Mega-Mergers Leave Bondholders Counting Their Losses

RJR Nabisco stockholders were ecstatic last month when the giant food company announced a possible management-led buyout. The stock price immediately shot up 38%, reflecting the premium expected to be paid in the deal.

But George K. Fenn and other RJR Nabisco bondholders were far from rejoicing. As investment counsel for Metropolitan Life Insurance Co., which owns $250 million of RJR Nabisco’s bonds, Fenn was irate because the proposed buyout could saddle RJR Nabisco with mountains of new debt, increasing the risk of a default or bankruptcy.

Accordingly, prices of RJR Nabisco bonds--viewed for years as among the safest of corporate debt issues--nose dived as much as $180 for each $1,000 of face value, a sharp drop for bonds with such high safety ratings. Prices also plummeted for bonds of other firms seen as buyout candidates.

“We were very angry,” says Fenn, who calls the incident “a real galvanizing event” that already has triggered increased demands among bond investors for protections against such losses.

The RJR Nabisco episode is far from the first time that investors in blue chip corporate bonds have been socked in recent years by mergers, restructurings or buyouts that have dramatically increased the bonds’ risk. Bonds issued by several giant companies have declined in value and safety under similar circumstances.

As a result, “investment grade” corporate bonds--those rated safe enough by bond-rating agencies to be considered most suitable for conservative investors--represent a smaller and smaller share of the total bond market. And investors--whether giant pension funds or insurance companies that buy bonds directly, or small investors who buy bonds through fixed-income mutual funds--are suffering the consequences and are increasingly wary of buying high-grade bonds of industrial corporations.

“Bondholders have been taken advantage of forever by managements,” says William H. Gross, managing director of Pacific Investment Management Co., a Newport Beach money management firm that has not bought corporate bonds for 18 months, contending that interest rates paid on the bonds are not high enough to justify higher risks, compared to safer Treasury securities. “Bondholders have been the suckers. . . . (They’ve) got to look out for themselves because nobody else is.”

The list of issues where bondholders have taken a bath due to buyouts or other moves has grown considerably in the past five years. For example, firms whose investment grade bonds were hit by leveraged buyouts--a type of acquisition using high debt--include Revco, Borg-Warner, Fruehauf and Owens-Illinois.

Such recent mega-deals as Philip Morris’ $13.1-billion bid for Kraft and RJR Nabisco’s plan to put itself up for auction in a transaction that could easily top $20 billion indicates that almost any firm of any size is vulnerable to a buyout. Even takeovers of such large firms as IBM and Exxon--IBM could command a price tag of $80 billion or more--don’t seem entirely out of the question anymore.

“It’s really reached unprecedented proportions,” says Fenn of Metropolitan Life.

Thanks in part to such deals, only 42.1% of industrial companies rated by Standard & Poor’s had investment grade ratings of BBB, A, AA or AAA as of February. That compares to 67.7% at the end of 1983. Those that remain investment grade are increasingly in the lower levels--BBB or A--rather than AA or AAA.

The median rating for industrial bonds rated by S&P; has fallen to BB, in the category of non-investment grade “junk bonds.” The median rating was A in 1981.

About $30.3 billion worth of bonds have become “fallen angels”--downgraded from investment grade to junk--between 1985 and 1987, according to the investment firm Drexel Burnham Lambert, the leading trader of junk bonds. Only about $8.3 billion have been upgraded from junk to investment grade in that period.

“Most companies are junk today,” says Gail I. Hessol, managing director for industrial and utility ratings at Standard & Poor’s.

In some industries, the decline in credit quality has been dramatic. In the food industry, a hotbed of takeover activity, only two firms--Kellogg and Campbell Soup--enjoy S&P;’s top rating of AAA on their senior bonds. In 1980, six companies--including Beatrice, Coca-Cola, Kraft and Procter & Gamble, as well as Kellogg and Campbell Soup--boasted that top rating.

In the oil industry, another takeover playground, only Exxon and Amoco hang on to AAA ratings at S&P;, compared to about seven firms a few years ago, S&P;’s Hessol says.

Meanwhile, the value of all junk bonds outstanding has grown to close to $160 billion, or 25% of the total corporate bond market, up from $35 billion, or 13%, in 1982, according to Drexel.

Lackluster Returns

The downgrades and resultant price declines have contributed to the relatively poor performance of investment grade bonds. Treasury securities, which are much safer than corporate issues, should return less but, in fact, have outperformed corporate bonds on average.

