Oct. 30 (Bloomberg) -- U.S. bond investors are demanding more protection from takeovers than ever amid concern that the biggest corporate bond market rally in more than a quarter century will spark a wave of credit-damaging leveraged buyouts.

For the first time, more than half of the lowest-rated investment-grade industrial companies that sold bonds this year included a promise to pay investors a premium to face value in a takeover, according to data compiled by Bloomberg. A total of 55 borrowers from Woonsocket, Rhode Island-based drugstore chain CVS Caremark Corp. to Dow Chemical Co. sold $44.2 billion of debt last quarter with so-called poison puts, a record 30 percent of all investment-grade issuers.

The steepest gain in the Standard & Poor’s 500 index since the 1930s, the lowest yields on corporate bonds since 2005 and a doubling in bank lending is raising concern among bondholders that the two-year drought in debt-laden mergers and acquisitions is coming to an end. KKR & Co.’s Henry Kravis and Stephen Schwarzman of Blackstone Group Inc. both said this month they’re poised to start buying again.

Investors are shifting out of “survival mode” and demanding better defenses against LBOs, said Tom Murphy, a money manager at RiverSource Investments LLC in Minneapolis, which oversees $145 billion in assets. “There are some credits I wouldn’t invest in without it.”

Price Premium

Poison puts allow investors to sell a bond back to the issuer at 101 cents on the dollar in the event of a corporate takeover, merger or restructuring that would result in control shifting hands. The provisions protect bondholders from deals that crush credit ratings and the prices of their securities, while allowing companies to pay lower yields on their debt.

The economy is demonstrating that the worst of the crisis is over, paving the way for deal-making to resume, Kravis said Oct. 20 at a conference in Quebec City, according to prepared remarks.

“We have very likely come through the worst of the Great Recession,” he said. “The beginning signs of a measured economic recovery are noticeable and real.”

Private-equity firms have been able to win financing commitments for transactions, especially those involving buying assets from large corporations, he said.

“The future now looks substantially brighter for us in the private-equity business,” Schwarzman, chief executive officer of Blackstone, told attendees at the Super Return Middle East conference in Dubai on Oct. 14.

Peter McKillop, a spokesman for KKR, and Christine Anderson, a spokeswoman for Blackstone, both in New York, declined to comment.

Damaging Buyouts

The use of poison puts in investment-grade bonds accelerated at the end of 2006, during a two-year, $1.4 trillion takeover binge. About 8 percent of issuers included a form of the provision in the fourth quarter of that year, up from 4.5 percent in the prior three months and less than 2 percent in all of 2005, Bloomberg data show.

About 50 percent of non-financial bonds sold this year with the three lowest levels of investment grade contained a poison put, up from 45 percent in all of 2008, Bloomberg data show. About 85 percent of bonds that included the provision were rated in that BBB category, as ranked by Standard & Poor’s, and 97 percent were from non-financial issuers.

Cost to Bondholders

The percentage of corporate borrowers offering bonds with poison puts began to decline early last year after the U.S. economy entered the worst recession since the 1930s. It dropped to 10 percent in the fourth quarter as investors sought only the highest-rated debt. The covenants returned this year as companies agreed to pay higher yields to build their cash hoards and debt markets opened up to lower-rated issuers.

A lack of protection can cost bondholders. Buyers of $3.5 billion of TXU Corp. bonds sold in November 2004 have lost about $1 billion in value in the past two years, since the Dallas- based power producer was bought by KKR and TPG Inc. for $32 billion.

The bonds, sold with the lowest S&P investment-grade rating of BBB-, were slashed to CCC, or eight steps lower, at the time of the October 2007 buyout. They’re now rated CC. TXU was renamed Energy Future Holdings Corp.

Poison puts have “become the de facto standard for all but the highest-rated companies,” said Brad Fox, chairman of the National Association of Corporate Treasurers and treasurer of Pleasanton, California-based Safeway Inc., the third-largest U.S. supermarket chain. Underwriters “basically say, if you want to get the deal done, it has to have the put,” he said.

Savings to Borrower

Investors may be willing to take as much as 50 basis points less in interest in exchange for LBO protection, RiverSource’s Murphy said in a telephone interview. That would save a company $5 million a year in interest on $1 billion of debt.

Corning Inc., the world’s biggest maker of glass for flat- panel televisions, sold $350 million of 10- and 15-year bonds with a change-of-control covenant on May 15 in its first offering with the provision, Bloomberg data show.

Underwriters told the Corning, New York-based company that adding the put might save about 25 basis points, or 0.25 percentage point, treasurer Mark Rogus said in a telephone interview. That’s about $880,000 a year in interest.

“We wanted quality execution, done quickly, with tight spreads,” Rogus said. The poison put “allowed us to achieve a better offering,” he said.

M&A Surge

Corning is using a poison put as merger activity picks up in the technology industry. More than $17 billion in acquisitions were announced in the past six weeks, Bloomberg data show. Norwalk, Connecticut-based Xerox Corp. agreed to buy Affiliated Computer Services Inc. of Dallas for about $6 billion. Round Rock, Texas-based Dell Inc. snapped up Perot Systems Corp. of Plano, Texas, for $3.9 billion.

A leveraged buyout is a takeover in which the buyer borrows money by usually selling high-yield, high-risk loans and bonds, which are ranked below Baa3 by Moody’s Investors Service and BBB- by S&P. The debt, along with the target’s existing liabilities, is paid back out of the purchased company’s revenue.

