Money Stuff

Bond Covenants and Skeptic Skepticism

Also antitrust, bitcoin, unicorns, buybacks and liquidity.


I used to build and sell bonds -- convertible bonds, but still -- and it was always a bit of an event when investors actually read the terms of the bonds they were buying. Every so often one would call me up:

Investor: This bond document says that if X happens, then the company can do Y to us.
Me: That's true.
Investor: I don't want the company to be able to do Y to us.
Me: I'm sorry you feel that way.
Investor: You should take that term out.
Me: Okay, what is your order if we take the term out?
Investor: $50 million at 4 percent.
Me: And what is your order if we leave it in?
Investor: You should take it out.
Me: No, I know, but just humor me. What if we leave it in, what's your order?
Investor: $50 million at 4 percent, but you should take it out.
Me: Thanks for calling.

And we'd leave the term in. Because the company wanted it, and the only cost of leaving it in was my time: Investors would complain about the term, but they'd buy the bonds anyway, and not charge any more in interest. (The trickier case is when wanted an investor-friendly term in the bonds, because I thought it was the right thing to do, and the issuer didn't. "How much will it cost us to take this out," savvy issuers would ask. "Well," I would say, "that's not the point.") You could imagine a theoretical world where a company could issue bonds for 4 percent with strict covenants and other investor-friendly terms, or for 4.05 percent with somewhat weaker covenants, or for 4.25 percent with really weak covenants. There'd be a sliding scale in which investors would trade off economics against more or less protective terms. Investors and issuers would decide what they wanted, and how much they were willing to pay for it, and price would intermediate their desires.

But in practice that is hard to coordinate, and no one reads the documents anyway. So what really happens is that there is some roughly market set of terms, and economics don't vary much within those normal terms, and the lawyers negotiate the specifics, and investors mostly don't read them, and occasionally they do, and complain, but buy the bonds anyway. Until one day they don't:

Investors drew a line in the sand on Wednesday, forcing companies to rewrite bond documents in a stinging rejection of covenant packages that were seen as hostile to bondholders.

Marketing material for bond offers by General Motors’ financial subsidiary, chipmaker Broadcom and the Brazilian pulp manufacturer Fibria Celulose dropped language that deprived investors of certain premiums should the companies breach their covenants and default, according to three people with knowledge of the sales.

Hey wow, people read bond documents! Actually what seems to have happened, according to this client memo from Davis Polk & Wardwell LLP, is that "a covenant review service recently proclaimed that new language in capital markets notes indentures is 'the end of covenants' and the 'single worst change to ever emerge' in the bond market," and investors read that and were convinced. (That's Adam Cohen's Covenant Review.) Still that is something; it sort of counts as reading the bond documents if you delegate someone else to do it for you.

The actual dispute does not strike me (or Davis Polk) as the "end of covenants," though I can understand the concern. Basically the rule is:

  1. If you issue a bond with covenants, you can't do stuff forbidden by the covenants, or else you are in default.
  2. If you are in default, the bondholders can demand their money back ("acceleration"), and you have to pay them back at par immediately.
  3. Also, separately, if you want to buy the bonds back, you can: You can just go to investors and negotiate to buy bonds back at the market price, which might be above (or below) par.
  4. And many (not all) bonds give the issuer the right to buy the bond back at a premium without negotiating: You can force investors to sell you back their bonds, if you pay them a "make-whole premium" set in the offering document.

If you are a company and you have a bond with covenants that you don't like, the traditional way to deal with that is to negotiate with the bondholders to get them to waive the covenant, or even to buy back the bonds -- with the make-whole, if necessary -- so that the covenant no longer applies. But there's a potential loophole: If you just default on the bond -- by, for instance, ignoring the covenants -- then the bondholders' remedy is to accelerate the bonds and demand to be paid back at par. But paying them back at par, especially when the bonds' interest rate is above market interest rates, is much cheaper than paying them a make-whole.

