Credit bash crowds out Crillon
Use your debt lest someone else does
The good, the bad and the illiquid
In June a €500 million ($510 million) deal by French construction and communications company Bouygues threw the new corporate-bond market in Europe into chaos. The borrower had mandated Crédit Agricole and Lehman Brothers to do a Eurobond deal, but it was assumed that this would be aimed at domestic investors. Early price discussions involved a price of around 70 basis points over OATs; extremely tight for an unrated debut borrower in the Euromarket, but theoretically possible if selling to retail investors in France.
As the deal size was relatively large, there was not sufficient demand for all the paper from French investors. The corporate market was becoming overcrowded and rising government bond yields were bringing more volatility. Lehman realized that the only way to drum up demand abroad was to increase the spread to 95bp. The two banks managed to come to an agreement and launched the repriced deal at 95bp on June 17, after a roadshow in Paris and investor meetings in London.
The deal aroused a lot of bad feeling, as the earlier price had become known in the market. In the hours before launch, rumours circulated that the price was going up and up. The fact that the lead banks had been forced to take drastic action by repricing the deal gave it an even worse reputation. This year, bankers have learnt the need to generate strong momentum behind corporate-bond issues. Success is as much about sentiment as crunching company’s financial statements. This deal generated the wrong sort of momentum.
Rival banks were resentful because they had tendered bids for the Bouygues deal at around 95bp but were rejected for being too expensive. They assumed that Crédit Agricole and Lehman had won their mandates on the basis of unrealistic tight bids: aggressive pricing and league-table manoeuvring have become common problems in the market.
The episode showed how easily confidence in European corporate debt could be shaken. In the days following the Bouygues deal some issuers even decided to postpone their deals to the following week for fear of widening spreads. For a few days, Europe’s corporate-bond market lost its sparkle.
Two approaches to pricing
At the heart of the Bouygues situation was the difference in approach to pricing between the international investment houses and some of the European commercial banks. The latter continue to target investors in their home countries as if the domestic bond markets still existed, by quoting tight, domestic-style pricing.
The investment banks, on the other hand, prefer to sell to international investors and believe that pricing needs to be higher to attract them to a corporate name that may not be known outside its home country. Most corporate debt deals this year have partnered regional commercial banks and investment banks as book-runners, a combination that has often led to conflict. The chief financial officer of another French corporate issuer recalls his unease when he asked banks for advice on pricing a e1 billion deal and receiving quotes 25bp apart. One bank said the company could raise no more than e500 million. It did.
After the honeymoon period of the first quarter of 1999, when almost any corporate paper could be sold at relatively tight spreads, the European corporate debt market ran into trouble. As borrowers raced to enter the market, as investors scrambled to get their hands on desirable corporate paper, and as banks hurried to jump on the bandwagon, mistakes were made. Pricing was aggressive, and as deals flooded the market investors saw that they could afford to be more choosy and didn’t have to accept new bonds that weren’t good value. This change was set against an increasingly volatile government-bond market dogged by fears of interest-rate rises.
But as the second half of 1999 opens up it seems that these first setbacks have been largely overcome. The eventual price of 95bp on the Bouygues deal proved to be suitable and bonds sold well outside France. Investors may be slightly more cautious than in the first half, domestic investors may be less willing to offer tighter pricing to corporates than international investors just because they know the companies well, and pricing deals may be tricky, but the volume of business continues to grow rapidly. The market is gaining size and solidity.
No-one could have foreseen last year that the market would take off so quickly. In the first six months of 1999 alone, €149 billion worth of bonds have been issued by corporates in Europe compared with €74 billion in the same period of 1998. Issuance for the first half has far exceeded what most analysts had predicted for the whole year.
Many companies have visited the debt markets for the first time, both high-yield, start-up companies and blue-chip household names. There has been a large increase in single-A and triple-B rated companies coming to market. “Almost overnight we have seen a new type of market develop,” says John Winter, head of debt capital markets at Deutsche Bank.
The amount of euro-denominated issuance, over 70% of all deals, has been particularly staggering. “Nobody anticipated the readiness of domestic investors to invest in cross-border euro-denominated corporate paper so early,” says Anthony Barklam, syndicate manager at Morgan Stanley Dean Witter. “Borrowers have suddenly realized that there is an appetite for their name in a currency that contains a vast number of different investors.” The dollar has been sidelined as the corporates’ currency of choice, even for many outside the eurozone. At the start of June, for example, UK media group Pearson intended to do a dollar deal, but found that there was little demand. It switched to euros and the deal was not only a success but was increased in size.
