Bond overview - Europe's battle of the bulge

Firms are each starting with different competitive advantages. Bank lenders will trade on their old lending relationships, M&A advisers on their strategic partnerships with issuers. And firms will seek to import each other's skills. The European firms, unused to a large domestic credit bond market, will copy American techniques, such as devising index products as a means to tie them to European bond investors who are being measured for the first time against new bond indices. The more ambitious European firms will renew their efforts in the dollar fixed-income markets in Europe and America. The Americans will bulk up their sales and origination teams in Europe, attempt to reach down to second-tier corporate issuers and will try to portray themselves more as entrenched domestic firms in Europe, with strong local managers, not mere collections of product specialists reporting to New York chiefs. Every firm will seek to get an edge by embracing the internet. Some will make dreadful mistakes. But for the winners, rich prizes beckon.

Last year, the new single currency was the focal point for powerful forces that began to create a new debt capital market in Europe based on credit. These forces have been endlessly analyzed, but are no less powerful for being so often talked-about. They include: the pressure on banks to make a decent return on equity by reducing their appetite for commercial lending; this at a time when European companies need to finance a wave of restructuring through mergers and acquisitions as they come under the same pressure to deliver shareholder value; all this while fixed-income investors seek better returns than are available from a shrinking supply of low-yielding European government bonds.

"These very large trends are not a one-year phenomenon," says Grant Kvalheim global head of debt capital markets at Deutsche Bank. "Last year corporate bonds, securitization, high yield and credit derivatives all exploded in Europe. For the first time last year the size of the primary corporate bond market in Europe exceeded that in the US, where corporate issuance was down. So there's a huge growth rate here. And we're still at the start of this. The order of the leading firms in Europe is far from fixed and there isn't a firm in global fixed income that's not targeting Europe as the key battleground."

Andrew Pisker, global head of bonds at BNP Paribas Group says: "There is going to be a European bulge, as in the US, of firms which accrue larger amounts of business and profit. Unfortunately, unlike in the US, the Europeans won't totally dominate Europe by themselves because several of the US firms are already well-established in Europe."

So which firms are the most credible candidates to form this European fixed-income bulge bracket? Most bankers reel off the same list of names. Among the Americans, Morgan Stanley, Goldman Sachs and Merrill Lynch definitely belong in the bulge bracket and, quite possibly, Salomon Smith Barney, Lehman Brothers and JP Morgan. That's already six American firms.

Of the Europeans, Deutsche Bank, Warburg Dillon Read, ABN Amro, Dresdner Kleinwort Benson and BNP Paribas stand out. Add on CSFB, which can be counted as American or European. That's 12 firms without even counting contenders such as Barclays Capital and Commerzbank. Twelve firms sounds rather a lot for a bulge bracket. "Maybe it will turn out to be the top five Europeans and the best three Americans that have the best chance of being part of that group," suggests Pisker.

Stephen Belloti

The true positions among firms are hard to determine. Bankers will argue over which new-issue league table to look at. The Europeans will say that the euro is the new currency so the euro league table is the key measure. And the European banks do well in those rankings for 1999. But, the US firms shout back, the Europeans have been so desperate to compete in the euro that many have neglected the significant dollar market, in which leading corporate and supranational issuers see a global audience of buyers.

"If you are the treasurer of a large European issuer, you're going to want more than just euro liabilities and, if you're the chief investment officer of a large European institutional investor, you're going to want more than just euro assets," says Merrill Lynch's head of European fixed income, Stephen Belotti. "As an intermediary, you have not only to be strongly positioned in the euro markets but in the dollar and yen blocks as well. You have to be global."

The dollar market is already more global than the euro-denominated bond market, being a vehicle for sovereign, supranational and corporate issuers. And this year the swap from dollars back into euros works better than in 1999.

At CSFB, Simon Meadows, co-head of global debt capital markets and Jonathan Fox, co-head of global credit products, insist that the league table of all international issues - irrespective of currency - is the key measure of bulge-bracket status. Global dollar deals are still a huge component of that. Meadows says: "The game is still the overall league table. Yes, we know that Europe is the growth area. But you have to be a bulge-bracket player internationally. And while everyone is chasing euro deals, many firms seem to have given up selling Eurodollars to European investors."

