of proper “ maintenance ” and timely “ replacement ” of the assets collateralizing their outstanding first lien bonds . The annual M & R covenant required the utility to set aside each year additional assets equal to 2.5 % of revenues . If those conditions were not met , however , the covenant required the utility to retire debt . Ironically , the Arab oil embargo of 1974 and the concurrent 400 % increase in oil prices , which drove up electric utility revenues , necessitated an unprecedented increase in the amount of assets required under the first lien mortgage to maintain the collateral-to-bond asset test . To satisfy the M & R provision , management had to decide whether to provide more collateral , if available , or call-in bonds to adjust for the asset-to-debt deficiency .
But while the M & R covenant gave the issuer the ability to exercise an early call at par on a bond that had been trading at a large premium , it also created a potential impediment to the utility ’ s ability to continue to issue lower-cost first mortgage bonds to fund capital projects . Lacking availability of first-mortgageable property left the utility with having to resort to lower-rated , higher-cost “ second mortgage ” bonds . Bond credit ratings thus came under pressure due to the restrictive M & R covenant .
This problem was acute for electric utility companies with nuclear plant construction projects . Electric utility indentures , post-oil embargo , needed modification . The Wall Street bond credit analyst was now being consulted and provided indenture modification advice directly to Gulf States Utilities , Texas Electric , Consumers Power Company and others as the need for indenture modifications spread within the electric utility industry .
Sinking fund covenants embedded in bond indentures were intended to provide a systematic retirement of the issuer ’ s outstanding bonds . The provision , originally designed for bondholder protection , evolved into a funnel sinker providing the issuing corporation the option of funneling its entire annual sinking fund requirement into the retirement of one specific , high-coupon bond at par , as opposed to a weighted selection of its high and low coupon issues .
Indenture analysis , heretofore the bailiwick of corporate lawyers at sedentary law firms that wrote the actual doctrines , crossed over to and blossomed into an
Penn Central share certificate , dated September 30 , 1969 . The railroad ’ s financial collapse in 1970 was the bellwether event that led to an unprecedented demand for corporate bond credit analysis and bond indenture research .
extension of the Wall Street bond credit analyst ’ s profession . Given their daily proximity to bond trading desks , coupled with their newfound knowledge of the covenants , Wall Street bond credit analysts became adept at quantifying the potential negative impact of a company ’ s covenants on its bonds ’ credit rating and , ultimately , their market price trading levels .
The credit analyst ’ s extension into indenture research contributed to the development of early bond redemption optimization modeling as well . The “ quant ” analyst had to be familiar with all the call provisions embedded in the bond ’ s indenture . Covenants varied greatly from issuer to issuer and even within a single issuer ’ s outstanding issues . 2 The analysis was complex , but the need for indenture expertise was great . The demand for a new breed of corporate bond credit analyst was expanding .
3 . Quantitative Research The surge of interest rates to doubledigit levels created new opportunities for those who understood the complex market price dynamics of deep-discount and high-coupon bonds . Sidney Homer and Martin Leibowitz ’ s groundbreaking 1972 book , Inside the Yield Book , became required reading for budding students of bond research . No longer were bonds boring investments . Homer and Leibowitz showed that the compounding effect of double-digit coupons on a bond ’ s total rate of return is profound . Mastery of the metrics of bond duration and convexity , as well as refunding analysis , escalated in importance .
Avoiding the risks associated with early redemption of high-coupon bonds required a portfolio manager ’ s acute understanding of early debt refunding risks — risks that were embedded in the bond indentures , but heretofore dormant . The latter required both specialized quantitative modeling analysis and bond indenture knowledge . During the early 1970s , optimization bond refunding analysis utilizing quantitative option-adjusted spread techniques was pioneered by quantitative bond analysts at AT & T Corporation ; it later moved to Dillon , Read & Co .’ s bond research group .
Beyond the 1980s : New Challenges
In the 1980s , credit analysts faced new challenges from what became known as “ event risk .” Corporate bond ratings , that previously changed gradually , were now subject to radical transformation within short periods . For example , Manville Corporation , rated investment grade A2 at the end of 1981 , filed for bankruptcy the following year under the weight of massive asbestos-related liabilities .
Along with environmental shocks , such as the Bhopal chemical accident in 1984 ,
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