Monday, July 21, 2008

Security Analysis: Chapters 18, 19 and 20

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

In these three chapters, Graham and Dodd discuss various covenants and protective provisions for fixed-income investments. Though the health of the company is the most important factor in the determination of the health of a fixed-income investment, sometimes a company can run into trouble, and so debt holders need further protection as backup. (Note that we will discuss from the point of view of bond holders, but these covenants and protections are equally important for those who hold preferred shares.)

The most common provision allows a bond to become due upon a default event, for example if a company cannot pay its interest. The authors argue that current rules (as they were at the time of writing) are either too strong or too weak, as the status quo is harmful to both the company as well as bondholders. The fact that stockholders rights are considered during a bankruptcy puts uncertainty on the bonds, and as such they often sell for far lower than they should, considering their senior position. At the same time, if bondholders could not enforce their rights, a company might be able to avoid bankruptcy for enough time to get its act together. The authors express hope, with caveats, that new bankruptcy legislation which allows a re-emergence upon agreement by 66% of each stakeholder group will help remedy this problem.

Often, bond indentures will also prohibit the launching of new debt with senior liens on an existing property. However, most indentures will allow unlimited debt placed on newly purchased property. The authors argue that this could put all bondholders in a precarious position if the company uses this to lever past the point of where it should.

A sinking fund should also be setup wherever bonds are secured against a depleting asset. The authors cite numerous examples where depletion of assets along with a lack of a sinking fund resulted in bond holders receiving subpar redemptions, while in the preceding years common stockholders had received dividend payouts from profits made on now depleted assets. Serial maturities (where some principal is due each year) can act as an alternative to sinking funds, but require securities of different market quotations, which add complexity and costs.

Further, Graham and Dodd argue that companies should be required to maintain working capital (and/or capital stock) at certain levels above the value of its bonds. Often, a bond will be issued with a certain margin of safety below the value of working capital. However, indentures often do not require that this level be maintained throughout the life of the bond.

In order to ensure these covenants are met, bond holders require the ability to enact some sort of punishment on a company. It should not be such that it cripples the company, but must be substantial enough to provoke a company into meeting its obligations. Various forms of protection are discussed, from default (the harshest) to disallowing commond dividends. The authors argue that a group whose covenants have been violated should have the right to voting control of the board of directors, in order to see to it that their covenants are enforced.

The provisions described above offer protection to the investor. But if that protection is not enforced, then the ensuring of the protective measures were an exercise in futility. The authors cite numerous examples where marketable securities had dropped below minimum thresholds (e.g. less than 120% of debt) and where trustees did not act. Often, bond holders were left with less than par value as trustees acted when it was too late. It is essential that trustees are vigilant in defending security holders.

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