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April and May brought a touch of frost to Europe's corporate bond market. The market blossomed in 1999 with record issuance by European companies eager to tap the new liquidity of the eurozone. However, the spectacular increase in gross issuance last year has not continued in 2000. The year began with volumes down modestly compared with last year. Then in April the market suddenly went quiet. For several weeks after the Easter holidays investors seemed reluctant to buy any bonds issued by European companies.
Several corporates postponed offerings planned for the second quarter, some came to market with more generous prices and others reduced the size of their issues. French retail group Carrefour, for example, took two goes to complete its planned 10-year e1 billion bond last month, first issuing e750 million on May 11 and launching a e250 million add-on two weeks later. French auto maker Renault issued a e400 million FRN, a little short of the e500 million it had hoped to issue.
It is little wonder that investors are nervous about buying corporate bonds. Almost every day seems to bring bad news for bond holders as event risk - the catch-all danger that dealmaking or outside interference will make companies less creditworthy - strikes another European credit.
The sky-high successful bids for the UK mobile phone auction? Bad for bondholders, because big bond issuers such as Vodafone AirTouch will have to increase debt. Mergers and acquisitions in the paper sector? Bad for bondholders because issuers may leverage up to make purchases. Olivetti's proposals to tidy up its ownership of Telecom Italia? Potentially bad for bondholders, because Europe's biggest single corporate issuer, Tecnost, may be submerged into Olivetti to form an entity with bigger debts in relation to its cashflows.
Event risk ought to be a two-sided coin. Some events should be bad for bondholders: others positive. If a company is taken over by a more creditworthy rival, for example, the price of its outstanding debt should soar. But investors fear that European credits are heading in only one direction - downwards.
There is little doubt that the European market's centre of gravity is shifting. "The average corporate issuer in the US has been rated at around BBB+, whereas 18 months ago the average international corporate issuer in Europe was AA," says John Winter, head of debt capital markets at Deutsche Bank. "Now we are starting to see the European average move to A."
Lehman Brothers has calculated the total number of companies with bonds outstanding in each broad rating category. The firm finds that Europe and the US are still miles apart in terms of the composition of the corporate bond markets. There are a similar number of AA-rated corporate issuers in Europe and the US. But lower down the rating scale, US issuers vastly outnumber European corporate borrowers. There are around six US A-rated corporate issuers for every one in Europe, for example. Leave aside UK companies and Europe has not many more than 50 such issuers compared with around 600 in the US.
New lower-rated borrowers emerge
The biggest change in Europe's corporate bond market since the introduction of the euro has been growing issuance at the bottom end of the credit spectrum. BBBs are the biggest single chunk of the US corporate bond market but until very recently they were virtually unknown in Europe. That is now changing fast, with the proportion of European corporate bond issuance rated BBB or lower increasing from 8% in the first quarter of 1999 to nearly 37% in the same period of 2000 based on Capital Data Bondware figures.
But just because the amount of BBB-rated debt is increasing, it doesn't necessarily follow that existing European issuers are leveraging up. Much of the volume of lower-rated debt is from newcomers to the market rather than old borrowers that have suffered a downgrade. Indeed, investors' fear that European corporates are on the verge of suddenly increasing their levels of debt may be based partly on misconception.
Morgan Stanley looked at the balance sheets of all non-financial companies among the 500 largest public companies in Europe (of which there were 306) and their 284 counterparts in the US. The analysts found similar levels of indebtedness on both sides of the Atlantic. The average debt for European companies was 2.2 times ebitda, while in the US the ratio was 2.3 times. "The view that European companies are under-leveraged is actually not true," says Morgan Stanley credit strategist Neil McLeish.
Nevertheless, the perception that corporate Europe is sliding down the credit curve adds to the tendency of investors and rating agencies to put a negative spin on every piece of corporate news. Gas distributor Gas Natural, for example, announced last month that it intended to spin off much of its cash-generating pipeline network into a separate company. Standard & Poor's responded by putting the company on credit watch with negative implications for its AA rating. The Spanish company's treasurer, Alberto Valdes, believes it is too soon to draw conclusions about the impact of the restructuring on the group's debt. "Some analysts are worried that this will increase Gas Natural's leverage," he says. "But if we float the company on the stock market that probably would produce extra cash for Gas Natural which we could use to reduce debt or invest in new projects without increasing the existing debt."
