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.
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.
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?
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.