Irresistible forces
The forces propelling the corporate-debt market forward are strong. The introduction of the euro allows investors to look outside their domestic bond market and to buy into companies in other eurozone countries without having to deal with currency risk. “Particularly in places like Germany, where investors in the past had centred on Deutschmark issues, investors have been keen to look at new names,” says Andy Lothian, head of dollar syndicate at Dresdner Kleinwort Benson. Restrictions which prevent many European investment funds from buying bonds below a certain credit rating are gradually being relaxed, giving fund managers more flexibility.
The factors pushing companies towards issuing bonds are just as powerful. The forces of consolidation currently affecting every sector of European industry are increasing the flow of M&A deals. Companies are under increasing pressure from their shareholders to maximize return on equity, through cost-cutting, balance-sheet restructuring and investment in new businesses. Even businesses that are not hell-bent on making acquisitions are thinking about increasing their gearing and paying attention to the cost of capital. All this restructuring activity demands ever larger sources of funds, and the bond market is best equipped to meet these needs.
At the same time, Europe’s commercial banks have been coming under similar competitive pressures. They can no longer afford to lend to corporates at unrealistically low rates without damaging their own productivity and leaving them open to takeover.
The start of 1999 was dogged by the hangover from the Russian crisis; spreads were still wide and liquidity was still non-existent. The flight to quality by investors in the previous months meant that new issues came mainly from the top of the credit curve. But it was not long before the potential opportunities of the corporate market, for issuers, investors and bankers alike began to become clear. Institutional investors still had to deliver returns, and, post-euro, these could only be found in credit.
By February investors were telling the bankers to find them corporate paper, and this demand coupled with the low-interest-rate environment meant that spreads tightened dramatically. Faced with little choice of deals, investors felt compelled to buy whatever was put in front of them. “In the first quarter I was struggling to find places to put my money,” says Stephen Holmes, credit analyst and fund manager at Fleming Asset Management.
Bankers on the syndicate desks could hardly believe their luck. “You could have brought almost any name to market and people would buy,” says a member of one origination team. Aggressive pricing quoted to borrowers by banks eager to establish themselves in the new market helped corporates to be less reticent about leaving the cosy world of bank lending behind.
Vehicle manufacturer DaimlerChrysler issued two euro-denominated deals at the start of the year, a e200 million issue on January 11 and a e600 million issue on February 23. Both were increased in size and still oversubscribed, illustrating the demand for quality corporate names. “The emotion for these deals in the market at the time was more like that for an IPO, a frenzy of tremendous enthusiasm,” says Winter at Deutsche Bank, one of the book-runners on the deals.
British American Tobacco was one of the early borrowers, and despite the caution investors sometimes feel towards tobacco companies, its deals generated plenty of demand. At the start of February BAT brought a e1.7 billion issue to market, led by Dresdner, which was at the time the largest-ever single-tranche corporate bond denominated in euros. The deal started life as a e1 billion tranche, but was oversubscribed. “Purely on investor demand the deal was increased to €1.7 billion,” says Stuart Bell, corporate syndicate manager at Dresdner. The deal achieved pricing of 125bp over the 2009 Bund. By May the spread had tightened to 105bp. The company has since launched two more well-received bond issues worth a total of e1.7 billion.
In the same week as the first BAT issue, deals were launched by French telecoms company Alcatel and Spanish electricity utility Endesa, giving the market further momentum. Alcatel’s e1 billion deal, jointly led by BNP and Deutsche, was priced fairly tight at 58bp over OATs. CFO Xavier de Mezerac was surprised when only 25% of the deal was bought by French investors, and 28% of the deal was sold to Italian investors, with German, UK and Benelux investors also taking large portions. “The market has really opened up,” says de Mezerac. “That a French corporate can sell its bonds primarily to Italy is something new.”
Alcatel’s share price had dropped substantially in the previous six months because of disappointing earnings, and BNP felt that its name would be out of favour with domestic buyers. Deutsche was confident that international investors would take a more long-term view of the company, and insisted that it would be possible to sell an increased size of e1 billion without relying on the home market. “It was a wake-up call to the market,” says Winter. “It showed that there was demand for high-quality French corporates outside France.”
The money was raised by Alcatel to fund the acquisition of several start-up internet firms in the US, part of the company’s reinvention in telecoms and move away from its previous life as a sprawling conglomerate. Alcatel was pleased with the preparation work done by all the banks in the syndicate, especially as they had only been mandated a few days before the deal was launched. The book-runners were selected not just on the price they promised but also on their ability to secure widespread distribution. “Choosing the banks was a competitive process, and price was very important, but it was not the only criterion,” says de Mezerac.