In an environment where investors are anxious about every companies' next move, bond buyers are increasingly demanding something the bond market never used to bother with: covenants. These are clauses, standard on corporate loans, penalizing the borrower if it does something that damages the interests of bondholders, increasing debt above a certain level for example. "The first thing our salespeople say these days when they hear we've got a corporate mandate is that it will need covenants to sell," says one banker. "Covenants are really the flavour of the moment."
But most believe that covenants will not become standard on all corporate bonds. "To some extent covenants will become a more and more regular phenomenon in this market," says Geert Vinken, head of syndicate at Barclays Capital in London. "But to a certain extent issuers can pre-empt the need for covenants by trying to actively manage in the interest of bondholders. Ultimately, that will give investors greater comfort than covenants, which can simply mean legal discussions."
Part of the problem for corporate issuers is that they are issuing debt to an increasingly sophisticated group of institutions. Many investors needed to bump up their exposure to European credit following the introduction of the euro, and that led to some fairly indiscriminate buying early last year.
Many got their fingers burnt. The price of Mannesmann's bonds tumbled following the announcement of the German company's plan to buy Orange last October. More recently, spreads on Stagecoach's bonds widened in April, after the UK transport company announced a corporate restructuring along with a profit warning. Investors have responded by hiring more analysts and calling in outsiders to advise them on managing credit portfolios.
"The three things investors are all interested in right now are event risk, the impact of equity volatility on spreads and sectoral analysis," says a banker who has recently given a series of seminars to investors. European asset managers are quickly becoming much more like their US counterparts, who spend time tracking credits by sector rather than dividing their portfolios into national buckets, as European bond buyers have tended to in the past.
"Increasingly, investors are realizing that the degree of excess returns is linked to the sector they invest in," says Neil McLeish, credit strategist at Morgan Stanley in London. "Since the third or fourth quarter of last year in particular, the more sophisticated investors have begun to devote credit analysts to specific sectors." But even if investors are becoming more circumspect about adding to their credit portfolios, there is no mass sell-off yet. "In Europe a massive reallocation is taking place from government bonds to credit," says Charles Berman, head of European debt capital markets at Salomon Smith Barney. "Most investors are still underweight corporates, which gives them a strong disincentive from selling their positions, although currently few are actively seeking to increase their exposure to the corporate sector".
In a market buzzing with talk of event risk and covenants, it is easy to imagine that corporate bonds have fallen sharply out of favour with investors. But in fact bond issuance by all types of borrowers has been sluggish in recent months and much of the slowdown is the result of temporary causes.
"Overall fixed-rate issuance in the international markets is down compared with last year," points out David Munves, head of credit strategy at Lehman Brothers. "We weren't projecting that the market would grow anything like as fast as last year, but the decline is more than we had expected." He points to three reasons for the slowdown. "First, interest rates are high at the moment and as a result there has been a switch to floating-rate issuance. Second, much of the M&A activity carried out so far this year has been financed by equity rather than debt. And third, corporate spreads have widened significantly in the past year."
The price of fixed-income debt in general has fallen as interest rates have risen, but the riskiest debt has suffered disproportionately. With investors demanding a greater premium for lower-rated assets, spreads on corporate bonds have ballooned. In part, that spread-widening reflects investors' concerns about event risk, but it is common for the credit curve to steepen in any rising interest rate environment.
Many bankers see the present dearth of issuance as no more than a temporary pause in the growth of the corporate market. "After a reasonably good start to the year, the market is now in a stage of reconsideration," says Vinken at Barclays Capital. "There has been some oversupply and investors have taken a step back. But this market tends to go in start-stop mode anyway. You get times of heavy issuance and then periods of quiet." The wild gyrations of the equity markets in recent months have also unsettled bond investors and are making bond pricing more volatile. "The biggest change compared with last year is not that volumes are down but that the market is more volatile," says Winter at Deutsche Bank. "There is tremendous volatility in spreads. But we continue to get a variety of deals done, and there are many more in the pipeline."
