Banking is a nasty, brutish business, in which kindness is a scarce commodity. There is a time, however, which comes but once a year, when a spirit of giving pervades the air. That time is bonus time. As bankers begin to salivate, Euromoney attempts to spot who the big winners will be.
One thing is certain: the absolute amount of the payouts is enormous. Indeed, the payment of bonuses in the Square Mile is enough to skew the UK’s national wage average for March by a third of a percentage point, according to Derek Bird at the UK’s Central Statistical Office.
So which bank employees will have the most to celebrate? Sterling and Ecu bond dealers at BZW are set for a windfall. The gilt-edged market-making operations of the bank generated pre-tax profits of over £30 million last year – making it the most profitable of all the City’s gilt market-makers. The Bank of England estimates that the total profit of all 20 gilt market-makers was £13 million last year, which suggests that many other firms suffered large losses.
A close eye is being kept on the newly-merged investment banks. For the first time Deutsche Bank and Deutsche Morgan Grenfell (DMG) employees have the same employment contracts. In theory, harmonization means that Deutsche staff in London should do rather well compared to their counterparts based in Germany.
But DMG has strayed into a compliance minefield, with staff formerly employed by Deutsche Bank, ranging from board level directors to associate directors, facing surprise bills for national insurance and income tax payments. Payouts could be slashed by thousands of pounds.
Initially, Deutsche staff members were told that their bonus payments would take the form of preference shares in the parent bank, immediately convertible to cash. This method of payment allowed staff to defer tax liabilities for up to a year and dodge national insurance contributions outright. Early in February, however, Deutsche’s compliance department realized that senior directors, due to be paid in advance of the announcement of Deutsche’s final results, could end up dealing in bank shares during the closed season. Consequently, DMG will be forced to pay some former Deutsche staff their bonuses in cash. Adding insult to injury, former Morgan Grenfell staff, unaffected by the changes, will receive their bonus payment on March 6, nine days earlier than Deutsche staff.
Although it wasn’t a record, 1995 was a bumper year for Wall Street firms. The second half of the year saw huge returns in equities and M&A, while returns from fixed-income trading began to pick up in the final quarter. Smiles were broadest at Goldman Sachs, where 1995 proved a relief after the trauma of 1994. Sentiments were mixed at Morgan Stanley and Salomon Brothers, while staff at Lehman and Merrill Lynch are the most likely to be drowning their sorrows on bonus day.
There will be a large discrepancy between bonus increases for top management and those awarded to more lowly staff. “We’ve seen increases of between 30% to 40% for the high flyers, but only 5% to 10% for the processors,” says Joan Zimmerman, an executive vice-president at recruitment consultancy GZ Stephens.
Fearless traders were kept in check by fearful managers, imposing stricter risk management regimes. Traders are being charged for the inventories of stocks and bonds they keep on the firm’s books, with the risks incurred factored into individual profit and loss accounts.
The move towards awarding a bigger share of bonuses in stocks and stock options will continue this year. More and more firms require their senior staff to hold a minimum amount of stock.
“Despite the declining tax advantages of awarding bonuses in the form of stock, it’s seen as way of ensuring the loyalty of staff,” says Raphael Soifer, banking analyst at Brown Brothers Harriman in New York.
But for many staff, time spent at a bank remains a dash for cash, with no loyalty and no long-term perspective. “Banks have toyed with the notion of adjusting for risk and volatility, but most still opt for the easy option of paying bonuses purely on the basis of return,” says Mark Rodrigues, a principal at AMS Management in London.
Rodrigues refers to this as “the Forrest Gump phenomenon”. The scriptwriters of Forrest Gump, Eric Roth and Ernest Thompson, agreed a cut of the net revenue generated by the film, while leading man Tom Hanks negotiated a cut of gross revenue. But the studio claimed that the film made no net return, limiting the scriptwriters’ payment to a $100,000 advance. Meanwhile, Hanks pocketed tens of millions of dollars for his work on the film.
“Banks should follow the example of the studio and pay a performance bonus out of net returns, including an estimate of risks incurred,” concludes Rodrigues.
Ronan Lyons
EVENT RISK
Hanson provokes bondholders
Bond investors in the industrial conglomerate Hanson plc recently learned the meaning of event risk – a half-forgotten term dating from the buyout binge in the late 1980s – when at the end of January the group announced a demerger designed to split it into four parts. Worried about the credit quality of the demerged entities, investors sharply marked down the price of Hanson bonds. As a result, spreads over UK gilts widened by some 30 basis points (bp).