French boom
In the second quarter there was an astounding amount of issuance from France, as consolidation in the banking sector took off and the old culture of bank lending came to an abrupt halt. “France has some superb companies coming to market,” says Winter at Deutsche Bank. The boom in French issuance will be echoed by waves of deals coming from Germany, Spain and Italy when M&A, particularly in the banking sector, takes off in each country. “As banking sectors consolidate in other countries, this is a catalyst for corporate-bond issuance,” says Stuart Sweeney, head of European corporate debt syndicate Warburg Dillon Read.
A high level of M&A activity across all sectors in France and a need for large amounts of funding have led companies to seek a wider investor base outside the domestic market. French issues in the first half of 1999 included Carrefour, Saint-Gobain, Elf Aquitaine, Renault, Lafarge, LVMH and the much-maligned Bouygues deal. “The French corporates have been the main issuers in the market in the first half of this year,” says Frederic Zorzi, co-head of corporate syndicate at Banque Nationale de Paris.
Retailer Carrefour and oil company Elf Aquitaine both launched deals in the first week of March, but the differing market reaction highlighted the importance of pricing and thorough preparation. Carrefour’s issue of e1 billion was announced on March 2 and led by Barclays Capital and BNP, and was intended to refinance its 1998 acquisition of French supermarket chain Comptoirs Modernes. Elf’s deal hit the market two days later, this time led by Goldman Sachs and BNP. Both are AA-rated 10-year deals, and Carrefour offered investors 41bp over OATs. Elf pitched its deal slightly tighter at 39bp over.
The Carrefour launch was preceded by roadshows in five countries and extensive bookbuilding. The marketing efforts were rewarded when the paper was easily placed across Europe and the spread tightened by 1bp. Elf, on the other hand, carried out less than two days of pre-marketing. Elf had posted its results for 1998 a few days earlier, and wanted to tap the market on the back of this and do a deal as soon as possible.
Elf’s hasty approach displeased many members of the deal’s large syndicate, some of which dumped their paper into the grey market, causing much confusion before pricing. BNP and Goldman managed the situation well, however, and had placed two-thirds of the paper by the time the deal was launched. Other market players criticized Elf for its aggressive pricing and for being overly opportunistic, and pointed out that the deal was only saved because of the company’s good name and benign market conditions.
New market conditions
The trend of aggressive pricing intensified into April and May, particularly among French corporates that by now had become the darlings of investors across Europe. But as market conditions soured and investors became more discerning, an aggressive pricing strategy was proving less and less successful. “The volume of corporate issuance from France has been massive and French corporates have been trying to engineer the lowest spreads possible,” says one syndicate manager. “But aftermarket trading of some of their bonds can be poor and they have not helped themselves for future issuance by angering investors.”
Deals launched from the beginning of May onwards have had to contend with a new set of market conditions. Rising interest rates, a weakening euro and worries about the emerging markets have been tempering investors’ early enthusiasm for credit. “The market has become a more volatile place,” says Winter at Deutsche. “The deals that struggle are ones that do not reflect the change in the market.” Or as one fund manager puts it: “The market isn’t prepared to be ripped off any more.” All spreads have widened and corporates can no longer get deals done at rock-bottom prices, even if it targets investors in its home market.
As more deals enter the market, investors become more expert at differentiating between good and bad deals, so borrowers have to compete harder for investor attention. “It is surprising how discerning the market has become, investors can now see through aggressive pricing,” says Holmes at Fleming Asset Management. “I don’t have to buy every deal that comes along.” Busch at Morgan Stanley agrees: “The market simply will not stand for transactions that do not work in the first three or four days of their life.”
A deal in May by German engineering and telecoms conglomerate Mannesmann showed that even a bond issue by a well-respected corporate name is not immune to the vagaries of the market. After much expectation, on May 18 Mannesmann launched the largest single-tranche corporate deal the market had seen so far, a €3 billion 10-year bond led by Deutsche, Dresdner and Commerzbank. Days later, Spanish oil company Repsol eclipsed this record with a €3.25 billion FRN in a week when the sizes achieved by corporate deals stunned the market. Because of investor demand the Mannesmann issue had been increased from e2 billion.