And much of the overall reduction in bond issuance this year has been in the dollar market rather than in euros. Interest rates are rising on both sides of the Atlantic, but concerns about an interest rate hike are particularly acute in the US. "The US market had a bumper year last year," says Berman at Salomon Smith Barney. "There was a lot of pre-funding, so it's not surprising the dollar market has had a slower start this year. But our euro corporate business has been very strong this year. Last year we completed 29 deals; so far this year we've already done 22."
In any case, many corporate treasurers do not watch interest rates or credit spreads as closely as bankers. Pekka Reijonen, treasurer at Finnish telecom company Sonera, for example, says high interest rates would not deter the company from issuing if it felt the time was right. "We are very careful to differentiate funding from interest rate risk management," he says. "There is no direct link between them."
The final figures for issuance in the first quarter of this year do not give too much cause for concern. According to Capital Data Bondware, international issuance by European corporates fell from the equivalent of nearly $34 billion in the first three months of 1999 to $26.7 billion equivalent in the first quarter of this year. Issuance by corporates from all nationalities in euros was flat compared with last year. In the first quarter of 1999 there was e22.7 billion of corporate issuance in the new currency. The same figure for this year was e21.9 billion.
Assume that the novelty of the euro encouraged an artificially high level of issuance at the beginning of 1999, take into account the rising interest rate environment and those figures don't look too disappointing. They are certainly not enough to worry bank chiefs who have bet their firms on the long-term growth of a European corporate bond market.
Question those growth forecasts
But what if it turned out that Europe doesn't have very much potential for corporate bond issuance after all? Now that would give serious grounds for concern.
A recent report by Merrill Lynch strategist César Molinas questions the assumption that given the similar size of the two economies, corporate bond issuance in Europe will eventually reach the same level as in the US. The gist of the argument is that Europe does not have the same number of natural bond issuers as the US - those large, listed companies that have the infrastructure and borrowing requirements to raise bonds. In addition, Molinas points out that the growth in European corporate issuance last year was not as dramatic as it seemed, since the gross issuance figures used by data providers such as Capital Data Bondware do not take account of the high levels of redemptions last year.
Lehman Brothers has done similar research on the number of potential issuers in Europe. The firm assumes that listed companies with book equity of over $500 million and operating income of more than $150 million are natural candidates for bond issuance. Lehman found 142 companies in western Europe that meet those criteria but that are not yet rated.
But even if all these companies obtained ratings there would still be only 350 or so such potential corporate issuers in Europe. Privatizations and spin-offs might create a few more. But in the US, by contrast, there are more than 600 such investment grade-rated companies. "There is room for a moderate amount of growth, but perhaps not as much as many people had thought," says Lehman's Munves. "The structure of European industry remains very different from the US. In countries such as Germany there are many thriving family-owned businesses that are unlikely to get rated because of their ownership structure."
And the really bad news is that a disproportionate number of large listed companies are to be found in just one country: the UK. Of Lehman's rated universe of 214 issuers, more than half are based in the UK. The 142 companies Lehman Brothers identified as possible future issuers included 50 UK companies.
But the argument that Europe has a limited universe of bond issuers gets short shrift from many in the market. "To suggest that corporate borrowing in Europe isn't going to change rapidly is simply ignoring the evidence," says Berman. "If you had an environment in which commercial banks continued to be aggressive term lenders it might be a different story. But all banks are looking to reduce term lending in order to improve return on capital. And bank consolidation is accelerating that process. If two banks merge which each have e100 million of loans to one company you don't come out with e200 million of commitments. You might end up with e150 million. Liquidity from the banking sector for term financing is rapidly diminishing. However, liquidity for short-term commitments which are less capital intensive is very high. New records for standby and bridge financing are being broken almost every month."
For many European corporates, the bond markets have become the only realistic source of medium-term and long-term funding in any size. Many do not even bother to shop around and compare pricing of loans and bonds, because they assume that the loan markets will not be willing to provide what they need.