Andrew Pisker

It's an old debate. How much low-margin, plain-vanilla business does a firm have to do in order to win the handful of key deals in a year on which it will make money? But that debate may be overshadowed for a while by the growth prospects in Europe.

US as forerunner

In America, the value of corporate bonds outstanding is equivalent to roughly 29% of GDP. In Europe, corporate bonds, including those of financial institutions, account for maybe 5% of euroland GDP. TJ Lim, head of global markets at Dresdner Kleinwort Benson, says: "A good analogy of the likely progress of the euro capital markets is the development of the US corporate bond markets during the late 1980s and early 1990s. However, what happened in the US corporate bond market over the last 10 years will probably take place in Europe over the next three."

And the profitability of the bond market in Europe may be improving. Firms that had been used to chasing league table status through low-margin trades for governments and frequent issuers are suddenly finding more attractive returns in the higher underwriting fees on corporate bonds. The lower down the credit rating spectrum you go, the higher the fees issuers will pay for bond funding, because the ability to access the market is more important to them than shaving borrowing costs. So firms are scrambling for leadership in European high yield.

Better-rated corporates may still bully intermediaries that are desperately fighting for places in the bulge bracket into buying overly aggressive bonds. But last year, many new issues were priced at market-clearing levels following book-building of orders. So banks were less likely to be left holding large positions with no buyers, though American firms suggest several European banks did get caught long of credit bonds on their balance sheets when credit spreads widened last summer.

Government bond trading in Europe has for years been an awful combination of high costs - associated with the technical and staffing requirements of dealing in several countries - low margin, and moderate-to-large volume. Secondary turnover has yet to develop in the European corporate market. When it does, firms hope that spreads and margins will favour them more than in government markets, though the transparency of the internet might dash such hopes. For now, all the European credit analysts and salesmen are spending up to 90% of their time on new issues. In the US, where relative-value credit trading is more established, credit analysts and salesmen might spend 75% of their time working on clever switching trades in the secondary market.

Recruitment drive

Stefano Corsi

Belotti at Merrill Lynch outlines the firm's hiring plans as it continues to rebuild following the setbacks of late 1998, when it responded to the Russian and LTCM crises by laying off large numbers of fixed-income people. Belotti says that Merrill shed 160 people from fixed income in Europe and 600 across the world. "In 13 years at the firm, I cannot remember a worse setback in fixed income. We had put ourselves on the back foot in the second half of 1998 and so we weren't really able to take advantage of the upcoming euro and the growth of the credit markets. Also we weren't able to pay people in fixed income very well so morale was pretty low. But this firm admits its mistakes and learns from them."

The mistake Belotti alludes to is over-reliance on position-taking, which the firm tackled last year. "We've radically reduced the capital and balance sheet applied to warehousing credit inventory, which is very different from what I see a lot of banks doing which are simply loading up on bonds instead of loans. In 1997 and 1998 we had put too much of our capital at risk to the markets in general. Equity and balance sheet decisions are now made around our clients and their needs."

According to Belotti, the firm now sees better returns and lower risks in customer business that once might have been a mere source of market intelligence to support directional trading. "Now we are back fully focused on clients, we cover more clients and our performance is much better. And if the same circumstances hit us as did in 1998, losses would be minimal."

Merrill intends to hire 75 to 80 people this year in fixed income in Europe, mainly dedicated to distribution and origination. Before the 1998 credit crunch, Merrill had an unrivalled distribution strength, with 140 institutional bond salesmen in Europe. That fell as low as 110 and is still being rebuilt. Corsi at Morgan Stanley, a firm that has been far more stable than Merrill with much less staff turnover, intends to grow from 84 salespeople covering Europe to 100 this year. Deutsche too claims 100 institutional salesmen in Europe. So 100 looks like the standard for top-league distribution.

One headache for firms aspiring to the bulge bracket, says Manfred Schepers, head of debt capital markets at Warburg Dillon Read, is that "in the institutional market, there is a big consolidation in what was once a fragmented market". He adds: "Large institutions are ruthless in moving their business to those firms with the best coverage across all sectors. Maintaining that research, sales and trading infrastructure is very expensive."

