchasing a
risky security that does embody meaningful protections (and especially
when it experiences an unexpected turn of events).
As we dip into lower-rated and riskier credits among bonds, the rela-
tive importance of covenants and their precise terms take on heightened sig-
nificance. Generally speaking, investors do not get too concerned when
evaluating precise terms and conditions of differences between junior and
senior subordinated debt when the issuing entity carries an investment-grade
rating overall. But when the credit actually is much closer to having to test
the boundaries or realities of becoming distressed, then precise terms and
conditions should move into sharp focus.
In the final analysis, whether there were good covenants in place or not,
if there are no assets to be seized and sold or exchanged in the event of a
worst-case scenario of default, then even covenants intended to be strong
are not worth very much. For this reason, just as valid a part of any due
diligence process that is followed when purchasing a bond is its fundamen-
tal business profile. For some holding companies, for example, assets may
not consist of much more than office furniture. And if we are dealing with
an entity with appreciable off-shore activities, then it would be time well
spent to trace through just how difficult it could be to lay claim to those
assets if necessary; some off-shore foreign legal considerations of favor to
the issuer could come into play.
Covenants sometimes can be too restrictive. There may well be instances
where a fine line sits in between conservative-oriented bondholders on the
one side and more aggressive risk-oriented bondholders on the other side.
And if the issuer™s management is inclined to be aggressive, then overly
restrictive covenants may be harmful to debt-management objectives oriented
to the longer term. In other words, it may very well prove to be prudent for
a given issuer to take on more debt at a particular moment since it might
add to a war chest for making meaningful acquisitions, acquisitions that
could well add appreciably to cash flow and profitability over time.
Generally, however, the perception among investors at large is that
covenants could always be stronger. Many issuers have conceded this point
as well. Why are bond covenants not stronger? There are three reasons.

1. Most local market orientations around the world tend to be equity
biased. That is, investors tend to be more interested in and focused on

Market Environment

equity phenomena, more likely to know where the price of Coca-Cola™s
stock is trading than the yield of its notes and bonds.
2. It often is easier for an institutional investor to be a large equityholder
but not necessarily a large bondholder (if only due to the fact that while
there typically are just one or two equity types in the marketplace that
trade on an exchange at any given point in time, there can be numer-
ous notes, bonds, and money market instruments trading in the OTC
market at any time). Accordingly, it may be relatively easier for equity-
holders to band together to express or press particular views.
3. There is a considerable gray area pertaining to covenants, ranging from
what different types exist, to whether or not it is always desirable to have
certain types. Not too surprisingly, generally it is thought that bond-
holders are not necessarily receiving all the protections that they might
otherwise be entitled to have or could expect to have if they were some-
how better organized.

Let us not lose sight of the fact that covenants are created out of words,
even if they look like mathematical formulas. When reviewing a prospectus,
it is not enough simply to note that a certain key turn of phrase is present.
What is all-important is how the key phrase is presented within its particu-
lar context as well as how it might be strengthened or abrogated by other
key phrases. For example, a prospectus may mention the issuer™s intent to
limit just how much future debt it takes on, but if those “limits” prove to be
well above typical industry averages, then perhaps no real guidelines exist.
As with many things in life, the devil is in the details. It is necessary
though not sufficient to know the types of covenants contained within a
given debenture. It is imperative to know how the covenants are represented
and how they sit relative to the overall package of proposed covenants. While
it is probably rare that a particular covenant or set of covenants would
inspire a rating agency to offer a credit rating a notch above what it would
have otherwise been assigned, it certainly can be argued that the absence of
key covenants can mean a far messier situation for a given issuer if things
were to begin falling apart. To put this another way, covenants are perhaps
best thought of as a type of safety net for when bad things happen to good
bonds, rather than being thought of as booster rockets designed to help push
a security into some kind of super-performance potential.
One fundamental consideration always will carry the day when it comes
to bonds, and even the most creative of covenants cannot supersede this:
There is no substitute for an issuer™s ability to generate sufficient timely cash
flows to make good on its obligations. But in the event that something goes
awry, wouldn™t it be comforting to know that there are some protections
underlying the security?