Event risk is a technical term describing a situation in which the credit rating of a corporate bond is affected – generally downwards – by an unforeseen special event, such as a takeover, restructuring or demerger. It first came to prominence nearly a decade ago during the US leveraged buyout boom, when bondholders complained bitterly about deals in which companies were either taken over by highly-leveraged vehicles or were forced to assume leverage themselves as part of restructuring plans in order to shore up their defence.
Hanson bondholders were particularly concerned by the company’s announcement that the bond obligations of Hanson plc would remain with the rump Hanson group after the demerger, while leaving open the question of allocating the bank debt. This, it said, would depend on the cashflow characteristics of the new companies. “Bond investors hate uncertainty,” says Shira Cornwall, head of bond research at BZW. “This has left a lot of unanswered questions.” Investors were also worried about the fundamental creditworthiness of the new Hanson, which will contain construction and aggregates businesses, as well as the group’s regional electricity interests. This makes it a far more cyclical business than the existing Hanson group and therefore likely to be accorded a lower credit rating.
The Hanson demerger is just one of a number of corporate deals in recent months which have left bondholders grumbling about their interests being sacrificed for those of shareholders. Granada’s highly-leveraged takeover of Forte was one bugbear, causing bonds in the latter to be downgraded and spreads to widen from pre-bid levels of 85bp to around 140bp now. Another was the fall last autumn in the prices of many regional electricity company (REC) bonds, prompted by a wave of bids in the summer from lower-rated US utilities.
Now investors are beginning to take defensive action. Following the Hanson announcement, prices fell in the bonds of what the market perceived to be “unbundling” candidates – conglomerates such as BAT Industries, Pearson and Grand Metropolitan – as institutions switched their funds into safer areas such as financials and debentures. “Event risk is definitely coming back as an issue for investors,” says Martin Wade, a fixed-income fund manager at Sun Life of Canada.
The market’s current bout of jitters is much more marked than it was in the late 1980s, largely because of the recent growth of the sterling bond market. Since 1990, when the UK’s decision to join the ERM encouraged international investors into the market, new issues have soared. In addition, falling interest rates and the economic upturn emboldened investors to open the market to issuers of lower credit quality, attracted by the prospect of higher yielding paper. Some are now ruing their former enthusiasm.
Investors first woke up to event risk at the end of 1994 when the engineering and construction conglomerate Trafalgar House launched a bid for Northern Electric. “This alerted the market to the attractions of a cash-generative utility to a lower-rated corporate,” says Andy Evans, head of bond research at SBC Warburg. Trafalgar House was ultimately beaten off by Northern Electric, but only at the cost of a scorched earth bid defence which substantially increased the company’s debt. This, says Evans, “indicated the extent to which utility companies could release value to shareholders to the detriment of credit quality”.
Other deals followed in the REC sector, including a series of bids from lower-rated US utilities. The net result was that spreads in the sector widened to take into account the possible downgrading of typically AA-rated utilities to single-A range.
Now, investors are beginning to demand that tighter covenants be built into bond agreements in order to give them better protection against event risk.
They are uncomfortably aware that in recent years bond covenants have been pared away by hard-nosed issuers, giving companies pretty much unfettered freedom of action to leverage themselves and undertake what restructurings they see fit without giving bondholders a cash exit.
“It’s been a function of supply and demand,” says Sun Life’s Wade. “There has been growing demand for sterling bonds – lots of funds chasing limited opportunities – enabling companies to issue bonds with extremely limited covenants.” This was particularly true in Hanson’s case. “Basically, the company was free to do what it liked,” moans one investor.
But what covenants to ask for? Warburg’s Evans is unconvinced that there is much investors can do to increase their own protection. “If you look at the classical covenants, specifying gearing and interest cover, these are generally so undemanding as to offer investors little real cover,” he says. “The other mainstay, which makes it a puttable event if a bond issue falls below investment grade, may be of value if you’re dealing with a single A credit, but with higher-rated companies, you’ve already lost so much by the time you get to put your bond back to the issuer that it hardly offers real protection.”
He may well be right, but investors are beginning to reward companies which offer tighter covenants. A recent 10-year £100 million issue by the AA-rated REC, East Midlands Electricity (EME), contains two covenants designed to deal with event risk. The first makes it a puttable event should an acquirer take over the company and transfer the electricity licence from EME to itself – a covenant pioneered by another REC, SWALEC, in a 20-year deal launched last year. The second ring-fences the electricity company, to prevent a new owner from stripping out EME’s retained earnings.