Poison puts increase the costs to the buyer by requiring them to put up more cash. An acquirer of Corning would have to pay $353.5 million for the company’s new bonds that include the poison put.

Hilton Buyout

LBOs and mergers tumbled to $58 billion this year from $212 billion in all of 2008 and $675 billion the year before, Bloomberg data show. During the LBO boom, firms were able to finance about two-thirds of the purchase price of their deals in debt. Blackstone put up $5.5 billion in equity and raised $21 billion in loans to finance its 2007 buyout of Hilton Hotels Corp.

Anheuser-Busch InBev NV, brewer of Budweiser and Stella Artois beers, raised $8.5 billion from bond offerings in May and October that included poison puts, after selling $5 billion of debt without the protection in January.

Leuven, Belgium-based AB InBev’s $2.25 billion of 5.375 percent bonds due in 2020, part of the October sale, pay a yield 178 basis points more than benchmark rates. That’s 27 basis points less than similar debt it sold in January without the protection, Bloomberg data show. AB InBev was created from the former InBev NV’s $52 billion purchase of Anheuser-Busch Cos. in November 2008.

‘Right Thing’

“Issuers did the right thing in thinking, ‘Let’s get investors to focus on the credit and get the bonds placed,’ rather than spending a lot of time arguing over change of control,” said Anne Daley, a managing director in U.S. fixed income syndicate at Barclays Capital in New York. The value of the covenants is “somewhat neutralized at this point because almost all issuers include it,” she said.

Barclays helped manage the May and January sales for AB InBev.

Increased use of change-of-control provisions doesn’t necessarily portend a wave of buyouts, according to Corning’s Rogus. The trend coincides with a debt-market rally that helped the lowest-rated investment-grade companies, which account for almost all the deals with a poison put, to sell more bonds.

It’s going to take some time before bank lending picks up more, Rogus said.

Even as the “table is set” for private equity deals to increase amid lower interest rates, “it’s not clear anyone has been invited yet,” he said.

‘Step-Up’ Provisions

Investors say they want more protection against leveraged buyouts, yet when the market for new issues heats up, such concerns are often forgotten, said Adam Cohen, founder of debt research firm Covenant Review LLC in New York.

In 2007, bond buyers began demanding that some issuers include a provision in their bonds that requires the interest payment to increase if ratings are cut. So-called step-up provisions are getting more “scarce” because investors haven’t been willing to pay for them, Cohen said in a telephone interview. The same thing may happen to poison puts, he said.

“There’s an ongoing disconnect in the market between what a bondholder says he wants and what he’ll pay for,” Cohen said. “Just like issuers realized they didn’t have to provide coupon step ups, maybe they’ll realize they don’t have to provide a change of control.”

Concern that buyouts may return comes as stocks have surged on optimism the economy is recovering from the first global recession since World War II. The U.S. economy grew in the third quarter for the first time in more than a year, the Commerce Department said yesterday.

Total Debt Sales

Company bond yields dropped to a four-year low of 5.895 percent this week from 10.46 percent in March, making it cheaper for companies and private equity firms to borrow, according to Merrill Lynch & Co.’s broadest U.S. corporate bond index. Borrowers have sold $1.11 trillion in debt in the U.S. in 2009, the fastest pace on record, data compiled by Bloomberg show.

Banks provided $5.8 billion of high-yield loans to finance leveraged buyouts and acquisitions in the U.S. last quarter, almost double the $3 billion sold in the first half of the year, according to S&P Leveraged Commentary and Data.

CVS, the largest U.S. drugstore chain, has been including poison puts in its bonds since at least May 2007, Bloomberg data show. In September, the company sold $1.5 billion of 6.125 percent bonds due in 2039 with the protection.

Carolyn Castel, a spokeswoman for CVS, said executives weren’t available for comment.

Dow Chemical

Dow Chemical began selling bonds with poison puts in May 2008, 13 months after Britain’s Sunday Express reported on April 9, 2007, that buyout firms were preparing to bid for the company. The cost to protect Dow’s bonds from default soared almost 50 percent. The largest U.S. chemical maker fired two executives three days after the report for holding unauthorized discussions to sell the company.

Dow raised $2.75 billion in a protected bond offering in August, including $1.25 billion of 4.85 percent notes due in 2012 that currently pay a spread about 40 basis points lower than similar debt sold seven years earlier without the provision, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Dow officials weren’t available for comment.

Even Blackstone, the world’s biggest buyout firm, included change-of-control protection in its debut offering of corporate bonds in August, when it raised $600 million in a sale of 6.625 percent 10-year notes, Bloomberg data show. The securities are rated A by S&P.

Blackstone agreed Oct. 7 to buy brewer AB InBev’s amusement park unit that includes SeaWorld and Busch Gardens for as much as $2.7 billion in the largest private-equity deal this year.

KKR, founded in 1976 by Kravis and George Roberts, bought Oriental Brewery Co. earlier this year from AB InBev for $1.8 billion. Kravis said similar opportunities may arise as companies pursue plans to shed units they don’t consider central.

To contact the reporters on this story: John Detrixhe in New York at jdetrixhe1@bloomberg.net; Bryan Keogh in New York at bkeogh4@bloomberg.net.

Last Updated: October 30, 2009 15:26 EDT