SKF's Automotive Spin-Off: Navigating Covenant Triggers and Bond Opportunities in a High-Risk, High-Reward Special Situation

The Swedish engineering giant SKF is navigating a precarious balancing act as it prepares to spin off its automotive business through a Lex Asea dividend structure in 2026. While the move aims to unlock value by separating its lower-margin automotive division (SEK 30 billion in sales, 5.6% operating margin) from its higher-margin industrial segment (SEK 73 billion, 15.4% margin), the plan has exposed a critical vulnerability: bond covenants that could trigger a rare event of default (EoD). This creates a compelling special situation for bond investors willing to parse the fine print of SKF's indentures and bet on forced liquidity events.

The Cessation Clause and Its Double-Edged Sword
At the heart of the risk lies SKF's bond covenant governing “cessation of business.” Under standard indenture language, a “cessation” can be triggered by material asset sales or structural changes that divest core operations. SKF's automotive spin-off, while legally distinct from a full business cessation, faces opposition from bondholders of its longer-dated debt (the €300m 0.875% 2029 and €300m 0.25% 2031 notes), who rejected consent to waive the clause. This creates a ticking clock: if the spin-off proceeds, these bondholders could demand immediate repayment, forcing SKF to either buy back the debt at par or risk litigation—a scenario reminiscent of the Essity case, where bondholders sued after a spin-off without covenant amendments.

The Bondholder Divide: Short-Term Relief vs. Long-Term Risk
While bondholders of the shorter-dated 2025 and 2028 notes consented to the spin-off (receiving a 0.25% fee for their approval), the refusal of the 2029/2031 cohort leaves SKF's balance sheet exposed. The 2031 bond's yield of 1.32% (vs. Sweden's 2.25% base rate) suggests markets believe SKF will avoid default by repurchasing the debt at par—a maneuver the company could afford given its €800m undrawn revolving credit facility. However, this optimism ignores the precedent set by Essity, where legal battles over covenant interpretations dragged on for years, imposing reputational and financial costs.

Opportunity in Subordinated Debt: Betting on Forced Redemption
Investors should focus on SKF's subordinated bonds—particularly the deeply discounted 2031 note, trading at a steep discount to its 2029 counterpart. The 2031 bond's subordinated status and paltry 0.25% coupon (issued during the 2020 yield-starved environment) make it an ideal candidate for a forced redemption. If SKF must buy back the bonds at par to avoid an EoD, holders stand to gain significantly. Even a partial repurchase could unlock alpha, especially as SKF's liquidity ($1.23bn in unused credit lines) suggests it has the capacity to act.

The Solvay Parallel and Strategic Implications
The SKF situation mirrors Solvay's 2021 spin-off of its specialty chemicals division, which faced bondholder challenges over covenant breaches. Solvay ultimately avoided default by negotiating a waiver, but the episode highlighted how low-coupon, long-dated debt—issued during ultra-low rate eras—can become liabilities during restructurings. SKF's 2031 bond, with its sub-0.5% coupon, fits this mold, creating a mispricing opportunity.

Actionable Thesis: Go Long on 2031, Short on 2029?
The optimal strategy is to buy the 2031 bond now, capitalizing on its discount while SKF's management navigates the spin-off. A short position on the 2029 bond (which has a higher coupon and less default risk) could hedge against a scenario where SKF prioritizes repurchasing the cheaper, more vulnerable 2031 issue first.

Risks and Considerations
- Legal Uncertainty: SKF may argue the spin-off doesn't constitute a cessation, citing its continued operations in both divisions.
- Market Sentiment: If bondholders escalate the dispute, SKF's credit ratings could face pressure, though its industrial division's strong margins provide a buffer.
- Alternatives: SKF might restructure its debt or renegotiate terms, though this would dilute current bondholders' gains.

Conclusion: A High-Conviction Play on Covenant Triggers
SKF's spin-off represents a rare “covenant arbitrage” opportunity. The combination of mispriced subordinated debt, precedent-setting legal risks, and SKF's financial flexibility creates a scenario where bond investors can profit from forced liquidity events. While risks exist, the asymmetric payoff—limited downside (given SKF's liquidity) and significant upside potential—makes the 2031 bond a high-conviction bet ahead of the 2026 spin-off.

Investors should act swiftly: as the spin-off deadline nears, pricing inefficiencies may narrow, and SKF's management could accelerate debt repurchases to preempt litigation. The SKF case underscores a broader lesson: in an era of rising rates and covenant-heavy debt, the fine print is where alpha lives.