Analysts are sceptical about the value of these covenants but investors seem to like them. The EME issue, led by SBC Warburg, was launched at a spread of 67bp over the relevant gilt, broadly in line with where the better-rated credits in the sector, Yorkshire Electricity and London Electricity, were trading. “There was no need to offer a price incentive,” says a Warburg spokesman. The market reacted favourably to the deal.
The EME issue may well provide a pointer for the future, at least while the current wave of restructurings in the UK equity market continues. “I think you will see investors getting tougher and tougher on covenants in future,” says one fund manager.
Jonathan Ford
CONVERTIBLE BONDS
Borrowers’ market
For months, investment banks have been pleading with corporate borrowers to consider the Euroconvertible bond market. Conditions for issuers have rarely been so favourable. Falling interest rates allow borrowers to lock in record-low fixed-rate coupons and fund well below government borrowing levels. With equity markets at or near all-time highs, issuers can also be aggressive in setting conversion premia at implied share prices way above where they could hope to sell new equity.
Above all, convertible bonds are in scarce supply. In 1993 and 1994 many specialist convertible bond funds were established in France and the UK. Neither these, nor other traditional institutional and retail buyers of convertibles have had much opportunity to invest recently. “Many UK companies sold convertibles in 1993. They have had to wait three years before returning to the market,” says Rupert Hume Kendall, equity syndicate manager at UBS. This is because of limits on the amount of equity capital UK companies can issue without either special shareholder approval or offering pre-emption rights to existing shareholders. A rule of thumb in Euroconvertibles is that a regular issuer is one which comes to the market every three or four years.
Many outstanding Euro-convertible bonds are approaching maturity. Others are now so far in- or out-of-the-money on the equity component that they are trading in the secondary market either like simple bonds or like pure equity.
In February UBS re-opened the sterling Euroconvertible primary market with a 10-year £260 million ($395 million) deal for airport services group BAA. Demand was so overwhelming that UBS closed its book of orders after just one-and-a-half hours. The bonds traded up to 102% of issue price in the secondary market, despite offering a coupon of just 5.75% and a high conversion premium of 17.9%. The coupon does offer a pick-up over the 2% dividend yield on the company’s shares. Nevertheless the AA-rated company is borrowing at 200 basis points (bp) cheaper than the UK government.
“Investors are desperate for newly-issued convertible bonds launched at a decent premium, offering some yield in a low interest rate environment,” agrees Benoît Bout, equity syndicate manager at Banque Indosuez in Paris. “We and other investment banks are talking weekly to candidate issuers.” Last month, continental European companies finally heeded the call. In France, water utility Lyonnaise des Eaux launched a ffr3 billion ($595 million) deal, closely followed by media group Havas with a ffr3.9 billion issue. That’s two deals in two weeks compared with just three French convertibles of any size during the whole of 1995. Both deals were well placed, with French and British fund managers and Swiss retail investors prominent.
Unconverted French convertibles are redeemed at a premium to issue price. This guarantees investors a decent yield to maturity, even if the company’s share price doesn’t rise to make conversion worthwhile. The Lyonnaise des Eaux bonds carry a coupon of 4% with a conversion premium of 13.8% to the share price at launch. That coupon is a shade higher than the 3.8% dividend yield on the company’s shares. But the redemption formula guarantees an annual yield to maturity of 5.65%. That, plus strong name recognition, particularly attracts Swiss retail investors. Even with that yield to maturity, the company is borrowing at 65bp lower than the French government. Bankers say that French borrowers can lock in costs of between 50bp and 90bp below French government bond yields and that attractive growth companies might command conversion premia in the high teens.
Some potential issuers are holding back due to concerns over their gearing – convertibles count as debt, not equity – either because their shares trade on high dividend yields, so convertible buyers will require high coupons, or because they fear shareholders will disapprove of potentially dilutive convertible deals. Other issuers are waiting for conditions to be perfect. “Some leading French companies have just announced weak earnings,” says one banker. “So even though share prices are high, they would prefer their convertible issues to coincide with some good news and may wait until after their half-year results.”
Bankers are now knocking on the doors of Total, Générale des Eaux, LVMH and Accor hoping to persuade them to follow. In the UK, any FT-SE company with moderate gearing of between 25% and 40% and a dividend yield of under 5% is now in the gunsights of mandate-hunting bankers. There are still hopes that the Italian government will launch a bond exchangeable into shares of electricity utility INA. Swiss corporates are also candidates to issue. Bankers say that European companies could issue dollar-denominated convertibles and achieve spectacularly low coupons. Competition is fierce, as reflected in the 2% fee on the BAA deal, lower than the normal 2.5% for convertible bonds. Meanwhile Asian capital markets are enjoying a convertible bond binge of their own.
