National Grid plc, which has been squabbling with UK energy regulator Ofgem over the maximum fine applicable for a series of blackouts on August 9, has compounded its problems with what we would call “unsparing” use of the terms and conditions in its own bond documentation, which disadvantaged holders of its hybrid debt to the tune of €4.8m.
On August 27, National Grid announced a repurchase offer for its €1.25bn NGGLN 4.25% hybrid bond with a response deadline of August 30 – requiring a quick decision from holders at a time of year when desks are often relatively lightly staffed. National Grid wanted to issue longer dated hybrids while the market was open to it, and sought to avoid paying coupons on two sets of bonds simultaneously. The company offered to buy back bonds at a price of 103.357. Compared to the market price prior to the announcement of 103.284, we felt this was not a particularly compelling offer for a bond with an expected call in June 2020. In fact, we were leaning towards passing up the small gain and remaining invested in the bond until its expected call in June 2020, until a key piece of language in the tender offer gave us pause:
“If ≥80% of the outstanding amount has been repurchased, proceeds from New Capital Securities are sufficient and the Offeror has accepted all valid tenders for purchase, it is the Offeror's intention to exercise its option to redeem remaining Securities at par.”
In other words, if less than 20% of holders declined the tender offer, then instead of receiving 103.357 for their bonds or being allowed to hold them until June 2020 and receiving additional coupons until then – they would be forced to return the bonds to National Grid for a price of 101.20 (par + accrued coupons). Anyone who understands a little about game theory will understand the poor upside/downside proposition facing investors who were minded to refuse the tender. Holders would have to be very confident that 20% of their fellow investors would decline the offer, in order to refuse and expose themselves to more than 2 points of downside. Indeed, they would also have had to consider how many fellow holders would be applying the exact same logic and feeling equally coerced to tender, further reducing the possibility of the outstanding remaining above 20%.
As it turned out, 81.6% of holders tendered their bonds, leaving €230m of the issue to be called at par. Though the 81.6% clearly made the “right call” on this tender, there should be sympathy towards those who did not consent. It is easy to envisage even well-run institutions missing the subtlety of this tender or misjudging the probabilities – especially with a mere three days of a typically quiet August to respond. Many could have been running buy-and-hold mandates with the bonds matched against specific liabilities; with everything in balance the tender would have looked even less compelling. To have generated a positive total return on the NGGLN 4.25%, an investor would have to have been fortuitous enough to pick it up between November 2018 and January 2019 before this year’s strong rally, or as far back as the third quarter of 2017 (the following two years’ income just pushing the investment into the black).
Clean-up call language has its place in bond documentation. It simplifies administration by allowing bonds to be completely taken out. There will always be some holders who do not accept a tender offer, no matter how generous; investors miss notices, administrative mistakes cause deadlines to be missed and so on. But in a world of ultra-low rates, cleaning up with a par call rather than something closer to market price is in our view a particularly punitive outcome for those remaining invested.
When we put this to National Grid treasury, they responded that there was not any punitive intent, but that the terms and conditions of the bond language did not require them to pay the last tender price so they were not going to. On this, we would disagree with what action best benefits National Grid in the long term. Bond issuance is a repeated game between borrowers and lenders. The language might legally entitle National Grid to make the call at par rather than the last tender price, but that does not mean the company has to take advantage of its ability to underpay for the bonds. Debt investment is about predictability. No matter how comprehensively worded the associated documentation is, unforeseen events will occur. This is where management intent is crucial, how bondholders are treated as stakeholders – in a word, governance. Investors who have been burnt by this action will be far more reluctant to fund future issuance by National Grid. Investors who escaped relatively unscathed on this occasion, but who may feel their options have been constrained by the company’s actions, will be less likely to fund future issuance. Even the trust of investors who are merely watching from the side-lines will likely have been eroded.
With 94% regulated revenue, National Grid has the kind of stable, predictable earnings that we generally favour in a credit investment. However, two issues are currently casting shadows over the company. Firstly, Jeremy Corbyn has set out plans to nationalise UK energy infrastructure, an eventuality which could raise serious doubts about debt repayment, particularly on subordinated hybrid notes. With the fluid situation in the UK parliament, a Corbyn-led government is not as remote a possibility as investors might hope. Secondly, following a major blackout involving a loss of power for one million people, traffic lights and railway networks for hours on August 9, National Grid faces a potential fine from Ofgem of up to £140m if found to have broken its licence conditions.
The balance of probabilities suggests neither will result in a major credit concern, but given that as debt investors our risk-reward is skewed to the downside, these should be considered. National Grid though will have to keep returning to the bond market in years to come in order to finance investments in updating the grid and connecting low carbon sources of energy to the network. It is essential they retain market access, even if other stresses depress investor appetite.
We struggle to see the merit in taking a corporate action, however legally justified, which will cost bondholders €4.8m, a 2% hit to their individual positions. National Grid has voluntarily manufactured a new risk for investors to consider – poor governance.