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"The risk area has moved from triple-B to single-A, causing a flight to double-A names. Double-A now pays as much as a single-A did eight months ago, so it’s just a case of maintaining similar investments"
Michael Nelskylä, RBS |
When the credit crunch hit in August, one consequence that passed relatively unnoticed was that holders of extendible notes decided in large numbers that they did not want to extend their investment any further. They began putting the notes. But despite investors having put nearly $250 billion of extendible notes since the summer, the market has been very active so far this year. "In the current environment there is a tendency towards putting notes," says Michael Nelskylä, European head of structured investor products at RBS. "There is now a significant amount of uncertainty in this space."
That uncertainty is a result of investors viewing X-notes as short-term securities that can be extended, while many issuers have seen X-notes as having a more medium-term character. Before the crunch, this created a win-win situation where investors could hold a note that paid out higher yields (with each annual step-up) than regular short-term investments, while issuers could fund in the medium term at relatively cheap prices. But when yields jumped at the short end after August, investors had no incentive to retain the paper. Come August 2008, many issuers have a lot of paper to redeem.
Turn back
The fact that liquidity is at a premium, and other forms of funding extremely expensive, if available at all, mean issuers have turned back to X-notes. Nearly $55 billion of new or repeat issuance has taken place since the beginning of January. The market has staged a recovery, but this has been confined to credits that are, by and large, double-A rated. "The risk area has moved from triple-B to single-A, causing a flight to double-A names," says Nelskylä. "Double-A now pays as much as a single-A did eight months ago, so it’s just a case of maintaining similar investments."
On the investor side, there has been good traction among those participating, although the investor base has shrunk substantially. Back when all was rosy in the financial markets, there were between 50 and 75 individual accounts making up the natural X-note investor base. Now that number is between 20 and 25, mostly US money market funds. Before the crisis, an average X-note order book included a number of securities lenders. Now, as in other markets, these are largely absent. "There are now fewer investors," confirms Andrew Ellis, executive director of money market origination at Goldman Sachs. "But those that are left are large enough and significant enough to allow decent deal sizes, albeit at prevailing spreads."
Maturity mismatch
Presently, those spreads are wider than at the turn of the year. A double-A rated US bank could have issued at around Libor plus 20 basis points at the beginning of January, but would have to settle for about 25bp now. Before August that spread would have been Libor less 3bp or 4bp. Step-ups are around 2bp a year, where before the crunch that figure would more than likely have been half that.
These figures are prompting issuers to look at shorter maturities. Traditionally, X-notes are issued with an initial maturity of 13 months, so as to slot into the maturity restrictions placed on (2a7) investments made by the US money market funds that make up the majority of the X-note investor base. Investors can then choose to extend their investment, with issuers given the option of calling the note after about five years.
But issuers are understandably reticent about committing themselves to a potential five-year issue at between 20bp and 30bp. If the environment improves within those five years, the issuers will be left with an overhang of debt that pays out at today’s inflated prices. As a result, many issuers are now trying to push deals with shorter initial maturities, rather than the normal 13-month period, on to investors.
"We are focused on three-month deals now," says Richard Soundarjee, head of structured bond syndicate at Société Générale. "That way we can create less volatile and more defensive structures."
Lock-in
This might be possible in smaller deals that can be privately placed but will not fly among traditional money market funds. Issuers might be interested in shorter maturities but investors are making it clear that they are not. And, as in so many other sectors, it is now a buyers’ market. "Unsurprisingly, investors prefer to see the full five-year issues on offer," says Ellis at Goldman Sachs. "There is not much in the way of support for shorter maturities. Investors want to lock-in the good rates."
So, for the time being, issuance of X-notes will be confined predominantly to banks rated double-A or better. Others that cannot issue in this environment will most likely defer the problem of refinancing until the notes that haven’t been extended come due in the summer. At that point, alternative refinancing sources, such as certificates of deposit or commercial paper, will be used, depending on where the market lies. That is the source of uncertainty in the market right now, but the fact that there is still a market at all is at least a little encouraging. "I’m broadly optimistic that the market will continue to function," says Ellis. "Traditionally, money market investors have found the extendible structure very attractive."