On its face, bond investing is simple. You lend money to a company for a certain period of time, accepting a certain interest rate for your trouble. When the bond matures, the company pays you back.
What makes bond investing a lot more complicated is what happens when things go wrong. Ideally, what you want as an investor is maximum protection from adverse consequences. But with bond yields having come down so far and with so much investor demand for corporate bonds, especially in the high-yield sector, some of the protections that bond investors have come to rely on are starting to disappear.
The ins and outs of bond protection
Bond investors make much different demands on companies than stock investors do. When you own a stock, you have a clear understanding that the amount of power you have over the company is extremely limited. You’re last in line to receive anything from the company in the event of a liquidation, and more often than not, adverse events like bankruptcy will entirely wipe shareholders out. Although shareholders may have the right to vote on certain major events, such as a proposed acquisition, they have little ability to drive ordinary corporate policy.
By contrast, bonds usually come with covenants that give bondholders rights to take action if the company doesn’t meet certain conditions. Here’s a short list of common provisions that you’ll find among bond covenants:
- Change of control. In order to protect bondholders from a leveraged buyout or other acquisitions that involve a massive increase in the amount of debt outstanding, some bonds have covenants requiring accelerated repayment in the event of a merger or acquisition or that simply forbid such transactions entirely. This has been an issue with Dell Inc. (NASDAQ:DELL)‘s bonds recently, as they apparently don’t include change-of-control covenants and thus plunged on fears that a massive increase in debt from the proposed leveraged buyout would reduce their quality substantially.
- What constitutes default. Clearly, not paying interest or principal when due is a default event. But any number of other provisions can qualify as default events, ranging from certain levels of debt-to-equity ratios or interest coverage to a bond-rating downgrade or other adverse impact on credit quality. In turn, once a default condition exists, it can give bondholders remedies that they don’t otherwise have.
With bond indentures and other materials extending for hundreds of pages in some cases, it’s complicated to understand all the protections a bond can offer. But knowing that they’re there can give you assurances about how they’ll perform if something goes wrong.
