Consider yourself the CIO of a small liberal arts college with a $65 million endowment. You start looking for an investment manager to build a portfolio that achieves this goal with students pushing for fossil fuel divestment. You find just what you’re searching for: a boutique firm that specializes in tailored accounts for small businesses like yours, with fees that are only slightly more than the index fund in which you’re already invested. When the firm’s chief compliance officer informs you that your account will only be eligible to own half of the stocks in the index, you’re ready to liquidate your index fund position and transfer the profits to this new manager.
Just over half of the high-yield bond market is now made up of 144A instruments, which are unregistered bonds available only to qualified institutional buyers, or QIBs. This is a significant increase from just a few years earlier, when 144As accounted for only 19% of the market. More importantly, 144A bonds accounted for nearly three-quarters of all new high-yield issuance in 2019. At this pace, by the middle of the decade, the whole high-yield bond market will be 144A.
If you’re wondering what a QIB is, it’s an institution having investable assets of more than $100 million. The QIB designation method differs in practice: Some investment management compliance officers use a by-the-book approach, which implies that even if a business manages more than $100 million in investable assets, any institutional customer with less than that amount in investable assets is not identified as a QIB. This holds true for a bigger set of institutions than you might think; for example, according to U.S. News & World Report, the median college endowment in 2018 was $65 million. According to Candid (previously the Foundation Center), U.S. foundations have an average asset under control of $10 million.
The ambiguous rules governing who can and cannot purchase 144As allow willful misinterpretation. Brokers avoid selling unregistered securities to “unsophisticated” (non-QIB) investors because they risk being sued. However, some brokers promote the Regulation S tranche of a 144A offering (which is ostensibly earmarked for non-US investors) to non-QIBs as a backdoor means to offer their clients access to this type of bonds. With institutional clients, some investment managers employ a “don’t ask, don’t tell” approach, hoping that their broker counterparties will not demand more specific certification.
By now, you’re probably thinking of 144A bonds as obscure securities issued by private companies no one has ever heard of — say, a small oil and gas driller with a few wells or a private equity–owned fertilizer manufacturer — with insufficient publicly available information to make an investment decision. True, corporations like these have used 144A issuance to gain access to the high-yield market.
Public corporations and SEC filers issue a lot of 144As, sometimes in combination with other registered bonds and exchange-traded common stock. In comparison to SEC-registered bonds, companies issue 144As to reduce origination expenses, documentation, and time to market. Only two of the top ten issuers in the Barclays high-yield index have no 144As in their capital structures, while more than half have minimum registered debt outstanding. Only 144A bonds are issued by one of the top ten issuers, Bausch Health. All but one of the top ten high-yield issuers, on the other hand, have publicly traded equities. As a result, “unsophisticated” investors can pile into the capital structure’s highest-risk asset, but the SEC considers the layer above it (and, in some situations, several layers above it) to be excessively hazardous.
To demonstrate the unexpected repercussions of 144A buyer limitations, I’ll offer a real-life case. Transdigm Group is an airplane component company that is publicly traded (and No. 11 in the index referenced above). Assume you’re a high-yield portfolio manager with a new client, a little endowment. Your credit analyst constructed a cash flow model and calculated ratios to gauge credit quality (e.g., debt/EBITDA, fixed charge coverage) for the company using publicly available information and filings (10Ks, 10Qs, earnings call transcripts). Transdigm’s financial sheet and trajectory become familiar to you, though you remain wary of the management team’s habit of issuing debt to fund significant acquisitions. Transdigm’s bonds are mostly rated low-single-B, which is just one notch over CCC. You’re concerned about downgrade risk because your client’s criteria don’t allow CCC-rated securities — a common restriction in the institutional world — and you don’t want to be compelled to sell.
