Bond Buyers Demand Record Downgrade Protection

By Bryan Keogh

April 5 (Bloomberg) -- Bonds with built-in protection against rating cuts are making up a record share of debt issues as investors hedge against a slowdown in the economic recovery.

Anheuser-Busch InBev NV, the brewer of Budweiser and Stella Artois, is among companies issuing so-called step-up bonds, whose interest increases if a borrower is downgraded. Sales surged to $37.3 billion in March, or 12.4 percent of all debt issued, according to data compiled by Bloomberg. Most of the notes are sold in the U.S., where almost half of bonds rated as so-called junk or on the cusp of non- investment grade include the protection.

Investors are concerned that debt-laden companies are at increasing risk of being downgraded this year, even as the global economy emerges from the deepest recession since the 1930s and credit markets rally. Reductions in corporate ratings and credit outlooks outpaced increases by 150 percent in the first quarter, according to Moody’s Investors Service.

“The recent use of step-ups shows some investors are still concerned about downgrade risks, despite a rally in corporate debt,” said Sarwat Faruqui, a director of capital markets origination at Citigroup Inc. in London.

Step-up interest coupons are typically used by companies rated at or below Baa1 by Moody’s and BBB+ by Standard & Poor’s, two notches above non-investment grade. Sales of the bonds globally are up from $16.6 billion in February and $8.4 billion a year ago, according to Bloomberg data. In the U.S., such borrowers sold a record $32 billion of the debt last month, or 46 percent of all bond issuance, the data show.

Spread Narrows

Elsewhere in credit markets, the extra yield investors demand to own corporate bonds rather than government debt fell 2 basis points last week to 149 basis points, or 1.49 percentage point, as of April 1, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. That’s the narrowest spread since November 2007 and down from a record 511 basis points in March 2009.

The cost to protect against non-payment on corporate bonds in the U.S. fell, with the Markit CDX North America Investment Grade Index of credit-default swaps dropping 2 basis points last week to 85.25 basis points on April 2, according to CMA DataVision. In London, the Markit iTraxx Europe Index of 125 investment-grade companies fell 1 basis point in the week to 77.5, CMA prices show.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Fannie, Freddie

Yields on Fannie Mae and Freddie Mac mortgage securities that guide home-loan rates rose to the highest in more than three months after the Federal Reserve ended its unprecedented purchases of the debt on March 31. Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds climbed 0.05 percentage point to 4.56 percent on April 1, the highest since Dec. 28, according to data compiled by Bloomberg.

Royal Bank of Scotland Group Plc is selling bonds backed by commercial mortgages of several borrowers in the first sale of its kind since June 2008, gauging investor demand for the debt amid climbing defaults.

New York to Missouri

The $309.7 million offering, backed by 81 properties in U.S. states from New York to Missouri, includes $240.8 million in top-rated securities, according to people familiar with the sale who declined to be identified because terms are private. Of those properties, 78 are retail sites, the people said.

Demand for collateralized loan obligations is reviving with more deals planned this year, Citigroup analysts wrote in an April 1 report. CLOs, shunned for their role in causing $1.8 trillion of bank losses and writedowns during the credit crisis, buy leveraged loans and then use the payments as collateral for bonds. Citigroup priced $525 million of CLOs last month in the first new issue in a year.

Investors are demanding more borrowers use step-up coupons in their bond sales because of the amount of debt on companies’ balance sheets.

“Companies are offering incentives such as step-up coupons and ratings commitment language in order to attract a broader range of investment-grade investors” that may otherwise be put off by their debt levels, said Mark Lewellen, London-based head of corporate origination at Barclays Capital.

Bondholder Protection

Step-up bonds offer a different form of investor protection from credit-default swaps in that they increase the interest spread should a company’s creditworthiness decrease. Credit-swaps, on the other hand, are a kind of insurance contract that pay out when a company defaults on its obligations.

Anheuser-Busch InBev, the world’s largest brewer, sold $3.25 billion of bonds with a step-up coupon on March 24, Bloomberg data show. The conditions require the Leuven, Belgium-based company to pay 25 basis points more in interest for every one rating notch it’s cut below investment grade, up to a maximum of 200 basis points, according to Bloomberg data. The brewer is rated Baa2 by Moody’s and one level higher at BBB+ by S&P.

The use of such bond conditions is increasing against the backdrop of a global economy that will grow 3.6 percent this year, according to a Bloomberg survey. Bond spreads are at their lowest in more than 2 1/2 years and issuance of notes of all ratings rose to $752 billion in the first quarter, compared with $583 billion in the previous period and following a record $3.18 trillion in the whole of 2009, Bloomberg data show.

Interest ‘Premium’

Even so, investors want the chance of “an additional premium” on the interest of a bond sold by a company at risk of a rating cut, said Dinesh Pawar, head of flow trading at Aviva Investors in London, where he helps manage 250 billion pounds ($380 billion).

More companies were downgraded or had their outlooks lowered by Moody’s than were upgraded for an 11th straight quarter between January and March. The New York-based rating company made a total 767 credit reductions against 309 upgrades in the period, according to data compiled by Bloomberg.

Western European companies showed the most deterioration, with 213 cuts in rating or outlook versus 40 credit improvements. A total 309 borrowers were at risk of a downgrade, Moody’s said, almost four times the number poised for an upgrade. Step-up interest may also be triggered if an issuer fails to register the securities.

Mondi Ltd., Europe’s biggest manufacturer of office paper, included a step-up condition in its debut 500 million- euro ($678 million) bond offering on March 26. The interest rate on the notes will increase by 125 basis points if the Addleston, England-based company’s rating falls to below investment grade at both Moody’s and S&P, according to Citigroup’s Faruqui.

Mondi’s notes are currently rated Baa3 by Moody’s, the lowest investment-grade ranking, and one step lower at BB+ by S&P.

To contact the reporter on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net