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Headline: Playing down rising rates
Source: Euromoney
Date: February 2000
At the end of last year a leading investment bank hosted a conference in one of Europe's livelier Mediterranean cities for investors and issuers to discuss the workings and prospects of the shiny new euro credit bond market.
Normally thick-skinned bankers were amazed at the sheer hostility which welled up from the conference floor as investors harangued corporate treasurers who were telling their companies' credit stories.
But it shouldn't have been a surprise. The diverse group of European investors who piled giddily into corporate bonds in the first half of 1999 were hurt in the second half as long-dated government bond yields started to rise and credit spreads widened, partly in sympathy with underlying rates, partly in response to credit events at specific issuers.
In the most notorious case, buyers of Mannesmann's benchmark e3 billion 10-year bond issued last May watched in dismay as the Libor spread on their bonds widened from a low of 68 basis points to a high of 129bp, following the rating downgrade that accompanied Mannesmann's acquisition of Orange.
At the conference, a clear pattern emerged. Investors wanted the corporate treasurers to reassure them - no, to guarantee - that their companies would do nothing to hurt their credit ratings and consequently their bond spreads. Of course, the treasurers blustered, they could make no such promises.
How could they? The whole point of the new corporate bond market is to make it easier for them to raise huge sums quickly to take each other over, isn't it? And event risk is good for bondholders as often as it is bad. Investors don't make such a fuss when a higher-rated issuer takes over a lower-rated one and the target's outstanding bonds are magically upgraded.
This is a good lesson for investors to learn. Simply buying credit instead of government bonds is no recipe for an easy life. If company managers who have their pay linked to a rising share price see an attractive if risky acquisition, then the interests of bondholders will not figure very prominently in their thinking. Fund managers have to think carefully about event risk, investment time-horizons and the psychology of company executives.
There may also be a lesson too for the investment bankers. As Euromoney journalists discussed prospects for the year ahead with scores of bond market folk during research for this month's special report on fixed income markets, all the talk was of expectations for market growth, the difficulty of hiring enough competent staff to cope with the expected bonanza, and the better economics of credit bonds over government bonds. The fact that the world is moving decisively into a rising interest-rate environment is dismissed as a mild inconvenience - 10-year German Bund yields rose from 3.75% last April to 5.62% at the end of January, the US Federal Reserve raised short-term rates three times last year from 4.75% to 5.5%, and the Bank of England raised rates last month.
These rises are neither as sudden nor as shocking as in the bond crash of early 1994, bankers say. And this time around there is less leverage in the financial system, less froth from the hedge funds: another 100bp or so on the US long bond - already up from 5.5% 12 months ago to 6.5% - won't hurt the markets.
But it's worth asking the question: how high do rates on government bonds have to go before investors return to the old habit of buying triple-As only and quit this confusing new corporate debt market? If benchmark euro government bonds start yielding nearer 7%, there might be fewer takers for the corporate stuff. And Europeans are increasingly coming round to the prevailing American view that investment-grade credit is expensive.
At the start of this year, analysts at Dresdner Kleinwort Benson presented some key thoughts to 300 investors in 19 European cities and told them that the bank expects spreads on corporate euro bonds to widen this year. They found that many investors had already reached the same conclusion.
It's not just buyers who might sit on the sidelines. While it's tempting for corporates to lock in low fixed-rate 10-year funding at a time when the drive to European convergence has pushed yields to record lows, things will look different if rates continue to rise.
The same applies to funding acquisitions, a mainstay of the primary bond markets in 1999. If a company calculates its cost of equity at say 8%, it's easy to conclude that debt funding at a modest spread over 2.5% base rates is a tempting prospect. Rising rates will make those calculations finer.
So what should a smart bank do, when all its competitors are staffing up for a determined push into a growth market? At the very least, bear in mind the possibility that corporate deals might be fewer and smaller in 2000 than in 1999. And perhaps devote research and origination resources to one large sector of the bond markets whose issuers are very sensitive to lower credit ratings that might directly hit their cost of funds and their attraction as trading counterparties.
If 1999 was the year of the corporates, 2000 may be the year of the banks.
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