Mannesmann entered the market to finance the acquisition of o.tel.o, a German fixed-line telephone business bought to complement its existing fixed-line operation, Mannesmann Arcor. The rest of the money raised was used towards the refinancing of a €7.6 bridge loan for the purchase of Italian telecoms businesses Omnitel and Infostrada. Mannesmann was buying out its partner in these ventures, Olivetti, which needed the money to help pay for its acquisition of Telecom Italia.
Few companies illustrate the shifts taking place in corporate Europe better than Mannesmann, a German company that has refocused its businesses away from heavy engineering towards the more glamorous and faster-growing telecoms sector, financing a strategy of growth by gearing up its balance sheet as well as by divesting non-core businesses. “It is our target to be the number one competitive operator in telecoms in Europe,” proclaims CFO Joachim Rauhut.
Mannesmann’s strong corporate story could have been expected to lead to a blow-out deal, but when the e3 billion issue was launched the three bookrunners had to fight to keep control of spreads. The week before, higher than expected US inflation figures had been announced, causing widespread anxiety about market conditions. The bookrunners admit that they had to put a lot of work into reaching a price on a deal of this size considering the mood of the market.
Mannesmann’s association with the Telecom Italia saga also injected some uncertainty into the deal, as the firm would only be buying Omnitel and Infostrada if Olivetti succeeded in its takeover bid. Another complication was the choice of bookrunners. Mannesmann wanted to reward its main domestic relationship banks for arranging its bridge finance at a low price, but having three rival German banks underwriting an issue is hardly the optimum situation for coordinated execution or widespread distribution of paper.
In the end the deal was priced at 70bp over Bunds, perceived to be a fair price if not overly generous. It was assumed that the Mannesmann name and its persuasive restructuring story would sell the deal to investors. The paper sold fairly well outside Germany but within two days the spread had widened to 75bp. As the week drew on it was clear that investors were being influenced by the expectation surrounding Olivetti’s Tecnost FRN, which totalled almost €9.5 billion and was launched on June 3 at an effective spread of 190bp. “The announcement of deals such as Tecnost, Yorkshire Water and Manpower at very attractive spreads has put a lot of pressure on the secondary market,” says Zorzi at BNP.
The Bouygues episode, and other difficult deals around the end of the second quarter, may have signalled the end of the market’s initial euphoria and the beginning of its maturity. The financial community is becoming more critical of bad deals and seems adamant that the market will not be harmed by the irresponsible actions of a few.
Banks accuse each other of making cheap bids to borrowers and consequently having to keep considerable amounts of paper on their books. Or worse, promising one spread and then widening it nearer the launch date. “Some banks are very long of paper and will be hurt if the bond markets get choppy in the second half of the year,” says Paul Hearn, head of European capital markets at JP Morgan. Few banks have escaped criticism.
In their defence, originators point out that if the market moves between a mandate being awarded and the launch of a deal there is no alternative but to widen the spread, and that borrowers will eventually come to terms with this. In addition, there are still very few templates for pricing in corporate debt, and it is inevitable that some misjudgments will be made while all participants learn how to handle the market. Hearn says that the nature of corporate debt means there is rarely a foolproof method for finding the right pricing. “Corporate pricing is always a lot more of an art than a science,” he says.
Though the market is growing out of some bad habits, inevitably banks will use all their tricks in order to get ahead of the crowd. “There are still banks running around trying to buy market share,” says Hearn. “You always run the risk that people are playing to borrowers’ greed.” Barklam at Morgan Stanley agrees. “There continue to be frequent instances where a company takes bids from banks and awards its mandate to the cheapest bank, which then widens the price before the deal is launched,” he says. “This just penalizes banks who give a realistic view.”
Even when deals appear to go well, there are often dramas behind the scenes. One particular bond deal that came to market in July, and in the event was a success, was beset by problems and charges of incompetence between the leads. The deal was led by a European bank paired with a US bank. The US firm alleges that the night before the deal’s launch the European bank wanted to pull the deal and then insisted on scaling back how much paper it would take. On the morning of the launch it became clear that the European bank was selling its bonds at a discount price, undercutting its book-running partner and poaching many of its investors. “This is irresponsible behaviour, and could have harmed the deal,” says a source at the US bank.
Strategic thinking
One trend that should ease pricing chaos is the decline of the bid system for awarding deal mandates. Borrowers are still looking for a competitive price, but they are focusing on which bank will be best at execution and distribution rather than just choosing the one that quotes the lowest price. “Issuers care more and more where their bonds trade in the aftermarket, and they want their paper placed on the first day,” says Busch at Morgan Stanley. Corporates have realized that a well-sold deal will improve their chances of securing tight pricing on future visits to the market.