This last point sheds some light on why investors often ignore covenants;
covenants tend to become most relevant when times turn bad. When times
are good, why be worried about something that only might happen? Why
not just enjoy the good times for as long as they last? Besides, markets today
have seen it all, so how bad could things really get anyway? While these sen-
timents may be offered in a sincere attempt to downplay market risks, the
simple fact is that recent experiences in the credit markets in particular offer
strong evidence that market risk is as great as it ever was, perhaps even
greater. In Europe, for example, swap spreads have become much more
volatile since the launching of a single currency. While a couple of explana-
tions might be offered for this phenomenon, one could very well be the fact
that with convergence of European currency risk such that intra-euro zone
currency volatility has collapsed to zero, the preexisting euro zone currency
volatility may have transformed itself into heightened interest rate sensitiv-
ity and credit-sensitive volatility. Borrowing from the second law of thermo-
dynamics, which states that matter cannot be created or destroyed, only
transformed, perhaps this can hold true (at least in part) for markets as well.
Until the market somehow finds a way to insulate itself from the types
of volatility and market shock that have surfaced within the past couple of
years, it appears that market protections have a role. Covenants do indeed
have a role, and how well they can be strategically positioned within a port-
folio depends to a large extent on the portfolio manager.
While euro zone members can be said to have achieved a convergence
in exchange rate policy and considerable homogeneity with interest rate pol-
icy, other market factors are rather heterogeneous in nature as with bank-
ruptcy laws. Yet even in the United States, these exists a long-established
bankruptcy code detailing various steps that formally define the process of
how a company proceeds in a bankruptcy scenario, but it is rare that the
complete process is ever fully brought to bear; in so many instances a work-
out evolves and respective parties sit down to reach some kind of agreement.
Finally, in some instances a covenant may be implied. For example, an
investor in an investment-grade sovereign nation typically does not demand
a prospectus detailing the various promises the sovereign nation intends to
keep when it issues debt. Rather, the assumption is (rightly or wrongly) that
a sovereign nation will generally do everything it can to promote and main-
tain a deserved reputation in the marketplace for making good on its oblig-
ations. In many instances (though certainly not all), similar attitudes prevail
toward the agencies of most federal governments, particularly if these agen-
cies also come with Aaa/AAA ratings (implied or explicit).
Chapter 3 also touched on the importance of legal considerations when
more complex products are created (as with synthetic collateralized loan
obligations). Table 6.5 outlines some of the legal considerations that may

TABLE 6.5 Product and Legal Characteristics
Equity Debt
ownership/ ownership/ Minimum Asset Time- Subsequent Flexibility
transfer transfer equity changes/ tranched debt with asset
rules rules rules additions debt issuance types
Special-Purpose Vehicle
(1) Special-purpose corporation No No Yes Yes Yes Yes Yes
(2) Pay-through owner No No Yes Yes Yes Yes Yes
trust/master trust (Partnership)
(3) Grantor trust pass-through No No N/A No N/A No Yes
(4) Real estate mortgage Yes No No No Yes No No
investment conduit (REMIC)
(5) Financial asset securitization Yes Yes No Yes Yes Yes Yes
investment trust (FASIT)
(1) A wholly owned corporation. Generally speaking, a contribution of assets in exchange for equity will be tax free to the transferor, though if cash or other property
also is received in the exchange, then any gains might have to be recognized. Alternatively, any gains must be recognized immediately upon a sale of the assets as with
to the SPV (or an intermediary) unless the consolidated tax return deferred intercompany transaction timing rules apply.
(2) In any pay-through trust structure, the interests of the SPV consist of debt and equity, and this is a typical financing structure for time-tranched debt. The term
“owner trust” usually is viewed as a pay-through trust structure typically taxed as a partnership. For tax purposes a master trust also is typically taxed as a partner-
ship. Gains or losses usually are not recognized upon a transfer of assets to a partnership, though there are exceptions.
(3) The grantor trust pass-through structure usually is treated as an asset sale to the extent that the trust certificates are sold to third parties. The investment is an
equity ownership in the assets, and no debt securities are issued.
(4) A REMIC is a collateralized mortgage obligation (CMO) issued after January 1, 1987, under legislation designed to eliminate certain tax and regulatory problems
that limited issuer and investor participation in multiple series (tranche) CMOs. Gains or losses are recognized immediately to the extent that REMIC securities are
issued to third parties. For REMIC interests that are retained, gains or losses are amortized over the life of the security.
(5) In February 2000 the Internal Revenue Service released proposed regulations concerning Financial Asset Securitization Investment Trusts (FASITs). Congress autho-
rized FASITs in 1996 to provide a nontaxable securitization vehicle for all types of debt instruments, including mortgage loans. The FASIT initially was seen as a
potentially more flexible vehicle than the REMIC. A FASIT election may be made only by a “qualified arrangement,” which includes a corporation, partnership, or
trust or a segregated pool of assets. A FASIT may not be either a foreign entity or a U.S. entity or segregated pool if a foreign country or U.S. possession could subject
its net income to tax. A FASIT must have one or more classes of debtlike “regular interests” and only one “ownership interest.” The FASIT election must be made by
the “eligible corporation” that owns the ownership interest in the permitted entity or segregated pool (the “owner”). For tax-reporting purposes, a FASIT is treated as
a branch or division of the owner. Losses are not recognized, and special valuation rules apply for non“publicly traded assets that may give rise to a gain even when no

