Tim Hortons Inc. (THI) bondholders will pay a price if theyrelinquish their debt under threat of a downgrade to junk becauseof the doughnut chain's purchase by Burger King Worldwide Inc.

Under what's known as a change-of-control provision, investorshave the option to hand the debt back at a price of 101 percent offace value, or five cents less than what the bonds traded at beforethe second-largest U.S. burger company agreed this week to acquireOakville, Ontario-based Tim Hortons for about C$12.5 billion(US$11.4 billion).

Investors will probably choose the so-called poison put to avoiddeeper losses given that Burger King is rated five levels lower,according to Noel Hebert, an analyst who follows the restaurantindustry for Bloomberg Intelligence. DBRS Ltd., the only firm thatrates Tim Hortons' C$1.2 billion of bonds, said yesterday it wasreviewing the BBB ratings for downgrade and that its credit riskprofile “will no longer be consistent with an investment-graderating.”

Tim Hortons is becoming the test case for a campaign by theCanadian Bond Investors' Association (CBIA) to expand the use ofpoison puts to protect investors from credit-damaging leveragedbuyouts such as the one by 3G Capital, the investment firm thatowns about 70 percent of Burger King. Flaws are emerging in thestrategy amid a rallying corporate bond market that has pushed upthe average price of bonds tracked by the Bank of America MerrillLynch's Canada Corporate Index to 108.5 from 105 at the start ofthe year.

“The typical structure of having a $101 fixed price makes nosense since its usefulness and value vary depending not only onspread markets, but also on the underlying benchmark,” said BillGirard, a fund manager at Bank of Nova Scotia's 1832 AssetManagement LP. “THI bondholders are learning this the hard wayright now as the $101 put is significantly lower than where thebonds were trading pre-announcement.”

Girard, who doesn't hold Tim Hortons' bonds, advocates a putbased on market valuations at the time of the put. In Europe,so-called Spens clauses force borrowers to redeem investors at arate closer to the market value.

A downgrade would push the price on Tim Hortons' 4.52 percentnotes due in December 2023 bonds to trade as low as 90 cents on thedollar and a yield of 6 percent, Hebert estimates. The bonds fellto 101 cents yesterday, from 106 at the start of the week.

'Mark-to-Market Hit'

“You're better off putting them back to the company at 101rather than taking a full mark-to-market hit,” Hebert said by phonefrom New York yesterday. “The Hortons bonds would likely getdowngraded because post-deal leverage will look more like BurgerKing than Tim Hortons.”

Burger King, which is raising $12.5 billion to fund the deal,has debt equivalent to five times its cash flows, Daniel Schwartz,the fast-food chain's chief executive, said on a conference callwith analysts yesterday. That compares with leverage of three timesfor Tim Hortons as of March.

Moody's Investors Service said today it was reviewing its BurgerKing for a downgrade, including the fast-food chain's B3 unsecuredbond rating and B2 corporate rating. Moody's cited the company'srising debt burden to acquire Tim Hortons, calculating leverage ofmore than 6.4 times compared with 3.8 times before the deal.

On the conference call yesterday, Tim Hortons Chief FinancialOfficer Cynthia Devine said the change of control provision for thecompany's bonds would be honored.

“We'll work through the details of it,” Devine said. “Werecognize the provisions that are in there” and “along with theBurger King team, we'll work through some of the details on thosethings.”

Tim Hortons succumbed last year to pressure from activistshareholders for share buybacks, issuing C$900 million of bonds tofinance the purchases. The debt triggered ratings cuts.

In its most-recent bond issues, the coffee outlet extendedscenarios that trigger the put clause, giving investors the rightto sell if a downgrade results from a new board installed byactivists as well as a takeover, Mark Rasile, co-head of financialservices at Toronto law firm Bennett Jones LLP who worked with theCBIA to draft the clauses, said yesterday in an interview.

Though the put protected investors from activists, it couldn'tprotect them from a global bond market rally.

“One day, if and when rates are much higher, we could be in thereverse situation, where the bonds trade well below the put price,”Girard said. “I am a very strong advocate of including the COCclause, I just don't like the fixed-price convention that has beenadopted; it should better reflect the pre-transaction marketlevel.”

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