Over the past 15 years, investment grade corporate bonds have earned an average annual total return--interest earnings plus price gains or losses--of only 9.0%, less than the 9.4% earned on Treasuries, according to Shearson Lehman Hutton. Data is not generally available that far back for junk bonds, but most experts believe that their returns also were superior to investment grade corporates. The prices of investment grade corporates also are more volatile than junk bonds and governments.

“The yield spreads (between corporate and Treasury bonds) have not been sufficient nor potential returns attractive enough,” says Madeline E. Glick, president of MEG Asset Management, a New York money management firm that no longer buys investment grade bonds.

Such lackluster returns and higher risks have caused many investors to reduce the portion of their holdings in investment grade bonds.

In the late 1960s and early 1970s, investment grade corporate bonds dominated the bond portfolios of pension funds, says Stephen L. Nesbitt, a vice president and consultant to pension plans at Wilshire Associates, a Santa Monica investment advisory concern.

Today, however, pension funds are increasingly attracted to Treasuries and mortgage-backed securities such as Ginnie Maes, he says.

Treasuries and other government issues today account for over 50% of the average pension fund’s bond portfolio, with mortgage-backed securities accounting for about 25% and investment grade corporates only 18%, according to Wilshire Associates.

Individuals Wary

Among corporate bonds, pension funds are increasingly attracted to non-industrial issues such as those of utilities, which make up about one-third of the corporate bond market and are generally seen as less takeover-prone due to regulatory protections. The pension funds also increasingly like bonds of finance companies, whose assets are backed by consumer loans. Industrial bonds, those most likely to be hit by takeovers, account for about a third of the corporate bond market.

Individual investors also are wary of buying corporate bonds. If individuals buy at all, it’s primarily through mutual funds, which offer added diversification to absorb some of the risk. Most small investors are buying mutual funds investing in junk bonds, also attracted by their higher yields.

These trends are not without some cost to corporations. Bonds increasingly carry shorter maturities, Nesbitt of Wilshire Associates says. That increases the risks to issuing firms because a rise in interest rates could mean they must replace low-yielding bonds that mature with new bonds at higher interest rates.

Firms also must offer higher interest rates to attract investors. Investment grade bonds typically yield about 0.75 to 1 percentage point more than Treasuries of comparable maturities, while junk bonds typically yield about 4 percentage points more.

The increased “event risk” of takeovers and restructurings are leading bond-rating agencies such as Standard & Poor’s and Moody’s to watch investment grade bonds much more more carefully.

Pension funds, mutual funds and other institutional investors also are pickier about which investment grade bonds to buy, often steering clear of issues from firms seen as vulnerable to takeovers. Alan M. Schreiber, an international credit analyst at the T. Rowe Price mutual fund firm, notes that the firm’s portfolio managers were alerted in June to avoid certain bonds because of event risk.

Some institutional investors also have organized an Institutional Bond Holders Rights Assn. to push for such rights as strengthened bond covenants that would protect bondholders from losses in cases of takeovers or restructurings. Some Wall Street bond underwriters, for example, are considering greater use of so-called poison puts, which typically allow holders to sell back their bonds to the issuers at face value in the event of a takeover.

But whether such covenants will become common practice is unclear. First, the fiduciary responsibility of corporate directors is to their shareholders, not to bondholders. More importantly, covenants could restrict the options of managements to pursue takeovers, which would be bad news to stockholders.

May Demand Higher Yields

Pension funds and others who are stockholders as well as bondholders thus may not push that hard for such covenants because their equity holdings--and opportunity to profit from takeovers--are far greater than their holdings of investment grade bonds.

Pension funds and mutual funds “are making money hand over fist on the equity side and they are not about to handcuff restructurings for a few bond holdings,” says consultant Nesbitt of Wilshire Associates.

Instead, Nesbitt and other experts argue, the solution for bondholders is to demand higher yields for higher risk. Some experts say that investment grade corporates should on average yield 2 percentage points more than comparable Treasuries, twice the current spread, or “risk premium.” That would put them closer to the typical 4-point spread for junk bonds.

“People have been willing to accept too low of a risk premium,” says analyst Schreiber of T. Rowe Price. Buying investment grade corporates with such a low spread “is stupidity,” he says.

THE DECLINE IN CREDIT QUALITY

Junk bonds upgraded to investment quality (billions).

1985: $4.6 1986: $1.0 1987: $2.7 Junk bonds upgraded to investment quality (billions).

1985: $9.1 1986: $9.9 1987: $11.3 Source: Drexel Burnham Lambert

MORE ‘JUNK’ IN THE BOND MARKET

High-yield “junk bonds” now account for 57.9% of rated industrial bonds outstanding, up from 32.3% in 1983.

Source: Standard & Poor’s Corp.