Safe, simple and small

NEAR THE END of October, International Paper finally gave bond market participants something to cheer about. The triple-B-rated company launched a deal for $750 million which proved sufficiently popular for the underwriters to increase the size to $1 billion.

Six months ago this would have raised few eyebrows, but since WorldCom admitted to accounting fraud in June few deals for $1 billion or more have come to market. Most that have were for triple-A rated issuers such as Fannie Mae and Freddie Mac, or KfW in Europe, which issued $3 billion at the start of October.

The only other deal for $1 billion or more recently was for newly merged oil company ConocoPhillips, which issued $2 billion at the end of September a couple of weeks before finalizing a $2.5 billion bank facility.

Why these two could get deals of $1 billion or more done while others could not is easy to explain: they have simple and uncomplicated stories. Standard & Poor's reaffirmed International Paper's rating after the deal, noting that the company benefited from scale and product diversity. More important was that the firm also has what the rating agency terms moderate financial policies.

As for ConocoPhillips, it's one of the few companies to be upgraded this year, from BBB to single A, and in the weeks preceding both its bond and bank deals had one of the most stable default-swap prices in the market, implying safety. The cost of buying protection rarely budged from 65 basis points. It might be a coincidence, but both companies chose to issue 144a Eurobonds rather than listing them with the Securities & Exchange Commission.

The bad news for large or frequent issuers is that simplicity and safety are what investors are looking for. They're turning away from the big deals that have dominated the bond market since 1998, when investors' thirst for liquidity meant multi-billion dollar transactions came at a premium.

But liquid deals are easy to sell and short and so underperform in bear markets. investors are reducing their overall exposures to the larger credits, and have shown a budding interest in buying deals that are either smaller or come from infrequent issuers such as International Paper, or both.

As a result the average high-grade deal size has shrunk: in the third quarter it stood at $485 million, down from $662 million in the first quarter and an average for 2001 of $705 million. Issuance in October has been so weak that the average size has dipped below $400 million.

It's the first time since 1997 that deals smaller than $500 million have been in favour. "A $300 million deal for an infrequent issuer wouldn't have had much support in the past," says the head of debt syndicate at an investment bank. "Now the support is pretty broad, and high- to mid-rated smaller deals are usually very successful. There are days and weeks at a time where they come at tighter spreads than larger deals."

They have performed better in the secondary market as well, according to research by Dennis Adler and Richard Salditt, credit analysts at Salomon Smith Barney. "For the year to date to the end of September, jumbo tranches have widened by 120 basis points, underperforming the index by 1.1% on a total return basis," they write in a report issued last month. "Meanwhile deals less than $500 million have widened by 69bp, equating to a 1.87% of outperformance relative to the credit index. That implies a difference in year-to-date performance of 2.97% overall."

Another barometer of pressure on the corporate bond market is a new, tradable index developed by Morgan Stanley called synthetic Tracers. It consists of a static pool of 50 equally weighted five-year credit default swaps offering exposure to the US investment-grade corporate market. It's weighted towards industrial credits and away from bank and finance names. It doesn't paint a pretty picture of the state of corporate credit in the US. Since its debut in late April the index has widened by more than double from 118bp over US treasuries to 275bp over, though by October 25 it was trading around 220bp over (see chart).

The large borrower underperformance is encouraging for the infrequent borrower, and certainly gives debt originators at the investment banks some targets to hound for business. But it's not all that comforting either to the large issuers or institutional investors.

The former will have to work out how to raise new debt and refinance old without what once seemed to be unlimited access to the unsecured bond markets. Convertible bonds are one option, asset-backed securities another. One sector facing these problems at present is the auto sector, which we examine on page 62.

Investors face a different set of problems. The entire premise of credit investing is to be paid a premium based on the view of a company's risk of default. Yet the high number of companies going very quickly - or immediately - into high-yield territory or even default has thrown a spanner in the works. "I've been a credit analyst or a portfolio manager for more than 10 years, and these are the most volatile markets I've seen," says Lou Zahorak, head of portfolio management and trading for investment-grade bonds at Barclays Global Investors. He points to the rapid reversal in performance of the telecom sector as an example. "Last year the telecoms sector returned 13% and was one of the top-performing sectors in the Lehman Credit Index. But in 2002 the same sector has posted a negative return of 8.3%."

View graph.

"A lot of investors aren't buying this because they like telecoms," one syndicate head told Euromoney in the spring of 2001. "They're buying it because if they don't and the spread then tightens to high-grade levels they'll have to explain why they underperformed their index and their peers so badly."