Wall Street all ears over a new way to rejig debt
Investment bankers have found a hot new product to sell to their corporate clients: defeasance.Skip to next paragraph
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Defeasance, while not exactly a term on the tip of everyone's tongue, is quickly being added to the vocabulary of many corporate treasurers. And within six months, shareholders and bondholders likewise may start mouthing the unwieldy word.
Exxon Corporation, the first company to do a deal involving defeasance, says it has received numerous inquiries from other corporate treasurers interested in finding out how the giant company did its recent deal. And investment bankers confirm that defeasance is a hot topic in the cold climate they're having.
Economic defeasance, as it is currently being construed, is a method that allows a company to restructure its long-term debt without voiding the covenants surrounding that debt. One example of a covenant may be that when a company issues a bond, it promises its lenders that certain revenues or income from properties will ensure payment of the principal of that debt.
A company may want to get around such promises without breaking them. It does this through defeasance by placing the debt in a nonrevocable trust. Then it covers its guarantees with the interest and principal of a pool, say, of US government securities or corporate securities of matching quality.
The advantages for the corporation are twofold. First, it can improve the balance in its books by taking note of the decline in market value of the old, low-interest-rate bonds it has issued. These old bonds can be covered by buying at a discount a smaller amount of old, low-interest securities of equal or better safety rating. Second, it will make a capital gain on the discounted securities if interest rates decline and the bonds' value increases, or as they mature.
Economic defeasance differs from what is termed ''legal defeasance.'' In legal defeasance, a covenant is written into a debt agreement permitting the issuer of the debt to restructure the arrangement sometime in the future. Most investment bankers are advocating economic defeasance, since institutional buyers of the bonds have for some years not been interested in having a legal form of defeasance. These bond buyers, mostly such institutions as pension funds , do not want their corporate bonds marked down to the market price, as would occur in legal defeasance. The markdown could shrink the visible value of their portfolios.
Shareholders and bondholders are finding that economic defeasance allows corporations to increase their earnings through only a few scratches of the bookkeeper's quill.
This happened recently when Exxon reported that through defeasance it had added $130 million to its second-quarter earnings.
Exxon did this by buying $312 million of long-term government securities, currently yielding about 13 percent, and assigning them to a trustee. The trustee was empowered to use the interest, principal, and capital gains from the government securities to cover the interest and principal on some $515 million of Exxon's old debt which had interest rates ranging from 5.8 percent to 6.7 percent. Since Exxon's accountants agreed that the company had removed $515 million from its balance sheet at a cost of $312 million, it was left with a capital gain of $203 million. After figuring in capital-gains taxes on the gains Exxon will make on the maturing Treasury securities over the next 20 years, the company reported a gain in the second quarter of $130 million.
According to Frank Risch, manager of corporate financial planning, Exxon decided to do this transaction in part because of a ''combination of very high interest rates and our expectation that interest rates will fall over the next 20 years.''
Exxon found that insurance companies that owned its debt were not eager to sell it, since it meant they would record a loss on their books. Thus, when Morgan Guaranty Trust proposed the defeasance idea, Exxon eagerly went ahead with it. (It has also been swapping some of its debt for stock, a common practice today, since it improves a company's balance sheet.)
Investment bankers point out there are some specific ways that corporations can benefit from deals like Exxon's. For example, many corporations are required to retire a certain percentage of their bonds each year, under what are called ''sinking-fund agreements.'' Treasurers, however, often find that as they get closer to paying down a bond issue, one bank or lender has cornered the market in the security. Thus, instead of being able to purchase the bonds in the open market at market rates, the corporation ends up paying par, or full value, to the bank or lender.
Pittsburgh's Mellon Bank for years cornered the market for the tail end of bond issues. It dropped the practice when it found that this annoyed potential corporate customers.
By defeasing its bonds, however, a corporation is at least assured of having its costs covered by its new portfolio of government issues, especially bought with maturities to match the retirement needs of its sinking fund. Thus, the government is essentially repaying the sinking fund. Investment bankers also figure that corporations with large ''balloon'' payments due when a bond issue matures can also use defeasance.
Investment bankers and accountants point out that defeasance raises several important issues for shareholders. For example, Exxon in its deal essentially acted like a bank, since it was using its cash to buy government securities. ''Do the shareholders want Exxon to invest in government securities or in oil and gas properties?'' one banker asks.
Mr. Risch replies that Exxon intends to stay in the oil and gas business, but viewed this as one alternative to managing its liabilities.