Expensive dealing costs

Corsi is concerned by the comparatively high costs of dealing in plain-vanilla government bonds in Europe. "It costs us three times as much to deliver a government bond in Europe as it does in the US. And we will always have to provide an adequate service to our customers on interest-rate views with sales backed up by research and a trading infrastructure to provide liquidity."

He predicts: "You will see us and all the other major securities firms encouraging further consolidation in clearing and settlement." It is frustrating that the low-margin rates business of interest-rate swaps and government bonds, which may have to clear and settle through a local exchange and an international clearing house, carry higher costs than the higher-margin credit business where bonds may settle through a single international clearer. No surprise which area Morgan Stanley wants to grow.

"In relative terms, capital devoted to interest rates will decrease over time," says Corsi. "Credit consumed 10% of capital in European fixed income in 1993. Now it consumes 40%. This trend will also be reflected in the allocation of our people." Although the growth of the bond market and the improving economics of the business may provide a mouth-watering prospect for bond market intermediaries, it also carries a challenge, especially for European banks. If they fail to make it into the top bracket in the new enlarged euro-denominated debt securities market, the national European markets will no longer provide much of a safety-net.

That pressure is apparent in any discussion with heads of European fixed income. "If the euro capital market takes off and this firm is not part of it, then we're finished," says the head of debt markets at one large European bank. "If this market really develops in Europe, there will be four or five houses in the top tier and we have to be in that. Second tier isn't good enough." Just in case anyone should miss the point, he emphasizes: "If we don't get this right, we're finished as a universal bank."

It's noticeable that many of the aspiring European banks have entrusted their efforts in fixed income to veterans of American investment banks. The most obvious example is Edson Mitchell, ex-Merrill Lynch, at Deutsche Bank. TJ Lim also won his spurs at Merrill before turning to UBS and then Dresdner. Andrew Pisker learnt the business at Lehman before joining Paribas. The European banks are filled with people who know how credit bond markets work, though this does not in itself make success easy.

When Lim arrived at Dresdner Kleinwort Benson, he pondered building a derivatives-based bond business that would seek to distinguish the firm as a leader in complex, structured products and risk management. But he quickly rejected this.

"The lesson from the US is that to be called a major bulge bracket player, you have to be a factor in every part of the US capital markets. A niche approach, such as being strong only in derivatives, is not sufficient," he says.

"As such, our goal is to build up expertise and capabilities across a wide range of products in the euro capital markets, from euro governments and high quality credits to corporate new issues, capital securities, emerging markets external debts, interest-rate and credit derivatives, synthetic securities, forex and local markets. In addition, we see significant growth opportunities in high yield, securitization and asset-backed securities."

Luckily, Dresdner and several other leading European banks have done a good job so far in converting old lending relationships with corporate customers into bond mandates. So as the corporate bond market has developed in Europe, the leading European banks have been there to capture their share of it, even though the American firms could probably lay claim to a greater experience of and technical expertise in credit bond markets derived from their large - and largely closed - domestic market. "What favours the banks in Europe over the traditional investment banks is that bank mergers are restricting the flow of balance-sheet liquidity to corporate clients and so those clients value more whatever credit extension they can still get," says Deutsche's Kvalheim.

And while banks may not be able to reprice old-fashioned loans so that they deliver an adequate return on equity, they can demand other sources of revenue - like bond mandates - in return for lending to corporations.

It remains to be seen how effectively leading continental banks can continue to translate lending relationships to bond-market position. It requires considerable internal reorganization. "If you walked onto the bond trading floor here two years ago, everyone was trading sovereigns and supranationals," says Jan Pethick, head of debt origination at Dresdner Kleinwort Benson. "Lending people and bond people never really came together. Now they are originating debt together."

An intriguing suggestion of large possibilities was delivered through the small e100 million ($100 million) deal the firm led last year for unrated and unlisted German tractor-maker Claas. "It was an important deal," says Pethick, "since it demonstrated that Mittelstand companies really can access the capital markets and that investors outside Germany really want to understand these companies and their credit. The firms that will occupy poll position are the ones that successfully capitalize on lending relationships as companies start converting their debt towards the bond markets."

