© Copyright 2000 Rogers Media. The following article first appeared in the May 2001 edition of BENEFITS CANADA magazine.

Corporate bondholder activism

Canadian pension funds are increasing their investments in corporate bonds. This trend calls for shrewd governance.

By Tony Treier

When the credit risk in a pension fund's fixed income mandate is increased, the fund's managers and fiduciaries should also expect an increase in financial risk premiums if fixed income investment managers are to retain their structural factors risk-adjusted allocation within the total fund. Otherwise, the fixed income mandate will be over- allocated. Historic norms have no relevance given the substantial structural changes recently seen in the fixed income portion of the capital markets.

Blind increases in corporate credit weighting within investment portfolios could imply a costly and dangerous acceptance of investor comfort with the following structural factors:

• Sustained higher normal rates of default and lower-than-normal rates of financial recovery going forward than the case historically in debt markets.
• Unfairly low real rates and low risk premiums in spite of widely publicized expectations of continued high long-term real rates of economic growth.
• Implicit validation by debtholders of unrealistic earnings expectations in optimistic merger and acquisition adventures.
• Blind bond investor acceptance of the outsized rewards that are presumed to accrue without question in favour of corporate stakeholders.

There are three major structural forces creating the false and exaggerated impression of what appears to be generously wide credit spreads. Rather than rely on irrelevant historic norms, bond portfolio managers need to reappraise fair-value corporate yields from first principles on a component-by-component basis, including fair-value risk-free discount rates and all of the various add-on risk premiums.

When it comes to indications of fair value, risk-free discount rates, it's important to recognize that the market-clearing fair-value intermediate-dated certainty-equivalent real yields, namely basic risk-free discount rates, are well above historic norms. In fact they have risen more than 100 basis points above where they were for intermediate-dated debt maturities about seven years ago.

Fair-value risk-free discount rates are comprised of: real yields, fair-value purchasing power compensation premiums and inflation and real growth risk premiums. Real yields on U.S. Treasury debt are sometimes naively taken as proxies for risk-free discount rates. In a stable environment, when government debt remains at a steady proportion of the value of the economy, this is generally valid. But given the recent and abrupt decline in the supply of U.S. Treasury debt securities, market-observed U.S. Treasury yields have been biased-low estimates of these higher, true fair-value risk-free discount rates.

Firm-specific credit spreads depend on the firm-specific level of sustainable real corporate earnings and, more precisely, on the risk of the earnings stream specific to the corporation. To the extent that lenders in publicly traded capital markets generally cannot extract firm-specific real economic participation premium, then only pure credit risk premiums, or risk of downward credit rating migration, is the major source of differences among individual corporate yield spreads above fair-value risk-free discount rates. Bond investors should be concerned about the recent tendency in the abrupt widening of the fair-value amount of these pure, credit risk-related yield premiums across large groups of borrowers in capital markets.

CREDIT RISK

Two factors have affected credit risk: broad economic or systematic influences and management-specific influences. In the first case, lending initiatives involving corporate enterprises that are operating in much more dynamic real economies represent exposures to greater broad systematic uncertainties for which rational providers of debt financing should be fairly compensated.

In the second instance, increasing short-termism on the part of senior corporate managers in their pursuit of corporate value-maximization (specifically for the benefit of corporate shareholders and their agents) represents the essence of an increased gaming risk working to the detriment of other providers of real and financial resources to corporate enterprises.

U.S. data tracking the flow of funds reveals a rapid acceleration in the amount of debt issuance in the corporate and household sectors, which has exceeded the amount of debt retirement in the public sector. Corporate crowding-in to the debt market has far outpaced the rate of crowding-out, for which the public sector was harshly criticized as recently as a decade ago.

Corporate borrowing excess has been unevenly distributed across regions and industry sectors. Ironically, the greatest excess is now in recently deregulated sectors where enthusiastic corporate enterprises seeking debt financing are bursting with unbridled optimism about the prospects of earnings growth. Historic norms in terms of credit risk premiums certainly have no bearing in this more risky economic and financial environment for providers of debt financing. In addition, corporate debt issuance has also exceeded the amounts needed for business investment.

The abuse of financial releveraging in a few sectors threatens to rob many more of much-needed capital as the economy begins to slow down and credit is not as readily available. The result of all of this is evident in the rising rates of corporate default and fairly marked rating transitions from higher-quality investment-grade status toward lower-grade status--a shift which began in late 1999. Interestingly, this shift occurred well before signs of the recent U.S. economic slowdown emerged.

The competitive race to the bottom in quality of debt outstanding across great numbers of borrowers in particular industry sectors should force rational investors to challenge preconceptions about random ratings migrations that used to underlie rational credit-granting processes.

With the average tenure of the U.S. chief executive officer slipping toward four years and the heavily skewed nature of payoffs that promote maximizing short-term shareholder return/stock prices, it should not be surprising that there might be less inhibition regarding the abuse of corporate debt. Despite lip service to the contrary, senior management biases favour achieving maximum short-term shareholder returns to the potential detriment of other stakeholders, and possibly even contrary to the long-term interests of shareholders themselves.

