This phrase is part of a longer question in Schweser Qbank: “The resulting capital structure from the share repurchase would be more favorable for investors in BEC’s bonds.” The answer is that the statement is INCORRECT. Their reasoning is as follows: “A share repurchase would decrease the percentage of equity in a firm’s capital structure, which would in turn increase the percentage of debt. An increase in debt would add more leverage to the firm which would be negative for the firm’s bondholders.” Obviously, lots of financial leverage is bad for equity holders. My question is, do bondholders really care about the increased leverage, being that they have no ownership interest in the firm? Should we assume that a company with lots of leverage can possibly go bankrupt and renege on its payments to bondholders as well? My confusion stems from the fact that I recall seeing a similar question earlier (unfortunately cannot find it now) where the answer says that since bondholders only receive principal and interest fixed payments, they have nothing else at risk and do not really care about the firm’s leverage.
Bond holders DO care about firm’s Leverage. The Equity Capital acts as a comfort cushion to bond holders, in a sense, that in adverse events, Equity Capital could be used to repay Bond Holders. Lower the Equity, Lower is this cushion and more the risk to bond holders on their Principal Repayment.
MM Proposition II
Three reasons why bondholders don’t like leverage increase. 1. It probably decreases loss absorption – so the firm can absorb less of a value downturn before debt claims become impaired. 2. It increases the likelihood of default. Everyone loses some kind of value in default, even if it’s just the legal fees they’ll need to pay. 3. Increased leverage can cut into earnings due to financial distress costs. For example, as your leverage increases, vendors will demand tighter A/P terms. Don’t conflate these concerns – though they often co-occur, they’re independent reasons why bondholders don’t like incremental leverage. Others include… 4. Increased likelihood of covenant violation – and given cross-default langugage, this may trigger a technical default across the entire debt structure. 5. Reduced credit rating, which can contribute to a vicious circle spiral downward.
of course they care, hence covenants!