But there is another issue looming for European banks that have so far failed to break into the US bond market in any meaningful way. If all their efforts in the US are focused just on bringing American issuers in euros and selling euro bonds to American investors, can they succeed as pure euro houses? The larger ones are sure they can't.

"If all you can do is euros, that's not much help to the company which wants to know the best way to finance itself in whatever market offers the best execution," says Deutsche's Kvalheim.

"We think we have got great investor distribution in Europe. But we still need to grow in the US. We're happy with the quality of what we've got. We just need more scale. To be a really successful firm, you have to be in the top three to five in euros and dollars. I see the two outstanding candidates as ourselves, being strong in euros and moving up in dollars, and Morgan Stanley, being strong in dollars and moving up in euros."

Playing to strengths

On the deal origination side in Europe, the American investment banks are playing to strengths slightly different from those of the European banks, using their dominant position as corporate finance and mergers and acquisition advisers to win bond mandates from European companies. Many large corporate bond issues are now linked to M&A deals that once would have been financed by banks. Investment bank advisers are implanting the idea among their European corporate customers that the investment banks have the right to lead-manage merger-related bond deals.

It's not just M&A related financings the investment banks have their eyes on. They want to change the whole process of awarding bond mandates. "On the credit side, we are in the middle of a multi-year plan to position ourselves as a premier player by beefing up origination and distribution. One key to success is better integration with the investment banking area," says Morgan Stanley's Corsi.

"The knowledge our corporate finance people have of companies' mission issues, risk problems and M&A tactics can lead to debt trades. We're trying to work up the decision-line on these, not wait for mandates to go out to tender."

What's worrying the Europeans is the US firms' dominance in European corporate finance and M&A. The sale of Schroders to Citigroup is a signal of how tough the European advisers have found that competition. Schroders was top three in European M&A in 1998. It was fourteenth last year.

Some American investment bankers are now pondering ways to take bank lenders out of the process of financing European takeovers. Last year, the bond markets speedily refinanced bank debt taken out for many acquisitions. This year, D'Angelin expects greater developments at the short end of the market. "This may be in commercial paper or large short-term floating-rate notes like the deal for Repsol. Bond markets have shown they can refinance large loan transactions. But bond markets can also provide short-term finance quickly and more cheaply than bridge loans. I think we will see capital markets solutions take the place of bridge loans."

It's a trend that many large European firms fully understand. "We are still trying to grow our investment banking and M&A franchise," says Deutsche's Kvalheim. With Bankers Trust, we gained great relationships with LBO sponsors on the high-yield side. We're trying to extend that."

And at Warburg Dillon Read, whose parent UBS has abruptly curtailed corporate lending, Schepers could almost be speaking from the US investment banking handbook. "What engages a corporate customer with a bank is a tricky question. In Europe banking relationships used to be regionalized and static. Companies in most continental countries went to banks for lending and basic transactions. But now many of these clients need strategic advice.

"Most capital markets activity now arises from changes in corporate strategy. Increasingly bankers will be lost if they cannot talk to the senior managers of these companies about business strategy inside and outside Europe and advise on their overall capital structure, including equity."

He adds: "In 1999 a lot of lending relationships could still be leveraged. But that is shifting now. Investment bank advisers will win the bulk of the business. We are leveraging our equity and corporate finance infrastructure and we see our competition very much as the US investment banks. We come across the European banks mainly in the commodity end of the bond and derivatives business."

Those very large takeover-linked bond deals tend to be the most profitable for intermediaries. The sizes tend to be large, the fees juicy and, because issuers care more about the deal's success than shaving funding costs, pricing tends to be generous. Meadows goes as far as to say: "Often the only corporate deals where you make money are those such as M&A related transactions or where the borrower has a specific strategic goal."

However firms win deals, the challenge remains to distribute them. That's especially so when bank's shareholders and risk managers have turned against position-taking. "Today firms first find out what investors want, then try and buy it," says Fox at CSFB. "No-one will acquire an asset without first knowing that there will be a buyer."