Members of the banks’ syndicate teams are finding that borrowers are learning all the time about what makes a deal successful. “A lot of borrowers are very wise and know what the market means, and are giving more and more flexibility to the syndicate people on the execution of the deal,” says Zorzi at BNP.
As corporate strategy becomes increasingly ambitious, borrowers will need to come to the markets more often and with ever-larger deals. “The vision of senior corporate managers has really grown,” says Busch. “As the fight to become the dominant players in each sector across Europe intensifies, companies are thinking really big and have significant strategic initiatives in mind that will need to be funded.”
Bankers thinks that deals like Bouygues illustrate the difficulties unrated borrowers have in securing a stable price. “Bouygues highlighted the variation of price views that investors have when looking at unrated companies,” one banker says. “It was a watershed for showing that having a rating makes a difference.” When a corporate name is not known to investors, they often have to rely on credit ratings as a pricing guideline. However, James Gledhill, a fund manager at M&G Asset Management says that he is not guided by credit rating. “I like buying unrated paper because even though it can be a little illiquid it is usually cheap and good for a long-term hold.”
Many companies that had previously avoided being rated, preferring instead to rely on their good name in the domestic market, are now seeking a rating. Rating advisory services, which provide coaching to corporates on how to handle the credit agencies and prepare the required documentation, are becoming a growing business for investment banks.
Investors have learnt rapidly about the new market. “The sophistication of investors to understand corporate credits is high and rising,” says Winter at Deutsche. “They don’t just rely on credit agencies any more, but increasingly do their own research. In fact the market often ignores ratings and prices deals on its own perceptions of credit quality.” Some investors remain sceptical of banks’ credit research, which is voluminous and usually very positive at the time of a new issue and then tails off.
Producing credible and effective credit research is a growing priority at banks. Although there has been strong coverage of high-yield debt for a few years, research on investment-grade deals is becoming more common, more impartial, and more in the style of equity research. More funds are hiring their own credit researchers, something that “has put funds in a stronger position to pick winners”, says Winter.
Investors demand contact
Fund managers are also becoming more assertive about what they want from borrowers. “Corporates are now accepting that the investors need to meet the management,” says Gledhill at M&G. “I would take a dim view of a company not doing a roadshow, and would not consider buying the deal.” Another fund manager explains that unrated and lower-rated companies have a particular need to meet investors face to face. “I wouldn’t buy a triple-B bond without meeting management. Management is crucial to such companies and I want to sit down with them and look them in the eye.”
Because of the heady pace of M&A activity in Europe, the notion of event risk is becoming more important to investors. They look for a stable or improving credit story but most are not upset by a credit downgrade if it was what they had expected and allowed for when they bought the paper. Investors are not impressed by companies that launch a takeover bid having told investors that their recent bond deals were intended for “general corporate purposes”, hoping the pricing would be tighter. “What people are going to do with the money you are about to lend them is an important consideration,” says Gledhill.
Several developments are expected over the next 12 months. When there is more of a spread history in the corporate-debt market, investors will be able to see more clearly what deals represent good value, and there will be more secondary-market trading. Deals will grow in size as liquidity continues to be a concern, and there will be more deals with longer maturities. As more pension funds come into the market there is more demand for longer-dated paper to match their liabilities. There will also be increasing diversity, and issuance will not be dominated by the telecoms sector.
Barring another economic crisis, the outlook is good for the corporate debt market, and many think that its recent trials have forced it to grow up. Busch at Morgan Stanley thinks that most of the current anxieties are just nerves. “One reason that the market is feeling nervous is that it is the first time that they have seen these levels of activity,” she says. “The next big test,” says one fund manager, “will be the first downgrade of a triple-B issuer to below investment grade. Many investors will be forced to sell and realize losses. It will be interesting to see how markets react.”
Wall of issuance
A more pressing problem now is that the abundant deal supply shows no sign of drying up. “We are getting a small wall of issuance which is slightly overwhelming the market, as people trying to beat any August lull,” says Gledhill at M&G. “The weight of supply is stopping this market from performing fully,” says Barklam at Morgan Stanley. “Why else would spreads be as bad as they are?”
