More runway less plane

Carlton Ling's picture

Recently it was announced that the Quebec government will be providing Bombardier with much needed new capital. The struggling CSeries commercial jet program will be moved into a joint venture (JV) and the Quebec government will contribute $1 billion into this JV in exchange for a 49.5% interest in the company. This cash contribution will be restricted to the JV and does not represent bondholder collateral. This would seemingly be a short-term positive for a company that has under-delivered on its aerospace program development and is quickly burning cash. Longer term, the company has effectively sold half its interest in a significant asset at a substantial discount (it invested $4.2 billion into the program), shrunk the bondholders’ asset pool and its share of potential returns from this program.

In our investment process, bond covenants are an important consideration. In the case of Bombardier’s unsecured bonds, we found the covenants lacking. Along with the poor fundamentals, this factored into our decision to not invest in the bonds. Bombardier was downgraded below investment grade over 10 years ago. However, since that time, they have been able to continue to fund the CSeries program with high-yield bonds with covenants considered investment-grade in nature, which offer less creditor protection.

For instance, asset sales by an issuer would reduce the size of a creditor’s collateral pool and a bondholder’s ultimate store of value. High-yield covenants typically require any asset sale proceeds to be substantially in the form of cash with the proceeds going towards reducing debt. Investment-grade covenants typically have no such restrictions. These covenants are typically a “blank cheque.”  The weak covenants allowed the company to put the CSeries into this JV without the need to reduce debt. Similarly, an IPO of a minority stake in Bombardier Transportation as contemplated by management would not require debt reduction.

With the new federal government contemplating further monetary support for Bombardier, it is useful to examine the company’s ability to incur more debt. High-yield style covenants generally limit the issuer’s ability to incur debt, including debt that is secured which would rank ahead of high-yield bonds that are typically unsecured. This protects bondholders from the addition of debt that dilutes their claims to the asset pool. These covenants are either non-existent or weak in investment-grade style covenants. Due to weak covenants in Bombardier’s existing unsecured bonds, there is virtually no limit to the amount of structurally senior / priority debt that can be issued ahead of the existing bonds.

Bombardier’s management has steered towards continued free-cash flow burn over the next couple of years. The CSeries program is likely to require an additional $1 billion of capital over the next five years with the prospect of this program generating positive cash, at the earliest, in 2020. The company may need to raise additional capital, however, given the weak covenants there is a significant downside risk to the existing bondholders. For fundamental and covenant reasons, for funds like the Signature Corporate Bond Fund and other Signature funds with high-yield bonds, we will remain on the sidelines.

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