GOOD GOVERNANCE

In light of this environment, corporate bond investors need to take their governance responsibilities more seriously. It is no longer reasonable for bond investors to vote with their feet and simply sell the debt of imprudently managed firms. Instead, to reinforce discipline of debt in the corporate balance sheet, corporate bondholder activism must increase. It should consist of more action on the part of all debtholders, as well as better examples of specific governance measures exercised by the larger, and presumably more influential, debtholders over particular corporate enterprises.

Adhering to fiduciary responsibilities requires debt financing providers to ration loanable funds more carefully in advance, and to cost debt financing at least at fair-value yield spreads that will be conspicuously above historic norms. Debt providers must also be prepared to engage in an active exercise of their fiduciary responsibilities.

This involves more than ensuring that an ongoing credit-risk screening and monitoring process is in effect, or that an increasingly active but simple buy-and-sell discipline is followed by individual investing institutions. Both actions are necessary, but neither one on its own acts as an active discipline on current and potential borrowers.

Greater collective bondholder activism as well as intelligently struck pre-emptive debt covenants are solutions. They provide more discipline and encourage a more prudent use of debt by corporate management--if not rationing debt out of some balance sheets entirely where appropriate.

Forums for efficiently monitoring credit risk and achieving bondholder activism might include:

• Standing debtholder committees involving lenders only, as opposed to debtholder committees struck at events of default only, that address going-concern macro-credit issues and provide appropriate signaling to corporate borrowers.
• Sponsored initiatives that publicly expose or target specific abusive borrowers or poor industry-wide borrowing habits. This forum could also provide independent, but not legally binding, vetting of the form of a particular borrower's debt issuance plans or industry-wide borrowing intentions.

DEBT COVENANTS

More intelligent debt covenants would recognize that increased gaming risks work against providers of debt financing. Such covenants would also tend to be more proactive as opposed to being accommodating, defensive and reactive, which is the case at present.

Proactive covenants presume the tendency for the gaming of debtholders by shareholders or their agents in advance. They institute penalties or hurdles that deal with the consequences as the temperature is just beginning to rise rather than when enterprise value is crashing down in flames.

For instance, recognizing that corporate managers (on behalf of equity stakeholders) might want to excessively maximize short-term earnings per share through effective financial releveraging, a suitable debt covenant would direct a share of excess earnings per share growth (above pre-determined thresholds) as a set of bonus payments to debtholders.

Debt covenants for the new economy must anticipate more debtholder intervention and participation in excess, above threshold gains. Specifically capturing this is earnings won at the expense of greater and undue financial risk.

Today's covenants cannot depend on the enforcement of hard security. Instead, lenders must recognize the greater and increasing prevalence of human capital and intellectual assets in the balance sheets of most corporations--whether or not these assets are properly recognized by the accounting profession.

Dynamic economic growth and change means that companies are evolving at a faster pace than ever before. Today's chip manufacturer may be tomorrow's management services provider. A gold producer might want to become a real estate information technology provider. This transformation of enterprises is increasingly exposing unsecured term-debt financing providers to undue management risk.

When companies drastically redefine themselves without restriking their debt, financial stakeholders that believe they are invested in a positive alpha management process are forced to go on faith that the same corporate management team can provide a positive alpha in an entirely new line of business.

Organizations that are substantially reshaping their lines of business are, in effect, circumventing the usual venture capital process which matches properly costed financing to the risk of the proposed enterprise as it matures and ultimately undertakes an initial public offering of debt and/or equity. Wider yield spreads demanded upfront recognize the potential for this sort of corporate adventurism, which tries to essentially forgo this process.

Appropriate debt covenants force going-concern workouts involving debtholders whenever significant corporate restructuring occurs. This allows investors to argue for more equity in balance sheets where appropriate rather than--as has been the case recently--less equity via undue financial releveraging of balance sheets.

TAKING RESPONSIBILITY

In terms of the separation of investment management responsibilities between equity and corporate bond mandates, investment management firms are not blameless in these developments. Latent biases among senior management and governing fiduciaries on the star status of equities as an undying returns manna leaves these parties making policy and strategic over-allocations to equities at the same time corporate enterprises have been issuing financial claims in the form of corporate debt.

The immediate concern is whether the risk of financial leverage is being under-appreciated at the same time recent outsized returns on equities are being over-appreciated. A single-leadership combined-mandate approach encompassing marketable bonds and equities--as opposed to relatively independent mandates for corporate bonds or equities going in potentially separate directions--would help take overall investment management efforts along a viable, consistent and long-term route.

Constructive alignment of common equity and corporate debt stakeholders' interests in the long-term viable and balanced growth of particular investee corporate enterprises has a greater chance of being achieved where a consistent and even-handed--rather than competing--perspective among debt and equity stakeholders exists.

Tony Treier is portfolio manager, fixed income investments at Telus Corp.'s Pension Plan Investments in Edmonton. tony.treier@telus.com. This article is an edited excerpt of Treier's paper on the risk management issues raised by an increase in corporate bond investments. It is available online at www.benefitscanada.com/Content/2001/05-01/treier.html.

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