Barklam says the pace of deals can be too fast for investors to look at everything on offer. “Morgan Stanley held five corporate roadshows in the first week of July in five different cities, and that is just one bank. In Paris, there were six other roadshows on the same day. Key investors cannot be at six presentations at once,” he says. Issuers will never coordinate the timing of their deals, and so if they find themselves issuing at a busy time they will have to make all the necessary efforts to make themselves attractive. “Getting investors’ attention is the difficult thing at the moment,” says Gledhill at M&G. The increasing number of virtual roadshows via Bloomberg is a useful way of coping with the understaffing at investment funds.
Another influence on spreads has been the mammoth financings for Tecnost, the funding vehicle for Olivetti’s takeover of Telecom Italia that has since June raised a total of e15.7 billion. The unprecedented size of its deals has meant that it has offered investors very impressive yield relative to its credit rating. Before Tecnost’s €6.25 billion bond deal in July it is said that many investors stopped buying new issues and waited to see what generous spreads Tecnost would offer next. “This will put more pressure on the triple-B names to compete through generous pricing,” says one syndicate manager.
The Olivetti saga has also shown that high levels of gearing are becoming more common in European corporates, especially in businesses with dependable cashflows like telecoms. There will undoubtedly be more takeovers financed almost completely by debt, and transactions of ever-greater size. At a recent conference in Paris, JP Morgan hosted presentations by a variety of corporate issuers. Almost one-third of the European companies had double-A ratings. As he jumped into a taxi at the end of the conference one fund manager looked ahead. “If they do that conference again two years from now, they’ll struggle to find a single double-A rated corporate left in Europe.”
Credit bash crowds out Crillon
JP Morgan hosted a corporate bond conference at the Hotel Crillon in Paris on July 9. The Morgan bankers had guessed that a Friday in the summer at one of the best hotels in Paris would be a reasonable attraction. But even they were surprised at the attendance – there was standing room only at several presentations and they were relieved that excessive festivities on a boat trip down the Seine on the eve of the conference delayed some delegates’ arrival at the morning sessions.
The high attendance underlined the topicality of the conference. And if any investors were bleary-eyed, Guy Coughlan, head of portfolio research, should have wakened them with some surprising findings from his team’s recent investigations into the risk-and-return characteristics of portfolios of credit bonds and government bonds. Coughlan isolated the performance due to credit in various portfolios by matching out currency and interest-rate profile between government and corporate indices. He looked at US corporate and government bond portfolios over the periods 1983-92, 1985-89, 1973-92 and 1926-97. His message: not only do credit bonds outperform government bonds, they are also less volatile and less risky. His conclusion: “Investors should hold much more credit than they believe. At least 50%, and depending on investor type up to 80% of portfolios should be in credit.” He adds: “These are enormous numbers by the standards of what investors are actually planning to do in credit.” A bold domestic investor used to owning government bonds might be planning to put up to 10% of its holdings into credit bonds. It is exactly this type of investor, Coughlan argues, that should ideally be shifting up to 80% into credit bonds.
When it comes to Europe, there is far less historical data available to compare corporate and government bond performance. Looking at the period 1995-99, Coughlan finds similar returns from corporate and government bonds, but he points out that this period includes the dramatic credit-spread widening of October 1997 and August 1998. Suddenly, turning a little more subjective, and drawing on parallels with the US market, he projects long-run excess returns for credit over governments of 50 to 70 basis points. Even if returns are equal, investment-grade corporate Eurobonds have historically experienced lower return volatility – between 70% and 90% – than that on government bonds. Here there is a clear distinction to be drawn with below-investment-grade corporate bonds where returns are much more, up to 300% that of governments. “High yield is clearly a separate asset class,” says Coughlan. But corporate bonds have less downside than governments, even during periods of market stress such as last August, as long as they are diversified, because there is a low correlation between credit events for different investors.
At this point, some investors might be forgiven for wondering whether the sudden discovery of the magical qualities of corporate bonds is not a little convenient for a bank that clearly aims to arrange lots of corporate bonds. And why have government bonds seemed like such a good market to be in for so long. The answer is that government bonds do provide the opportunity for excess returns and lower volatility for global investors, with few restrictions on their investments and who can trade in and out of many government-bond markets for diversity and profit. That’s why JP Morgan recommends that such investors move only to 60% credit in their portfolios, while domestic-oriented buy-and-hold investors are best advised to move more heavily into credit up to 80%.
