Guarding against LBO risk in bond funds

According to Simon Surtees and Karl Bergqwist, Co-Heads of Fixed Income at Gartmore, the risk posed to bond investors by private equity-backed leveraged buyouts (LBOs) is growing.

Takeovers initiated by private equity investors generally involve a high proportion of debt to equity. As a result, default risk is higher and holders of what was previously an investment grade bond can find themselves stuck with a much lower quality credit. In a discussion paper published earlier this month, the Financial Services Authority warned that the collapse of a large private equity-backed company was now inevitable.

“Both the number and the size of this type of deal is increasing,” say Simon and Karl. “European bluechips Vivendi and Telecom Italia have emerged as the latest companies to attract private equity attention. In the past it was generally felt that companies with a market cap of over $1-1.5 billion were immune to LBO-risk due to their size. However, this is definitely no longer the case. US buyout group Blackstone recently agreed a record-breaking deal worth $36 billion and a deal of this size isn’t a one off either.

“In this environment, we are avoiding corporate bonds - especially long-dated paper - without appropriate protective covenants. We have also been using Credit Default Swaps (CDS) to guard against this type of risk in the portfolios of the Gartmore Corporate Bond Fund, the Gartmore High Yield Corporate Bond Fund and the Gartmore SICAV Sterling Bond Fund. By taking a short position in the credit of a company which we believe may become a potential LBO target, our Funds can actually benefit from these events.”