Transdigm has two types of bonds, according to your analyst: secured and unsecured. You say to yourself, “Great, I can invest in secured bonds to protect myself from another leveraged acquisition.” Secured bonds offer an additional layer of security to investors in the form of collateral. Furthermore, they frequently have superior covenant protection against additional debt issuance secured by the same security. In the (unlikely) event of Transdigm’s bankruptcy, the secured bond would provide a far greater return. The rating agencies are aware of this; both Moody’s and S&P rate secured bonds two to three notches higher than unsecured bonds (Ba3/B+ against B3/B–). Investors are aware of this; a secured bond has a lower yield and spread than an unsecured bond of equivalent maturity. The SEC is the only one who is unaware of this; because Transdigm’s secured bond is 144A, it is unavailable to non-QIBs. You can invest your client’s money in Transdigm’s unsecured debt or publicly listed stock, but you can’t buy the safest security in the capital structure, which is the best fit for their money.
This transition to private issuance has a number of unfavorable effects.
For one thing, it forces small businesses into an investment vehicle that may not be right for them. Because managers are obliged to sell securities into frozen markets, high-yield funds expose investors to the whims of bear credit markets. In strained markets, they promise liquidity that the underlying securities do not have. T+2 settlement dates are common in high-yield bonds; try matching these to the regular T+1 settlement date of a mutual fund suffering panicked redemptions. Furthermore, funds do not allow for client-specific exclusions (for example, no fossil fuels), which can be critical for endowments and foundations.
Two, it exacerbates challenges of diversity. Minority and female-owned investment firms account for less than 1% of total assets under management in the industry. Fortunately, some clients are beginning to prioritize the hiring of MWBE investment managers. Imagine trying to raise $50 million in initial capital for a high-yield bond fund while only being able to invest in half of the market.
This new high-yield market accessibility difficulty is particularly hilarious because it runs against to the general trend of easier access for smaller investors. Limited trading liquidity outside of massive “block” deals made getting proper diversification in high-yield accounts under $10 million problematic. Trading in sub-$1 million lots (sometimes known as “odd lots”) used to imply greater bid-ask spreads, insufficient liquidity, and poor execution. Trading has become easier for small high-yield investors since the credit crisis. MarketAxess and other e-trading companies, as well as a new class of broker-dealers that specialize in algorithmic and matched trades without prop desks, are providing liquidity in odd-lot trading. Trace, a bond pricing service offered on Bloomberg, has expanded price transparency by including trading levels and volumes for 144A bonds as of 2014. For odd-lot deals, bid-ask spreads (the gap between the prices at which you can buy and sell a certain bond) have decreased. These are positive changes that have made high-yield bonds more appealing to both investors and issuers (by lowering trading costs) (by reducing funding costs). However, because half of the market is closed to non-QIBs, these benefits aren’t available to some of the smallest institutions who may profit the most. The Gates Foundation and Harvard University have long had access to tailored, sufficiently diversified separate high-yield accounts; the little liberal arts college with a $65 million endowment is still excluded.
Because I’m neither a securities lawyer nor a regulator, I don’t have a solution to this problem other than the obvious: reduce 144A trading limits and registration papers for well-known issuers. The easiest place to start is to distinguish between 144As issued by “reporting” and “nonreporting” issuers (businesses that submit public financials with the SEC against those that don’t). If the issuer already has other registered securities or if the bond is guaranteed by an organization with registered securities, another option is to construct a streamlined or fast-track, low-cost registration process.
To study these corporations and their 144A bonds, there is a wealth of publicly available information. The QIB buyer restriction primarily serves to protect the market share (and fees) of large mutual fund managers.
Who is eligible to buy 144A securities?
Only qualified institutional buyers (QIBs) are permitted to trade Rule 144A securities, according to the SEC. These are huge, sophisticated organizations whose primary function is to manage large investment portfolios including at least $100 million in assets.
Is it possible for a non-US investor to purchase 144A?
If the buyer proves that it is not a U.S. person and the sale otherwise conforms with Regulation S, Rule 144A securities can be resold to non-U.S. individuals. If the resale complies with Rule 144A, the Regulation S securities can be resold to QIBs in the United States.