Coughlan says: “We have spent the last month or two presenting these results to investors and it’s gradually beginning to change the way they think about credit. We’re now expecting the shift from governments into credit to be even greater than we earlier thought.” As they seek to take more exposure to credit, investors are worried about still limited opportunities to gain much needed diversity. Some are seeking it through credit derivatives, because there aren’t enough bonds outstanding. For the moment, corporates wondering about whether they might expect a strong welcome in the bond markets might do worse than study the gaps in market outstandings from a portfolio perspective. There aren’t many bonds for European energy or technology companies, for example. There are plenty of lead managers whose portfolio advisory teams would be eager to point these gaps out to issuers. Peter Lee
Use your debt lest someone else does
An oft-cited reason why the European corporate bond market will continue to grow is that the pressure to provide shareholder value will force European companies to leverage up at a time when banks, facing the exact same shareholder pressure, are less keen to lend. At a conference in July, Paul Gibbs, head of mergers and acquisitions research at JP Morgan, attempted to apply scientific analysis to this much-touted link between increased leverage and shareholder value.
Gibbs set out a new way of analyzing a company’s weighted average cost of capital. That is the weighted cost of its debt and equity. It is intuitive that the more debt a company has, the lower its cost of capital, because equity investors demand a risk premium over debt providers. The lower that weighted average cost of capital, the lower the discount rate markets will use to value a company’s expected free cashflow and the higher the appropriate value – and therefore share price – the market will place on a company.
That raises the contentious question of how to measure the cost of equity. Gibbs says: “Most academics look at the wrong data. They look at historical equity returns but equity returns can come from falling interest rates or inflation that have nothing to do with a firm’s cost of equity today. The equity market is priced on the future. And you have to calculate cost of equity using today’s market prices.”
Gibbs uses a dividend discount model to derive the returns priced into equity markets. So in the UK on June 30, the dividend discount rate for the FTSE 100 was 7.76%. The expected return on the equity market is the premium of this rate over the 5.12% risk-free yield on benchmark 10-year government bonds. To calculate the expected return – and therefore the cost of equity – for a specific stock, Gibbs multiplies this risk premium of 2.64% by the beta (volatility measure) of the specific stock and adds back the risk-free rate. So for a low beta stock such as British Telecom, the cost of equity is the risk-free rate (5.12%) plus BT’s beta (0.64) times the equity market risk premium (2.64%). It’s cost of equity is 6.81%.
That doesn’t look very high, but reflects the high value put on low-volatility stocks in a open equity market, during a time of low and stable interest rates and inflation. Gibbs’ analysis shows a low cost of equity (6.55%) and equity risk premium (1.81%) in Finland – which basically reflects the dominance of the highly regarded Nokia – and shows higher cost of equity (8.44%) and equity risk premium (3.71%) in Austria, perhaps reflecting investors’ dislike of a stock market that is closely held by the country’s banks. The equity risk premium in France (2.91%) is much higher than in the US (1.34%), perhaps reflecting greater confidence among investors that US managers are pursuing more sensible strategies to deliver shareholder value than their French counterparts.
The cost of debt is easy to calculate as the risk-free rate plus an issuer’s credit spread. The real advantage of using more debt in a company’s capital structure applies in countries where interest expenses are tax-deductible. Debt is a way to include that tax benefit in the weighted average cost of capital and shield operating earnings from the taxman, to the benefit of shareholders. BT pays 4.2% on its debt, after tax.
BT, at the time when Gibbs worked the example at the end of June, had a market capitalization of £67.9 billion and net debt of £1 billion. Debt is 1.4% of its total capital employed. Leveraging up to a point where net debt is 10% of total capital would reduce its weighted average cost of capital from 6.81% to 6.61% and increase the firm’s value from £67.9 billion to £74.5 billion. That implies a share price rise from £10.57 to £11.49. The art of leveraging is not overdoing it. The more leveraged a company becomes, the higher the risk premium equity investors will demand and the higher the spread bondholders will charge.
And tweaking the capital structure won’t help a company’s share price if it is not operating proficiently in its core businesses. But a simple way for a company like BT to increase its share price would be to issue debt and buy back shares. And there is another lesson for companies that are applying high hurdle rates to various projects in which they might be tempted to invest. Using more debt in the capital structure reduces the weighted average cost of capital and makes more projects viable. And Gibbs, being an M&A analyst, cannot resist one final nudge. If you don’t exploit your unused debt capacity, someone else might. “Remember Telecom Italia.” PL
Pots, plots and fair shares
Debates on how to wring the best efforts out of bond-syndicate members are of long standing. But the debate has intensified as the US, Euro and global bond markets struggled to cope with market meltdown and then with the dramatic growth of corporate bond issues in Europe, which required lead managers to pre-market credit stories to potential investors, often for the first time.
