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The Dangers Of Chasing Yield: Always Read The Fine Print
One of the hazards of digging around in the discard bin of the junk bond market is that an investor is constantly looking through what other people have run the heck away from. Sometimes they have run away with good reason, sometimes they have panicked unnecessarily. The only way to have a reasonable idea of whether a given bond is an opportunity or a trap is to very carefully do your own due diligence, including reading all the fine print.
As I regularly do at least once a week, I was trawling through the junk bonds available in retail lots sorted by the highest yield to maturity. The junk market has been rallying lately as investors reach for yield. This tends to magnify the risk of buying garbage instead of junk, since a strong market often results in the cheapest bonds being the real refuse that should not be bought (unless it is at extremely low prices). One of the highest yields with the lowest dollar price were the 6.75% RadioShack bonds maturing 2019 (CUSIP 750438AE3), offered at 82 and change for a double digit yield to maturity. At first glance, these bonds appear attractive. A 10+% yield in today’s market for a BB/Ba rated bond is very high. As a reference point, similarly rated Chesapeake Energy (CHK) just issued a $1.3Bn 2019 bond with a 7% YTM and an early call allowed at the end of 2012 at par. The RadioShack bonds are not callable for some time and they trade quite frequently and are therefore quite liquid.
A quick look at the company’s financial statements makes this 10% yield look like free money. As of September 30, 2011 the company had about as much cash as it had debt and had a large, untapped bank facility which provides even more liquidity. Although RadioShack has bonds maturing in 2013, the cash on hand and credit facility available should be more than adequate to pay off the bonds as they mature even if RadioShack is unable to issue new bonds. While the company has recently experienced reduced operating income as margins come under pressure, the business requires very little capital expenditures to maintain operations and grow and in a recent press release management indicated that they expect to remain free cash flow positive for 2012. Finally, while RadioShack does not own the real estate it occupies, there is significant tangible asset support for the bonds with net working capital (aside from cash) almost equal to the bonds outstanding.
Yet we have not yet done a critical piece of due diligence, namely a review of the prospectus for the bonds. The prospectus can be found here
. While a review of the lawyer-inspired risk factors is mildly amusing, the most important section of this document is the description of the covenants the company is bound to as a condition of issuing the bonds. Covenants serve as key protections for bondholders as they keep issuers from doing excessively risky things with the bondholders’ money (or even simply distributing it to the shareholders). Covenant discussion begins on page 55 of the prospectus and the change in control provisions begin on page 50. Always
read the prospectus before buying a junk bond and always pay attention to the change in control provisions and the covenant package.
There are three potentially bad outcomes for bondholders with a company like RSH:
1) the company could have a lengthy run of poor operating results and “bleed to death”
2) the company could be taken private in a leveraged buyout and the bondholders could be stuck with underpriced bonds issued by a far more highly leveraged company than they had originally anticipated.
3) the company could distribute its big pile of cash to shareholders, get into trouble, and go bankrupt in a messy fashion. The first problem is really outside the scope of contractual protections offered to bondholders; no amount of covenants can protect against a bad business.
The risk of a leveraged buyout can be substantially mitigated via what is known as a “change of control” provision. Like most junk bonds and even some investment grade bonds, RadioShack’s bonds include a requirement that the company offer to pay 101% of par to bondholders in the event that the change in control provisions are triggered. This gives bondholders a way out if an issuer chooses to go private via leveraged buyout, yet preserves the ability of bondholders to keep their bonds in the event that the company is bought by an acquirer with a better credit profile (which would make the bonds appreciate). As with most things, the devil is in the details when it comes to change in control provisions.