Recent deals have shown that a wide range of international buyers will now take up Euroconvertible bonds. These include specialist convertible funds; equity funds with certain income targets; retail investors; large dedicated bond funds in France, Italy, Germany and Switzerland which cannot buy equity but which use convertibles as a speculative addition to their portfolios; and hedge funds which buy convertibles and sell equity. BAA also sold a hefty portion of its deal in the US.
It would be fanciful however to expect convertible bonds to start appearing as frequently as conventional bonds. “This is not a commodity product,” warns Hume Kendall. “It is demand-driven.”
Peter Lee
ASIAN CONVERTIBLE BONDS
Return of the Asian issuers
The Asian convertible bond (CB) bonanza is back, with new issue volume predicted to be in excess of $3 billion for the first quarter of 1996. A total of 54 Asian corporations issued only $3.43 billion in CBs during 1995, largely because of poorly performing regional bourses and an uncertain interest rate environment. Investment bankers are now predicting a return to the primary market glut of 1993 and early 1994, when $12 billion of Asian convertible paper hit the market.
“The market is about to explode,” says Carson Cole, head of convertible research at UBS Securities in Singapore. “There is an almost limitless supply of large Asian corporations with very aggressive expansion plans which, mainly for reasons of credit, are denied access to the international straight debt markets. In an environment of very low interest rates and bullish regional stock markets, convertibles offer the easiest route and lowest cost of funds for most of these companies.”
With echoes of the 1993 boom, when Morgan Stanley opened up the Asian convertible market with a $402.5 million issue for Wharf Capital, Hong Kong has again got the ball rolling. A $130 million exchangeable deal for property group Paliburg Holdings was jointly led by Jardine Fleming and UBS in late January and was quickly followed in early February by a five-year $175 million issue for Sino Land led by Jardine Fleming.
Investors will be hoping that the comparisons with 1993 stop here. Emboldened by regional stock market gains of over 100% in that year, corporate financiers fell over themselves in efforts to bring Asian CBs to the market. “No attention was paid to the needs of the investment community. Credit concerns were non-existent with the result that a number of dubious names entered the market. And by early 1994, when interest rates began their rise, pricing had become farcical,” says the director for international equity syndication at one US investment bank in Hong Kong.
Aware of their poor track record, investment bankers are keen to stress that things will be different this time and that the market is more mature. “You will only be seeing quality names, and deals are being much more carefully structured,” says Colin Hermon, director of capital markets at Jardine Fleming. “Competition for mandates is as fierce as ever but there is an all-round awareness that a more level-headed approach is required.” The blue chip standing of issuers including Indonesia’s Indocement (which road-showed a $150 million transaction led by Morgan Stanley in mid-February) and Taiwan’s Winbond (which offered a $250 million CB jointly led by Salomon Brothers and SBC Warburg) suggests that close attention is indeed being paid to the calibre of borrowers.
Bankers note the emergence of a more sophisticated investor base. “Previously there was a feeling that anything with an Asian name would fly,” says the US syndicate chief. “But after two years of tight markets and a greater familiarity with Asian products, we know that investors will be more selective.” The relatively strong performance of the secondary CB market in the past year has also provided investors with a series of benchmarks upon which to judge the new issue market. “We continued to champion Asian convertibles throughout 1995,” says Cole, “because they appeared unusually cheap relative to share valuations. Most convertible issues had little room to fall further because their yields were high enough to attract fixed-income investors, and a substantial drop in US interest rates further increased convertible valuations.”
Hong Kong issues recorded the best absolute performance, increasing by an average of 14.8% in 1995. And the best relative performer was India, where convertibles rose 2.4%, while their underlying shares fell 38.7%. “An increasing number of fixed-income buyers were buying the issues which have been at high yields, regardless of the fact that their underlying equity valuations were declining [in 1995]. Even today, the average Euroconvertible in India is yielding 7.6%, which is 220 basis points (bp) over the 7-year US Treasury yield,” says a Hong Kong banker.
Early investor reaction to the 1996 crop of Asian CBs has been largely favourable. The Paliburg issue, which is exchangeable into the shares of group subsidiary Regal Hotels International, was increased from $125 million to $130 million because of strong demand and was nearly three times oversubscribed. A $100 million offering for top-rated brokerage house Finance One of Thailand in early February was also well-received and oversubscribed seven times. The five-and-a-half year deal was priced at par with a 2% coupon and an 8% conversion premium.
Tony Shale
