As the use of shareholder rights plans — known as poison pills — began to fall out of favor among corporations, new bond provisions took their place. This has resulted not only in executive protections but also in equity underperformance.
New research shows that when companies began to eradicate poison pills, protections against activist investors didn’t go away. Instead, companies began to implement bond covenants that grant holders the right to immediate repayment in a “change-of-control event.”
Although these so-called poison bonds were initially used to protect bondholders during leveraged buyouts, they also act to keep management in place — and drag stock performance down.
Rex Wang Renjie, a researcher at Vrije Universiteit Amsterdam, and Shuo Xia, an academic at the University of Leipzig, were studying bond covenants when they came across something odd.
“There was, in general, a downward trend in using bond covenants,” Renjie said. “There has been a covenant-lite period because of quantitative easing. While most covenants are going down, one has increased: the poison bond covenant.”
The use of poison bond covenants isn’t new: In the 1980s and ’90s, these provisions existed, although they weren’t common. However, in 2005, when major companies began to remove poison pill protections, the use of poison bond provisions rose significantly, Renjie said.
The researchers were able to link the rise of so-called poison bonds with the fall of poison pills using governance data from Institutional Shareholder Services. This was especially visible between 2004 and 2010, when the number of investment-grade companies fell from 59 percent to 17 percent. Simultaneously, the number of firms with poison bonds rose from 7 percent to 63 percent.
The presence of poison bonds affects both short- and long-term stock returns for investors. In the seven days following poison bond issuance, the companies posted equity returns that were 26 basis points lower than their non-poison counterparts. This is amplified if a firm recently removed a poison pill, which caused equity shareholders to lose an additional 62 basis points.
Over the long term, this effect is more pronounced. Portfolios that hold stocks of firms that have removed poison pills and added poison bonds inked “significant negative abnormal returns” of between 5.1 percent to 7.3 percent per year for the period between June 2007 and June 2021.
Although Renjie and Xia hypothesized that these provisions were used to protect bondholders, what they found was the opposite — company executives implement these provisions to entrench themselves.
As they surveyed the prior academic research on the topic, they found little prior work on the topic, aside from a 1989 paper that references this idea of entrenchment in a footnote. “It’s in the footnote of their paper that there’s a possibility that managers can use this...to entrench themselves,” Renjie said. “This idea hasn’t been followed up on.”
The research has implications beyond the study of how poison bonds might affect stock performance. According to Renjie, the general academic view of corporations using leverage was that the more bonds they have, the more disciplined they are. “Our paper shows that this is not necessarily the case,” he said.