The wording of the change in control provision appears pretty tight:
“(a) The Issuer may not consolidate or merge with or into or wind up into (whether or not the Issuer is the surviving corporation), or sell, assign, transfer, lease, convey or otherwise dispose of all or substantially all of its properties or assets, in one or more related transactions, to any Person unless:
(1) the Issuer is the surviving Person or the Person formed by or surviving any such consolidation or merger (if other than the Issuer) or to which such sale, assignment, transfer, lease, conveyance or other disposition will have been made is a Person organized or existing under the laws of the United States, any state thereof, the District of Columbia or any territory thereof (such Person, as the case may be, being herein called the “Successor Company”); providedthat in the case where the surviving Person is not a corporation, a co-obligor of the Notes is a corporation;
(2) the Successor Company, if other than the Issuer, expressly assumes all the obligations of the Issuer under the Indenture, the Notes and the Registration Rights Agreement pursuant to supplemental indentures or other documents or instruments in form reasonably satisfactory to the Trustee;
(3) immediately after such transaction, no Default exists;
(4) immediately after giving pro forma effect to such transaction and any related financing transactions, as if such transactions had occurred at the beginning of the applicable four-quarter period,
(a) the Successor Company or the Issuer would be permitted to incur at least $1.00 of additional Indebtedness pursuant to the Fixed Charge Coverage Ratio test set forth in the first sentence of the covenant described under “—Limitation on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock,” or
b) the Fixed Charge Coverage Ratio for the Successor Company and its Restricted Subsidiaries would be greater than the Fixed Charge Coverage Ratio for the Issuer and its Restricted Subsidiaries immediately prior to such transaction;
(5) each Subsidiary Guarantor, unless it is the other party to the transactions described above, in which case clause (b) of the second succeeding paragraph shall apply, shall have by supplemental indenture confirmed that its Guarantee shall apply to such Person’s obligations under the Indenture, the Notes and the Registration Rights Agreement; and
(6) the Issuer shall have delivered to the Trustee an Officer’s Certificate and an Opinion of Counsel, each stating that such consolidation, merger or transfer and such supplemental indentures, if any, comply with the Indenture. “
In other words, RadioShack can get away without repurchasing the bonds at 101, but only if the surviving entity had at least as good credit metrics after the merger as RadioShack did on a stand-alone basis before the merger. Since we are primarily concerned about protection against a buyout in which the company is leveraged to the moon right away, this feature of the bonds likely provides sufficient protection against a leveraged buyout.
Finally, we come to the covenants which restrict the company’s ability to simply pay out all of its cash to the shareholders and then file for bankruptcy, leaving bondholders holding the bag. RadioShack’s bonds have fairly common language restricting the company from paying out its cash:
“The Issuer does not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly:
(I) declare or pay any dividend or make any payment or distribution on account of the Issuer’s, or any of its Restricted Subsidiaries’, Equity Interests, including any dividend or distribution payable in connection with any merger or consolidation other than:
(a) dividends or distributions by the Issuer payable solely in Equity Interests (other than Disqualified Stock) of the Issuer; or
(b) dividends or distributions by a Restricted Subsidiary to the Issuer or any other Restricted Subsidiary (and if such Restricted Subsidiary is not a Wholly-Owned Subsidiary, to its other holders of common stock on a pro rata basis) so long as, in the case of any dividend or distribution payable on or in respect of any class or series of securities issued by a Restricted Subsidiary other than a Wholly-Owned Subsidiary, the Issuer or a Restricted Subsidiary receives at least its pro rata share of such dividend or distribution in accordance with its Equity Interests in such class or series of securities;
(II) purchase, redeem, defease or otherwise acquire or retire for value any Equity Interests of the Issuer, including in connection with any merger or consolidation involving the Issuer;
(III) make any principal payment on, or redeem, repurchase, defease or otherwise acquire or retire for value, in each case, prior to any scheduled repayment, sinking fund payment or maturity, any Subordinated Indebtedness, other than:
(a) Indebtedness permitted under clauses (7) and (8) of the second paragraph of the covenant described under “—Limitation on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock;” or
(b) the purchase, repurchase or other acquisition of Subordinated Indebtedness purchased in anticipation of satisfying a sinking fund obligation, principal installment or final maturity, in each case due within one year of the date of purchase, repurchase or acquisition; or