This is particularly true for companies in smaller European countries, which do not have the deep-pocketed house banks that a French or German company might still count on. Sonera is one company that has taken enthusiastically to the bond market following the birth of the eurozone. "The bond market has become very much more important for Sonera," says Pekka Reijonen, the company's treasurer. "Before 1999 we mainly tapped the syndicated loan market. Last year we set up a Euro-MTN programme and did an inaugural bond of e300 million in 10 years. Then we decided to do a true benchmark of e1 billion this year. The euro has given us a much deeper and more liquid market to tap into."
But what of Sonera's equivalents in larger European countries? Given the cosy relationships between French, German and Italian banks and their biggest corporate customers, surely the flow of cheap lending is not going to dry up any time soon? Winter at Deutsche Bank points out that it is not a matter of banks' willingness to lend: hard economic facts will prevent them from doing so. "If you have a A-rated bank and a AA company, it is obviously hard for the bank to lend to the company profitably," he points out. "In a relatively deep credit market like the US, many banks simply cannot afford to provide traditional loans to their most creditworthy clients. And that is the trend for European banks also. As pressure on these intermediaries increases, the corporate bond market will continue to grow steadily."
However, turning off credit lines is not the only way banks are reducing their exposure to corporate credit. The boom in credit derivatives and collateralized loan obligations is another sign that things are changing. "European banks are under pressure from their shareholders to reduce the credit risk on their balance sheets," says McLeish at Morgan Stanley. "They are doing that in a number of ways - by using credit derivatives, for example, and also by encouraging companies to switch from loan to bond funding." For many companies, the decision to issue bonds is driven by more than simply price and availability of funding. "It was very important for us to diversify our sources of funding," says Valdes of Gas Natural, which raised e252 million in January through a 10-year offering led by Invercaixa Valores and Merrill Lynch. "Until we issued out first bond in January, all our debt was bank debt. Now the percentage is around 75% or 80%. It was not simply that we wanted to reduce costs, we wanted to adjust the mixture of fixed- and floating-rate debt. Having the euro means that we are able to do this more easily. Now we have a market which is as large as the US market - or even larger. And we can borrow without taking any currency risk."
Getting the right mix of liabilities is becoming as important a goal for corporates as it is for larger borrowers such as sovereigns or agencies. "Diversification of funding sources is emerging as a key objective for many corporates," says Winter at Deutsche Bank. "Companies are saying 'we need to diversify by location of investor and by the type of investor'. Those funding sources may include quasi equity investors, as well as bond investors and commercial banks around the globe."
The loan market can be an attractive source of short-term funding, especially when it is undrawn, but almost every company that needs to borrow to make a big acquisition has to look to the bond or equity markets. Indeed, many corporates seem to be dipping a toe into the bond market in preparation for the day they need to borrow to make a really big purchase.
"Our experience of the market was quite positive," says Panayiotis Vlassiadis, group treasurer at Greek telecoms operator OTE, which raised e1.1 billion in January through a seven-year issue led by Merrill Lynch, Morgan Stanley and National Bank of Greece. "It was a valuable learning experience and it made us more ready to contemplate using the capital markets rather than the loan markets where we have traditionally been active. The bond market is something we are likely to use in due course, when we have particular financing requirements."
M&A is the volume driver
All the biggest European corporate bond raising exercises in 1999 sprang from M&A activity. Mcleish at Morgan Stanley says: "Our study of M&A trends showed that 35% of global M&A was in the media and telecoms sector. It is no coincidence that telecoms is the largest sector in the euro industrial bond market."
Last year produced a bumper crop of M&A deals affecting European companies, such as Olivetti's takeover of Telecom Italia and Vodafone's purchase of AirTouch. Typically, they were financed by short-term syndicated loans and then refinanced in the bond market. So far this year, many of the biggest takeovers by European industrial companies have been structured as equity mergers, notably Vodafone's acquisition of Mannesmann, UPM-Kymmene's so far undecided bid for Champion and Alcatel's purchase of Newbridge Networks.