Most companies prefer not to default on their debt -- there are some bad consequences to that! -- but I suppose it is a loophole. But a few recent court decisions closed it. Davis Polk:

In Cash America, decided in September 2016, a U.S. district court held that a make-whole is payable where a company defaulted through voluntary action without a finding that the company had acted in bad faith with an intent to avoid the make-whole. In Energy Futures, decided in November 2016, the U.S. Third Circuit held that a company must pay a make-whole if notes are repaid in a bankruptcy.

That seems a bit extreme. As they note:

Not all capital markets notes include an optional right of redemption. We believe that market participants and practitioners have generally understood that an issuer’s right of redemption, including at a stated premium or make-whole, exists to provide flexibility for the benefit of the issuer. It would be odd, to say the least, if when an issuer defaults on notes without this feature, the issuer only has to pay principal and interest, but if that additional feature is included – for the issuer’s benefit – the issuer must pay a premium.

So some issuers "added language to their capital markets indentures to clarify the understanding that no make-whole is due upon a default or bankruptcy," and the fury of Covenant Review was unleashed upon them. And investors stood up on their hind legs and said "this shall not pass," and the issuers caved. As a substantive matter here I am sympathetic to Davis Polk and the issuers: The make-whole is for optional redemption, not for default, and it seems confused to require the make-whole on default. 

But who cares? I can't help but root for a bond buyer rebellion, even if I think it's a little misguided. They happen so rarely. And they're good for the world. They validate the idea that capital markets are about striking bargains between issuers and investors, and that the terms of bonds are the result of negotiation between buyers and sellers rather than just esoteric poetry chapbooks written by securities lawyers and read by no one. Every so often the terms of bond documents matter, and it's good for issuers and investors to fight over what matters to them when the bonds are written, rather than waiting until they end up in court.

Pyrrhonian skepticism.

This is apparently how Peter Thiel became a billionaire?

Mr. Thiel shows, again and again, how he likes to “flip around” issues to see if conventional wisdom is wrong, a technique he calls Pyrrhonian skepticism.

“Maybe I do always have this background program running where I’m trying to think of, ‘O.K., what’s the opposite of what you’re saying?’ and then I’ll try that,” he says. “It works surprisingly often.”

So for instance: You think corruption is bad, but Thiel thinks that "there’s a point where no corruption can be a bad thing. It can mean that things are too boring." You think it's weird to hire people based on looks, but Thiel thinks, you know, what the heck: "You’re assuming that Trump thinks they matter too much. And maybe everyone else thinks they matter too little. Do you want America’s leading diplomat to look like a diplomat?" Et cetera et cetera et cetera, as easy as you like:

“Everyone says Trump is going to change everything way too much,” says the famed venture capitalist, contrarian and member of the Trump transition team. “Well, maybe Trump is going to change everything way too little. That seems like the much more plausible risk to me.”

Pyrrho was an ancient Greek skeptic. "The main principle of Pyrrho's thought," Wikipedia tells me, "is expressed by the word acatalepsia, which connotes the ability to withhold assent from doctrines regarding the truth of things in their own nature; against every statement its contradiction may be advanced with equal justification." I am all for Greek philosophers, but they lived in a sort of pre-scientific age, and many of them left no writings and are best remembered mainly for their most outrageous claims. Actually that sounds a lot like us. It can't be literally true that "against every statement its contradiction may be advanced with equal justification." Some facts are true! The opposite of those facts would be ... not true? Pyrrho was a skeptical ancient Greek philosopher, but that means that he wasn't a credulous 21st-century American businessman. 

But I suppose the way to get a reputation as a Silicon Valley visionary is by telling people that something that they always thought was right is actually wrong. And the easiest way to make sure that you'll do that is by telling people that everything that they always thought was right is actually wrong. As an intellectual process, Thiel's simplified "Pyrrhonian skepticism" -- just saying the opposite of what everyone thinks about everything -- is a catastrophe. But as a marketing strategy, it's great. If you constantly wander around saying gnomic contrarian things, then you are bound to hit on a few that sound insightful. Some might even be true! I am working on my Silicon Valley best-seller right now. It's called "Acatalepsia: Why Everything Bad Is Actually Good." You think massive companies collecting and sharing data about you is bad, but what if it's good? You think job losses are bad, but what if they're good? You think democracy is good, but what if it's bad? You think you paid too much for this book, but what if you paid too little?