(IV) make any Restricted Investment (all such payments and other actions set forth in clauses (I) through (IV) above being collectively referred to as “Restricted Payments”), unless, at the time of such Restricted Payment:
(1) no Default shall have occurred and be continuing or would occur as a consequence thereof;
(2) immediately after giving effect to such transaction on a pro forma basis, the Issuer could incur $1.00 of additional Indebtedness under the provisions of the first paragraph of the covenant described under “—Limitation on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock;” and
(3) such Restricted Payment, together with the aggregate amount of all other Restricted Payments made by the Issuer and its Restricted Subsidiaries after the Issue Date (including Restricted Payments permitted by clauses (1) and (12) of the next succeeding paragraph, but excluding all other Restricted Payments permitted by the next succeeding paragraph), is less than the sum of (without duplication):
(a) 50% of the Consolidated Net Income of the Issuer for the period (taken as one accounting period) commencing April 1, 2011 to the end of the Issuer’s most recently ended fiscal quarter for which internal financial statements are available at the time of such Restricted Payment, or, in the case such Consolidated Net Income for such period is a deficit, minus 100% of such deficit; plus
(b) 100% of the aggregate net cash proceeds and the fair market value, as determined in Good Faith by the Issuer, of marketable securities or other property received by the Issuer since immediately after the Issue Date from the issue or sale of:
(i) Equity Interests of the Issuer, including Treasury Capital Stock (as defined below), but excluding cash proceeds and the fair market value, as determined in Good Faith by the Issuer, of marketable securities or other property received from the sale of Equity Interests to members of management, members of the board of managers or directors or consultants of the Issuer and the Issuer’s Subsidiaries after the Issue Date to the extent such amounts have been applied to Restricted Payments made in accordance with clause (4) of the next succeeding paragraph; or
(ii) debt securities of the Issuer that have been converted into or exchanged for such Equity Interests of the Issuer;”
The above is pretty common language and effectively keeps the company from paying out basically half of its consolidated profits, all well and good. However, there are always “carve-outs” from the above restrictions and in the case of the RadioShack bonds they are doozies. Most notably:
“The foregoing provisions do not prohibit:
(6) any Restricted Payments in an aggregate amount, taken together with all other Restricted Payments made pursuant to this clause (6) not to exceed the amount of the aggregate net proceeds of the private offering of outstanding notes;
9) other Restricted Payments in an aggregate amount, taken together with all other Restricted Payments made pursuant to this clause (9) not to exceed $100.0 million;
11) any Restricted Payment so long as the Leverage Ratio is less than 2.00 to 1.00 after giving pro forma effect to such Restricted Payment;”
In other words, the company can pay out to shareholders the amount of cash raised by selling the 2019 bonds ($325MM), another $100MM, and any amount at all so long as the leverage ratio is not above 2. Between the amount of the 2019 notes and the additional $100MM, RadioShack could pay out most of the company’s cash to shareholders. Since the rest of the working capital assets (inventories and receivables) secure the untapped credit facility (which can be drawn down any time) and there are no other assets available to secure the bondholders in the event of a bankruptcy, it is clear that the attractive balance sheet is highly likely to be in much worse shape in a hurry if the company will eventually get into trouble and possibly file for bankruptcy.
In case this were not enough to kill your interest in these bonds, the bonds lack a requirement that RadioShack stay in its existing line of business and have a very loose restriction on new debt incurred as part of an acquisition. Taken together, this leaves the door wide open for the company to go charging off into a completely different business line (oil exploration, weapons manufacturing, nuclear waste hauling, you name it) and finance the risky new venture with lots of new debt.
I have probably bored most of my readers to death by now, but I keep saying in all of my posts that you should always take the trouble to do careful due diligence before buying any investment. In the case of junk bonds, that most definitely means reading the prospectus of the bond before you buy to see how well you are protected by the restrictions on the issuer. I apologize for the length and amount of fine print in this post, but I hope that actually seeing an example of the down and dirty details would be helpful.
As always, do your due diligence and be careful. You can lose money on this stuff.