Cash-financed bids, by contrast, have been relatively rare. Robert Bosch and Siemens' joint bid for Mannesmann's Atecs arm, worth e9.6 billion, is one of the few big deals to have been agreed, and much of the asking price for that purchase can be paid from the two buyers' existing cashflows. But the pace of dealmaking may now be picking up. Anglo-Dutch food company Unilever's $18 billion bid for Bestfoods of the US is the first blockbuster deal this year likely to lead to a big debt-raising exercise.
A handful of multi-billion euro acquisition refinancings later in the year would make corporate volumes look a lot more healthy than they appear now.
And another big source of bond issuance is looming. The winners of the UK UMTS mobile phone licence auction have to find a combined £22.5 billion ($33.3 billion). Although the UK government offered bidders the choice of paying for the licences in a lump sum or gradually, the terms on offer have not been sufficiently attractive to encourage any of the companies to spread the cost. In addition to raising the cash to pay for their licences, the winners need additional funds to build new infrastructure for their third-generation mobile networks. With similar auctions due in Germany, France, Italy and the Netherlands this year, the amount of funds required for the mobile phone industry could be substantial, perhaps hundreds of billions of euros.
However, estimates of the potential cost to the companies of this round of licences vary enormously between countries. The mechanism used in the UK auction proved highly effective at eliciting sky-high bids. Spain's four G3 licences were sold for a mere e500 million after a beauty contest.
And then there is uncertainty about how the bidders will raise the money. Some companies are likely to pay for their licences by selling assets or issuing equity rather than taking on additional debt. But for the UK licences at least, it looks as if much of the money will be raised first through the syndicated loan market and then by issuing bonds.
Several winners of the UK auction are now seeking loan facilities geared towards bond refinancing: the terms include rising interest payments designed to encourage the borrowers to refinance as soon as possible.
Certainly, the market has assumed that there will be a lot more bond issuance from telecoms companies as a result of the success of the UK auction. David Meade, telecom credit analyst at Morgan Stanley in London, points out that spreads on telecom credits, notably Mannesmann, widened more than the market in the wake of the auction on the assumption that there will be more supply.
The wave of corporate restructuring in Europe will not only lead to more bond issuance in itself, it will also create more potential issuers. Many new European corporate issuers in the past 18 months have been born out of larger European companies as they have merged with long-standing rivals, found a new strategic focus and spun off unwanted assets through IPOs and through sales to private-equity firms. This widening of the corporate universe represents the best hope that Europe can be home to as many corporate bond issuers as the US.
Certainly, many believe that the market has the capacity to absorb a greater number of issues. "We are nowhere close to fulfilling the potential of corporate bond issuance in Europe," says Berman at Salomon Smith Barney. "So far this year just over 100 corporate deals have been done. In the US the figure is much higher. There is no reason why the European market cannot sustain a similar level of issuance as it deepens and matures."
| Corp bond issuance in euros Q1 2000 |
| |
ebn |
% |
| Netherlands |
3.9 |
14 |
| France |
3.4 |
12.4 |
| Germany |
1.2 |
4.3 |
| Luxembourg |
1 |
3.6 |
| Other eurozone |
1.1 |
3.9 |
| Total eurozone |
10.5 |
38.3 |
| UK |
5.3 |
19.3 |
| Other Europe |
1.4 |
4.9 |
| Total Europe |
17.2 |
62.5 |
| USA |
7.7 |
28 |
| Asia |
1.7 |
6.2 |
| Other world |
0.9 |
3.3 |
| Total |
27.5 |
100 |
| Source: Capital Data BondWare |
| Corp bond issuance in euros 1999 |
| |
ebn |
% |
| Netherlands |
42.8 |
34.3 |
| France |
25.5 |
20.5 |
| Germany |
1.9 |
1.5 |
| Luxembourg |
2.7 |
2.1 |
| Spain |
1.8 |
1.4 |
| Other eurozone |
2.4 |
1.9 |
| Total eurozone |
77 |
61.7 |
| UK |
15 |
12 |
| Other Europe |
3.3 |
2.6 |
| Total Europe |
95.3 |
76.4 |
| USA |
21.3 |
17 |
| Asia |
7 |
5.6 |
| Other world |
1.2 |
1 |
| Total |
124.7 |
100 |
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