economic gain exists.


be involved with the various special-purpose vehicles (SPVs) commonly cre-
ated in support of launching complex products.
Again, the prospectus accompanying a structured product can be instruc-
tive about any relevant SPVs and what their particular role and responsi-
bilities involve.
Finally, destabilizing events are not the sole purview of corporations;
governments often take center stage as with the U.S. federal budget impasse
in 1997. Outside of the United States, while certainly a debatable point, some
Europeans may counter the accusation of being interventionist with the claim
that the largest of state-supported bailouts of industries within the past 20
years or so actually occurred in the United States: Consider the Chrysler
Corporation and the savings and loan industry.
Though originally intended to suggest how discrepancies may exist
across certain perceptions and realities, the previously cited bailout exam-
ples also highlight how a credit call option may be said to be quietly embed-
ded within the debt or equity of certain issuers™ equity and/or debt, especially
the debt and equity of large issuers.
The idea behind “too big to fail” has been around for a while, and can
be described in a variety of different ways. One way follows: If you owe your
bank $10,000 and cannot manage to pay it, you are in big trouble. But if
you owe your bank $100 million and cannot pay it, your bank is in big trou-
ble. If a given enterprise is perceived to be vulnerable enough to significant
negative economic and/or political consequences, then there is a likelihood
that extramarket forces (a government body or perhaps even a supranational
body) may have to intervene. This was certainly the case in the United States
with Chrysler in the 1980s and the savings and loan crisis in the 1990s.
What are of interest, certainly, are the various political and socioeco-
nomic issues (and issues that can and do differ along cultural lines as well)
that might prompt a government body to intervene in support of a particu-
lar credit event. When a particular industry type is thought to be in a spe-
cial position to enjoy the bailout of an extramarket body, then it may be
appropriate to view that industry type (or company) as having an invisible
call embedded in its debt. That is, the government does not explicitly sell
the industry or company a call option (which is in turn shared with equity
and/or bond investors), but the likelihood of its stepping in to intervene could
well be construed to imply the existence of a call-like support.
Because we are dealing with a less than explicit call option, we must con-
tend with a list of vagaries. What is the strike price of the invisible call? Its
appropriate volatility?
Rather than trying to focus on the minutiae of how such questions might
be answered, perhaps it would be sufficient simply to highlight the variables
that are deserving of consideration. Active investors interested in credit-

Market Environment

sensitive products should consider which national industry types might be
more likely than others to enjoy special financial treatment if worst-case
scenarios were to surface. For that matter, since state and local governments
also are in a position to offer financial assistance to industries, they should
be considered too. And in certain situations, as with emerging market
economies, sometimes extranational (perhaps even supranational) bodies
might become involved. In recognition of different cultural perceptions of
what is or is not a key industry (for our purposes, an industry deemed wor-
thy of saving), these cultural considerations would have to factor into our
thinking about embedded calls as we look across countries.
And just as we might evoke the notion of a credit call option embedded
in certain bonds and equities of various companies, a call option might be


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