Left holding the bond
The purchase of big public companies by private-equity firms, like this summer's acquisition of hospital giant HCA Corp. , come prepackaged with a standard win-win spin.
HCA shareholders made about 20 percent on their stock. Some thought the company was worth more, but the deal went through because stockholders voted their approval.
Private-equity firms that spent more than $21 billion for HCA, including Boston's Bain Capital, came away with a trophy company for their portfolios. The business itself, many people argue, will operate better out of the public spotlight.
Everybody happy? Not quite.
Investors who own HCA's corporate bonds got clobbered on news of the deal. Those bonds quickly shed 15 percent of their value, a loss that would take about two years of interest coupons to recoup. "That was a painful one," says Michael Roberge of MFS Investment Management in Boston.
HCA bondholders are not alone. Investors who own bonds of big public companies with businesses that generate lots of cash, generally considered low credit risks, have discovered a new minefield in the surging market for leveraged buyouts.
Public companies acquired in leveraged buyouts pay off stockholders but usually don't redeem existing bonds. The company, and its new owners, assume the old debt and continue making the interest payments.
Private-equity firms finance deals by borrowing most of the money, loading the businesses with new debt. That makes the company less creditworthy and their old bonds worth less. Sometimes, much less.
Until recently, this was a real but rare risk. Now money is pouring into private equity funds at an unprecedented pace, so leveraged buyouts are much larger and more frequent. Companies with fat and dependable cash flows, most likely to own sterling credit ratings, are the prime targets.
"It's become a long list of companies," says mutual fund manager Margie Patel of Pioneer Investments. "What's good news for the equity holder is bad news for the bondholder."
Investors who own bonds issued by Clear Channel Communications Inc. , the radio giant that has agreed to a takeover by Bain and Thomas H. Lee Partners of Boston, know it. Their bonds lost about 11 percent of their value.
Sometimes, mere rumors of a buyout can affect bondholders. Talk last week that private-equity investors might be interested in Home Depot Corp. caused jitters in the bond market.
Investors have responded in two ways to the new and unpredictable risk of some corporate bonds. Most directly, they are demanding new covenants protecting their interests.
Companies issuing riskier junk bonds often must promise to buy back their debt at face value if the business is sold. Now, highly rated companies are doing the same.
Investors also are hedging against leveraged buyout risks by purchasing credit default swaps, a kind of tradable insurance policy. The swaps pay off only if a company defaults on its debt, but they become more valuable and their market price goes up when risk increases. The profit on the swap can offset the decline in the bond.
Just as stock short-sellers try to make money anticipating price declines, some fixed-income investors are using credit default swaps in the same manner. They target companies or industries that could be susceptible to leveraged buyouts and buy swaps without owning the actual bond. If risk increases, they pocket the insurance profit.
One example: A recent public report by the MFS Research Bond Fund shows it owned credit default swaps for The New York Times Co. and Autozone Inc. but no bonds issued by either company.
The new wave of leveraged buyouts means more and bigger deals ahead. Buyers and sellers will walk away satisfied. Blue-chip bond investors won't always be so fortunate.
Steven Syre is a Globe columnist. He can be reached at syre@globe.com. 