(By the way, please don't e-mail me to be like "aaaaactually job losses are good because creative destruction." My point here is not that these statements are all wrong! My point is that negating everything is not an intellectual process at all; it is just a game with words.)

Elsewhere in Trump news, he doesn't really plan to do anything to resolve conflicts of interest between his businesses and the presidency. But wait: What if that's actually good? Oh Thiel already said that: "I think in many cases, when there’s a conflict of interest, it’s an indication that someone understands something way better than if there’s no conflict of interest."

Should index funds be illegal?

If you've followed the argument that diversified mutual funds are bad for competition because they encourage managers to seek high industry-wide profits instead of increasing market share by cutting prices, then you might remember that the theory originated with a paper claiming to find evidence of a connection between institutional investor cross-holdings and anticompetitive behavior in the airline industry. We all had a good laugh, but then the Justice Department started looking into airline pricing, and for a little while it looked like maybe, just maybe, U.S. antitrust authorities might get on board with the far-out theory that index funds lead to collusion. But, nah:

The U.S. Justice Department is unlikely to bring an antitrust action against U.S. airlines after finding little evidence the carriers coordinated to raise fares by curbing the supply of seats, a person familiar with the matter said.

That seems like the end of it, unless you think that a Trump administration is going to make a priority of cracking down on antitrust enforcement based on a somewhat arcane academic theory.

Blockchain blockchain blockchain.

We talked the other day about how it's sort of sad that big incumbent financial intermediaries have co-opted the concept of the "blockchain," so that, rather than standing for a decentralized, disintermediated, democratized financial infrastructure, the word "blockchain" now refers mostly to a new way for big banks to run their databases. But you can see where they're coming from. The "real" blockchain, the one that still pursues those libertarian dreams, is the bitcoin blockchain, and as far as I can tell its main use is for money laundering in China. Or at least that's how I interpret the fact that the price of bitcoin fell by 16 percent when "officials with the Shanghai branch of the People’s Bank of China and the city’s finance office conducted an on-site inspection at the BTCC online bitcoin exchange, according to a statement from the PBOC, looking for evidence of violations." 

People are worried about unicorns.

My Bloomberg Gadfly colleague Shira Ovide is worried that, while there are plenty of venture-capital investments in startups, there aren't enough exits, and so the pipes are clogged and "Silicon Valley Needs Startup Drano." In financial markets, the most effective form of Drano is usually price: If lots of VCs are investing in startups at high valuations, but they can't quite find a way to sell those startups to the public markets at high valuations, then you can clear that right up by bringing the valuations down. 

Elsewhere, millennials aren't starting startups because they have too much student-loan debt.

People are worried about stock buybacks.

Here are a paper and related blog post from Jesse Fried of Harvard Law School and Charles Wang of Harvard Business School about "Short-Termism and Shareholder Payouts: Getting Corporate Capital Flows Right." They object to some criticisms of corporate stock buybacks on the grounds that buybacks aren't as big as they seem. For instance:

A focus on S&P 500 firms—which generally have fewer growth opportunities than smaller and younger firms—creates a misleading picture of net shareholder payouts in the public markets as a whole. We show that while S&P 500 firms are net exporters of equity capital, public firms outside of the S&P 500 are net importers of equity capital, absorbing $520 billion of equity capital, or about 16% of the net shareholder payouts of S&P 500 companies, during the period 2005-2014. Across all public firms, net shareholder payouts from 2005 to 2014 were only $2.50 trillion, about 33% of the net income of public firms over this period.

I sometimes casually say that the U.S. public stock market is not a place for companies to raise capital; it is a place for companies to return capital to investors. That is, in the aggregate, true. But if you ignore the S&P 500 and focus only on smaller public companies, you will find companies who actually use the stock market to raise money. 

People are worried about bond market liquidity.

