Event Risk

As bond investors we are used to defending against the evils of inflation, default risk, and sudden increases in interest rates – all things that can hurt bond prices.  Last week, though, gave us a reminder of one of the most nefarious risks out there for bond holders: event risk.  Event risk is defined by Investopedia as “The risk due to unforeseen events partaken by or associated with a company” and can do as much or more than any swing in interest rates can.

Take Heinz as an example from last week.  We own some of the Heinz 1.5% bonds that mature in 2017 for clients, and as a Valentine’s Day present, Warren Buffett and some of his Brazilian cronies announced their agreement to buy Heinz at a nice healthy premium to the previous day’s stock price.  Stockholders were rewarded with a nice 20% jump in the stock price (event risk can be positive), but as the details of how Mr. Buffett would finance the purchase, existing bond holders started to get a bit uneasy.

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As it turns out, Mr. Buffett doesn’t plan on actually spending all of his own money on buying Heinz.  Instead, banks will be lending $14 billion to the deal on top of the previous $5.4 billion in debt that was on the Heinz balance sheet.  Immediately, the ratings agencies sprang into action, putting Heinz’s credit ratings on watchlist for a possible downgrade to junk bond status.  What did that mean for existing Heinz bond holders, like us?  As always, it depends…

The bond below is a bond (that we don’t own) that Heinz issued paying 6.75% and maturing in 2032.  As you can see, Valentine’s Day was a bit of a massacre for holders of this bond, as its price dropped almost 19% on the news of the imminent downgrade to junk status.  Mind you, Heinz was (and probably still is) a perfectly strong company that will pay its obligations as they come due, and the bond’s price reflects that belief.  However, if you were unlucky enough to buy this bond at a price of $125 a few weeks ago, that is little consolation.

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Here is the graph of the 1.5% Heinz bond mentioned at the top of this post, and you can see how it, too, suffered on the news of the buyout, but two things are worth noticing here: the price drop was just 2.3% (thanks to the 2017 maturity) and within 4 trading days the bond had recovered essentially all the loss.  What gives?

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As always, the devil is in the details when it comes to bonds.  Certainly, buying bonds that mature in 4 years is one way to manage risk, but another protection we have is in the bond’s covenants, or legal protections. Buried in the prospectus (yes, we read those things) are a list of covenants, and listed there is a Change of Control clause that requires the company to repurchase this particular bond at a price of $101 in the event the company ever changes hands.  As swell as Mr. Buffett is as a new owner, he won’t be able to buy Heinz without buying back the bonds we own at a price of $101, and that’s nice protection to have.