Risk is no longer what it once was

By George Athanassakos
Globe Investor Magazine Online, May 26, 2008

The risk of investing has certainly changed in the past 20 years. It is no longer what it used to be. Investors always took risks - this has not changed. Risk always went with higher expected rewards - this has not changed either. But there was also the potential for big losses resulting from such risk-taking behaviour, if things did not turn out the way they were expected. Not any more.

Nowadays, one can take huge risks and, if things turn out well, the investor reaps the benefits. However, if things go terribly wrong, there is no longer a downside. Either the government, U.S. Federal Reserve or Bank of Canada will bail out investors or the courts will feel sorry for them and help them out.

Recent events in the financial markets bear proof of that. The U.S. Federal Reserve has bailed out failing banks and investors that took excessive risks in the subprime malaise. And, closer to home, the Quebec Court of Appeal last Wednesday backed Bell Canada bondholders who were complaining that the leverage buyout offer for BCE Inc. was unfair to them.

Twenty years ago, RJR Nabisco bondholders took the company to court to try to thwart the leveraged buyout of RJR Nabisco by Kohlberg Kravis and Roberts & Co. (KKR) or get compensated for their losses resulting from it. Their claim was thrown out of court. On Oct. 20, 1988, with the stock trading at about $50 (U.S.) a share, RJR Nabisco announced that a group, including the company's management, was proposing to take the company private in a leveraged-buyout transaction for about $75 a share. Four days later, KKR made a counter offer of $90 a share. In the end, KKR prevailed by raising the ante to $109 a share. Shareholders gained by more than doubling their money but bondholders lost. RJR's bond prices fell by 20 to 30 per cent, depending on maturity.

Why did bond prices fall? A restructuring such as a leveraged buyout creates uncertainty, which bondholders despise. While equity holders are rewarded for the extra risk they are taking (they lose if share prices fall, but the upside of their claim is unlimited), bondholders lose on the downside without gaining on the upside. The upper limit for a bond at maturity is its face value, namely $1,000. No matter how well the company performs after privatization, all benefits go to equity holders. Meanwhile, the maximum bondholders can make at a bond's maturity is the face value of the bond.

While the risk for equity holders also rises after privatization, the increase in their expected payoff is faster than the increase in risk. Value creation is the result of a tradeoff between risk and return. If return rises faster than risk, value rises.

For bondholders, the risk of bankruptcy increases with a leveraged buyout, but the expected payoff at maturity doesn't change - it's contractually fixed. Hence, the value of debt falls.

The bondholders of RJR Nabisco were caught off guard by the leveraged buyout, not anticipating that such a large company was going to be taken private. As a result, they didn't require a risk-premium for this possibility and they didn't include provisions in the bond covenants to prevent something like this from happening. As with all leveraged buyouts, KKR took on substantial amounts of debt to finance the acquisition - with debt after the leveraged buyout rising to $29.9-billion versus $1.2-billion of equity.

RJR Nabisco leverage rose to about 90 per cent after the leveraged buyout from about 20 per cent previously. The company's bond rating fell from A1 to B3. The yield spread to a benchmark U.S. treasury bond rose to 350 basis points from 100 previously. U.S. bondholders, including Metropolitan Life Insurance and ITT Corp.'s Hartford Insurance, took KKR to court, but they lost as KKR didn't violate any promises made to bondholders by RJR Nabisco.

The transaction affected not only RJR Nabisco bonds, but the whole corporate bond market as investors worried that other large companies could also be subject to leveraged buyouts. Bondholders started to demand an additional protective bond covenant, which would force the issuer to redeem bonds at par in the event of a leveraged buyout giving rise to poison put bonds.

Did Bell Canada bondholders learn from the RJR Nabisco bondholders' experience? Apparently not. They stand to lose a lot. This is the first time in Canada that a company as large as BCE has become a target for a leveraged buyout. Bondholders didn't anticipate this and, despite the U.S. experience, they hadn't taken sufficient precautions and appropriate steps to protect themselves.

Bell Canada long-term bonds reflected this uncertainty immediately after the announcement of the leveraged buyout. Take the example of Bell Canada bonds that pay a coupon of 6.1 per cent and mature in March 16, 2035. They were issued back in March, 2004 at a yield of 6.131 per cent, representing a spread of 112 basis points more than equivalent long-term Government of Canada bonds. Before the privatization rumours, these bonds were trading at a spread of about 150 basis points more than the long-term Government of Canada bonds. As the news hit the street, those bonds closed at 210 basis points more than the long-term Government of Canada bonds. A few days later, they were trading at a 280 basis points spread - an increase of 130 basis points since just prior to the rumours.

Investors take calculated risks and expect analogous returns. This is how the system has always worked. The rules are now changing. The U.S. Federal Reserve's actions in bailing out risk-taking institutions and the Quebec Court of Appeal decision in favour of Bell Canada bondholders are a testimony to that. The top five U.S. hedge fund managers averaged a compensation of more than $1.3-billion last year - yes, it is billions. How can they make so much money without taking extreme amounts of risk through super-leveraging their investment positions? But today investors, such as these hedge funds managers, know that if they win they win. And if they lose they still win.

What does this all mean for risk-taking in the future and what signals do investors in general get from this? It means that one should take uncalculated and unlimited risks, as this will increase the upside without any downside risk.

And what are the potential effects of such risk-taking on the economy? The system can not function this way and the risk of a systemic failure and massive breakdown has increased immensely. We are at such a critical juncture in the evolution of capitalism that if large borrowers and risk-takers are left to fail, a deflationary spiral may ensue. On the other hand, if they are prevented from going into bankruptcy by lowering interest rates to a level where real rates are negative and flooding the system with liquidity, inflation may get out of control and decimate economies and livelihoods around the world. We are already seeing early signs of this. No wonder gold prices have risen sharply in the last year or so.

George Athanassakos, Ph.D., is a Professor of Finance and the Ben Graham Chair in Value Investing at the Richard Ivey School of Business at The University of Western Ontario.