Who is able to trade 144A?
Rule 144A, also known as the Private Resales of Securities to Institutions, was established in 2012 and allows qualified institutional buyers to trade these investments (QIB).
Who is eligible to employ Rule 144A?
Rule 144A can be used by someone who isn’t an issuer. For the offer and sale of unregistered securities, issuers must find another exemption. Typically, issuers depend on the Securities Act’s Section 4(a)(2) (typically in conjunction with Regulation D) or Regulation S. Rule 144A can be used by the issuer’s affiliates.
Who is eligible to purchase regs bonds?
Corporate and governmental issuers continue to use the debt capital markets to fund big transactions at this moment of exceptional market turmoil.
Resilience in time of uncertainty
Throughout H1 2020, the Eurobond market has demonstrated to issuers and investors that its depth and stability set it apart from other markets in times of uncertainty, as it continues to provide large-scale finance and stable investment possibilities around the world.
Reg S and Rule 144A bonds
Reg S and Rule 144A bonds are forms of bonds that do not require the issuer to register the securities under the Securities Act of 1933. The following are the two rules:
- Qualified Institutional Buyers (QIBs) can trade debt securities without having to register or be reviewed by the Securities and Exchange Commission under Rule 144A. (SEC).
- The Reg S bond type is accessible for offers and sales of securities to U.S. and non-U.S. QIBs outside of the United States.
Issuing Reg S and Rule 144A securities to global investor base
Clearstream’s AA-rated infrastructure is ideally suited to facilitate the issuance of Reg S and Rule 144A securities, as it provides direct access to a large number of worldwide intermediaries while also broadening the scope of post-trade connection, securities lending, and collateral management options.
Facilitating efficient funding
Clearstream enables full USD cash clearing for Reg S and Rule 144A securities via internal DVP settlement of cash and securities. Furthermore, by centralizing the issue and storage of both note forms, Clearstream can drastically minimize the time required for conversion via secondary market trade.
Reg S and Rule 144A securities with a common depositary
In a bifurcated structure, Clearstream supports the issuing of Reg S and 144A securities:
- Two independent global notes in registered form that are lodged directly with a single depositary, one Global note evidencing the Reg S portion and the other the 144A portion, are held via Clearstream and Euroclear.
- Both worldwide securities are registered in the common depositary’s nominee name.
- The Global notes have two different ISIN codes: one XS ISIN for the 144A and another XS ISIN for the Reg S.
Are 144A securities traded publicly?
As a result, until the appropriate holding period under Rule 144 expires, these securities are restricted and may only be publicly resold under Rule 144, pursuant to an effective registration statement, or in reliance on any other available exemption under the Securities Act.
Individuals can be QIBs.
Individuals, regardless of their wealth or financial sophistication, can never be QIBs. Individuals, regardless of their wealth or financial sophistication, can never be QIBs. QIBs can buy unregistered securities at any time and freely swap them with other QIBs under Rule 144A.
How can I tell whether my securities are 144A compliant?
The Stocks and Exchange Commission (SEC) adopted Rule 144A in 1990, which changed the two-year holding time restriction for privately placed securities by allowing QIBs to swap these positions among themselves.
Securities identity IDs for RegS and 144A bonds are usually assigned separately. Reg S bonds usually have a single code and an ISIN (International Securities Identification Number) “ISIN”) and are widely approved for clearing through Clearstream, Luxembourg, and Euroclear. CUSIP and ISIN numbers are assigned to 144-A bonds “ISIN” and are generally accepted by the DTC system for clearance.
What is the procedure for selling unregistered shares?
Although it is generally considered a felony to sell unregistered shares, there are exceptions to this law. The following are the situations under which unregistered shares may be sold under SEC Rule 144:
- A sufficient amount of public information regarding the security’s past performance is required.