The New York Fed's Liberty Street Economics blog, which in 2015 and 2016 ran series of posts about how all the evidence points to bond market liquidity being fine, is kicking off 2017 with a series of posts about evidence that it's not fine. Here's one on "Credit Market Arbitrage and Regulatory Leverage," finding that the supplementary leverage ratio and other post-crisis capital and trading regulation have had an effect on credit-default-swap trading and, thus, on bond market liquidity:

While we cannot precisely measure the costs associated with the SLR capital requirements, it does appear that executing credit basis arbitrage trades is now costlier—and less profitable—largely due to the extra capital these trades require. The amount of capital required depends largely on the cash instrument position of the trade, which is fully recognized, rather than the derivatives portion. As a result, while the recent CDS-cash basis levels may have created attractive trades in the past, our analysis suggests that more negative spreads are now required to cover dealers’ heightened balance sheet costs and to generate adequate returns on equity. These considerations indicate that there may be a “new normal” level at which dealers are incentivized to enter into spread trades. If dealers are less willing to participate in spread-narrowing trades, market liquidity in both corporate bond and CDS markets may suffer as, historically, dealers have been the providers of liquidity in both markets.

Updates, etc.

Yesterday I wrote:

If a company went public with a charter saying that it could never pay dividends, could never buy back stock, could never merge, and that if it ever went out of business or sold its assets it would donate all of its money to charity -- then I think the stock would be worthless? I hope? I suppose someone should try it and find out.

Several readers pointed out that Green Bay Packers, Inc., the football team, is a company that seems to satisfy all these requirements, and then some. (You also can't, for instance, trade the stock.) Here is a 2012 Wall Street Journal article asking: "Are the Green Bay Packers the Worst Stock in America?" Here is a prospectus for the Packers' 2011 offering, where shares were sold for $250 per share, plus a $25 handling fee. So there's your answer. You get a nice certificate, though, and other exclusive merchandise offers, so the whole thing feels a bit more like "sports memorabilia" than "stock." Still it does kind of count, doesn't it? Like surely Apple could sell shares for $250 apiece on this model, though probably not $600 billion worth of them. The real question is: How much would you pay for a share of Money Stuff, Inc., with no economic rights?

That was in the context of a discussion of meme stock markets, so I should point you to "The Wolf of Meme Street." Dialogue includes "Half my clients' retirement is in Pepe" and "Harambe can't collapse, it's too big to fail." 

Also yesterday we mourned, or whatever, the demise of the NYSE MKT's physical trading floor. But in compensation, the New York Stock Exchange itself is expanding its floor-based trading to cover all U.S. stocks, including Nasdaq-listed stocks and exchange-traded funds, and not just NYSE-listed stocks. 

The rationale is to offer traders and investors different options, including for speed which has become a controversial issue. The trading floor, for example, uses a “parity” model — enabling competing orders at the same price to share executions regardless of when an order arrives — versus Arca, which prioritises speed. Orders there are filled at the best price on a first-come, first-served basis.

In this era of skepticism about high-speed trading, I kind of don't understand why NYSE doesn't do more to play up the fact that trading through human floor traders is soothingly slow. 

Things happen.

JPMorgan Ordered to Pay Damages for Firing Whistle-Blower. 6 Volkswagen Executives Charged as Company Pleads Guilty in Emissions Case. U.S. Expected to Launch WTO Complaint Against China Over Aluminum. Investors Bolt Mexico as Peso Enters Free Fall. SEC Blesses Negotiable Mutual-Fund Fees. Scandal at Korea’s Retirement Giant. Samsung Heir Questioned as Bribery Suspect in South Korean Probe. Chris Rokos Is Said to Be Seeking to Raise More Than $2 Billion. Chancery Provides in Depth Analysis of Fair Value Determination in Appraisal Proceeding. Norway Is First Nation to Switch Off FM Radio. "One of the biggest employee gripes was a low frequency of intimate romantic encounters — both in and out of the office." Brooklyn is expensive. Polish minister mocked over meeting with fictional nation of San Escobar. These Are the World’s Cheapest Places to Buy Drugs, Alcohol and Cigarettes. "I was like, 'Wow, drug dealers care!'" Man found stuck in kitchen vent in Manhattan apartment. Fast-food headhuntersManbassadors.

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