Test of the Poison Put

Tim Hortons Inc. (THI) bondholders will pay a price if they relinquish their debt under threat of a downgrade to junk because of the doughnut chain's purchase by Burger King Worldwide Inc.

Under what's known as a change-of-control provision, investors have the option to hand the debt back at a price of 101 percent of face value, or five cents less than what the bonds traded at before the second-largest U.S. burger company agreed this week to acquire Oakville, Ontario-based Tim Hortons for about C$12.5 billion (US$11.4 billion).

Investors will probably choose the so-called poison put to avoid deeper losses given that Burger King is rated five levels lower, according to Noel Hebert, an analyst who follows the restaurant industry for Bloomberg Intelligence. DBRS Ltd., the only firm that rates Tim Hortons' C$1.2 billion of bonds, said yesterday it was reviewing the BBB ratings for downgrade and that its credit risk profile “will no longer be consistent with an investment-grade rating.”

Tim Hortons is becoming the test case for a campaign by the Canadian Bond Investors' Association (CBIA) to expand the use of poison puts to protect investors from credit-damaging leveraged buyouts such as the one by 3G Capital, the investment firm that owns about 70 percent of Burger King. Flaws are emerging in the strategy amid a rallying corporate bond market that has pushed up the average price of bonds tracked by the Bank of America Merrill Lynch's Canada Corporate Index to 108.5 from 105 at the start of the year.

“The typical structure of having a $101 fixed price makes no sense since its usefulness and value vary depending not only on spread markets, but also on the underlying benchmark,” said Bill Girard, a fund manager at Bank of Nova Scotia's 1832 Asset Management LP. “THI bondholders are learning this the hard way right now as the $101 put is significantly lower than where the bonds were trading pre-announcement.”

Girard, who doesn't hold Tim Hortons' bonds, advocates a put based on market valuations at the time of the put. In Europe, so-called Spens clauses force borrowers to redeem investors at a rate closer to the market value.

A downgrade would push the price on Tim Hortons' 4.52 percent notes due in December 2023 bonds to trade as low as 90 cents on the dollar and a yield of 6 percent, Hebert estimates. The bonds fell to 101 cents yesterday, from 106 at the start of the week.

'Mark-to-Market Hit'

“You're better off putting them back to the company at 101 rather than taking a full mark-to-market hit,” Hebert said by phone from New York yesterday. “The Hortons bonds would likely get downgraded because post-deal leverage will look more like Burger King than Tim Hortons.”

Burger King, which is raising $12.5 billion to fund the deal, has debt equivalent to five times its cash flows, Daniel Schwartz, the fast-food chain's chief executive, said on a conference call with analysts yesterday. That compares with leverage of three times for Tim Hortons as of March.

Moody's Investors Service said today it was reviewing its Burger King for a downgrade, including the fast-food chain's B3 unsecured bond rating and B2 corporate rating. Moody's cited the company's rising debt burden to acquire Tim Hortons, calculating leverage of more than 6.4 times compared with 3.8 times before the deal.

On the conference call yesterday, Tim Hortons Chief Financial Officer Cynthia Devine said the change of control provision for the company's bonds would be honored.

“We'll work through the details of it,” Devine said. “We recognize the provisions that are in there” and “along with the Burger King team, we'll work through some of the details on those things.”

Tim Hortons succumbed last year to pressure from activist shareholders for share buybacks, issuing C$900 million of bonds to finance the purchases. The debt triggered ratings cuts.

In its most-recent bond issues, the coffee outlet extended scenarios that trigger the put clause, giving investors the right to sell if a downgrade results from a new board installed by activists as well as a takeover, Mark Rasile, co-head of financial services at Toronto law firm Bennett Jones LLP who worked with the CBIA to draft the clauses, said yesterday in an interview.

Though the put protected investors from activists, it couldn't protect them from a global bond market rally.

“One day, if and when rates are much higher, we could be in the reverse situation, where the bonds trade well below the put price,” Girard said. “I am a very strong advocate of including the COC clause, I just don't like the fixed-price convention that has been adopted; it should better reflect the pre-transaction market level.”

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