It's a challenge running bond distribution in Europe, with its mix of sophisticated institutional buyers such as the UK investment management groups and retail accounts such as clients of the Swiss private banks - those two groups from outside the eurozone together account for more than 50% of bond buying in Europe.

All firms are making careful choices in how they manage investor coverage. Morgan Stanley has made a big effort to cover insurance companies across Europe, with 30 specialist sales staff, one-third of its total, dedicated to accounts that, to date, do not produce anything like one-third of its revenues. It's a strategic decision.

Most firms are moving away from sales coverage organized according to investors' nationalities. Some have arranged salesmen by product knowledge, with separate credit and rates sales teams.

Corsi at Morgan Stanley says the firm is falling back on the old rule: know the customer. "Insurance is a very highly regulated industry that cannot be covered by generalist salesmen. Insurance companies will become increasingly important buyers of all types of credit bonds in Europe," he says.

All firms are now pondering the likely impact of the internet on bond distribution. All are working on systems with various applications to secondary trading and even to new issues. It's easy to see the internet allowing wider and more open distribution of plain vanilla government bonds.

This might complement the new role of the bond salesmen as the strategic adviser to the big institutions, advising over the telephone on the $500 million trade that will have a real impact on the portfolio, while the $5 million to $20 million trades are executed on-line.

Several deals have been sold over the internet this year for supranational, agency and corporate issuers. To some bankers, this is not so exciting. It may be appealing for an issuer to see his deal's order book develop in real-time on-line. But this is no more than a speedy replay of what issuers have been used to being fed with a few minutes' delay by phone or fax.

The internet may make the business more efficient, if salesmen spend less time faxing and delivering prospectuses, in-house and rating agency credit research and legal documents to buyers and can, instead, refer potential buyers to all this on the web and chat about finer perceptions of issuer's prospects and a deal's momentum that clinch buying decisions.

New internet horizons

Will the internet really change the patterns of bond distribution? There are many sceptics. But some bankers are beginning to get excited. For years, they have dreaded the thought of a handful of super-investors so dominating the pricing of new issues that borrowers would find an open and cheap means - such as the internet - to auction bonds to them directly.

So when Lehman's D'Angelin found that 9% of a $1.2 billion three-year deal that the firm executed over the internet for Ford last month was placed with smaller institutions buying $5 million of bonds or less, he sensed something new.

"The internet allows access to institutional investors that are so small we would not normally have a salesman covering them," he says. "In the 1990s, the large institutions became very important in the bond market and in pricing transactions. This may be the decade of the retail and small institutional investors in bonds."

The sceptics point out that to gain real price tension, such new retail and smaller institutional accounts would have to begin covering whole deals, or at least 40% to 60% of them, not 9% to 10%. Others point out that underwriters can hardly sell bonds on-line to any random buyer. Investors must be prior-approved.

It is not as if an undiscovered constellation of buyers awaits in cyberspace. On-line retail buyers may drive the stock markets. But they are more interested in stock than bonds. And even in equity, they are less of a factor in the primary market than in the secondary.

But Lehman has an exclusive arrangement with Fidelity Investments to market all Lehman products and research. That's an audience of 3.2 million on-line investing accounts. And Lehman's own client access site gives password-protected access to 2,500 institutions, including many mid-range accounts such as regional banks that its institutional salesmen would not normally cover on a new issue.

A typical Ford deal would be 25 to 30 institutions buying $20 million to $100 million tickets, says D'Angelin. The internet gives access to a huge number of smaller accounts that are de facto barred from the new issue market. This trend could be enormous. Many bankers cling to the view that the bond market is essentially institutional. But perhaps not so.

Firms will continue to develop their own internet systems and buy into other on-line exchanges and trading networks. But they risk over-spending on the wrong approach.

Corsi at Morgan Stanley points out: "Though we placed 10% of the recent Fannie Mae deal through our e-system, proprietary systems may not be the way forward. For example, IMGs are bound to compare prices from at least three sources, so perhaps we should all be looking to deliver bonds on common internet platforms."

The leading international investment banks all talk privately about possible agreements with large European banks that have huge national distribution franchises.

Though banks are now competing fiercely for domination they may eventually end up having to find ways to work together or simply take each other over. The next wave of big mergers could marry American banks with the leading Europeans.