In recent months, the pot method of setting aside part of an issue to be allocated to investors brought into a central order book by any and all members of a syndicate has cropped up more often in Euro and global deals. It is long established in the US primary market. Under the pot system, all syndicate members can contribute orders to the pot, which is ultimately controlled by the one or two banks leading the deal. The lead banks have discretion over how many bonds are allocated to which investors and should pass this information on to all syndicate members, so that they all know where bonds have been placed and have an equal chance of trading these in the secondary market. Investors are entitled to designate which syndicate members should be paid a selling concession on their pot order.
In the past, the typical US investment-grade corporate bond deal has combined a 50% retention, 50% pot structure. Say an issuer plans a $400 million deal using one bookrunner and three co-leads, syndicates typically being much smaller for US deals than on Euro or global bonds. Each of the four banks will have a $100 million underwriting position and be guaranteed to receive $50 million of bonds, so its salesforce can round up orders from key clients confident it will receive some paper to fill these. The other $200 million will be sold through the pot and syndicate members have the incentive to try to bring extra orders into it knowing that they can be allocated by investors to receive selling concession on pot orders. If the process works properly, investors should determine which firms are paid two-thirds of the fees on the half of the deal going through the pot. Ideally, the pot structure allows for a combination of lead-manager control, incentives for junior syndicate members and transparency for issuers to see how their bonds have been placed and how well each bank has performed.
The problem with the pot system is the degree of control the lead manager exerts over allocations of bonds to investors and, therefore, indirectly over investors’ decisions on which syndicate members to designate for receipt of selling concessions. The market ultimately has to be self-policing. “Any lead manager that abused the system could expect strong criticism,” John Cooley, head of HSBC’s US debt capital markets business, told an audience at an HSBC presentation on the pot system and syndicate structures at Euromoney’s global borrowers and investors forum at the Hilton Hotel in London this June. But he conceded that even if a co-manager brought a large order to the pot, it wouldn’t get more than 50% of the selling concession and lead managers might receive up to 80% of the designations on a US pot. For this reason, there was great commotion in the US market when, during the credit spread widening of the second half of 1998, 100% pot structures were used on new US investment-grade corporate bond issues. This had been previously restricted to junk bonds and was used after the market downturn in August when control of placement became crucial. The 100% pot diminishes the role of the junior syndicate member, depriving it of any guaranteed earnings from retained bonds, and raising the prospect of the lead manager controlling every bond in a deal.
In Europe the debate over pot systems is highly emotional and concentrated on the associated question of name give-up. In a pot, each syndicate member has to reveal the identity of the investor behind an order. Lead banks often scoff that those who oppose the system do so because they have no real distribution to speak of and only pretend to have a proprietary seam of distribution in their home market or among retail investors. Pots reveal this ugly truth. The opponents of the pot respond that it is a system open to abuse by regular lead managers seeking to solidify their league table position by gaining access to the smaller banks’ client lists.
HSBC’s particular contribution at this workshop was to reveal the findings of a survey of frequent issuers in the Euro and global bond markets to find their attitudes. It asked borrowers why they invited co-lead managers at all. The most popular reason was the vaguest: 37% cited relationship reasons, 31% said for broader distribution, 25% for commitment to market-making, only 7% included co-lead managers for their research support. It asked how satisfied borrowers were with co-lead managers’ performance: only moderately, said 55%, though 33% said very satisfied. It asked whether borrowers had considered using a US-style pot on Euro or global bonds and 64% said no, with 36% saying yes. Issuers saw the main potential benefit of the pot as greater transparency over where their bonds had been placed (29%), with 19% citing better incentives for co-leads, a further 19% mentioning better sense of co-leads’ performance and 21% broader distribution. Borrowers’ main concerns about using the pot were banks’ resistance to name give-up (37%), with another 20% saying the system is not universally accepted by underwriters and another 25% worrying about general lack of familiarity with pots.
This debate over syndicate structure will intensify with the growth of the corporate bond market. Total-return investors want well-motivated syndicate members that will make markets in deals. They do not necessarily equate size with liquidity. One Dutch bond fund manager says: “We’ve seen e1 billion deals that haven’t been liquid because the lead manager wasn’t committed to paying a fair price. That’s what we ask from lead banks, that they make a market.” A European bond fund manager at a large US investor agrees: “In Europe, lots of banks still want to bring deals as sole leads. We need more than just one firm to turn to, to trade out of positions, which means we want joint bookrunners and genuine co-lead managers in a syndicate through a pot system, not low-level co-managers who the lead just throws e5 million of bonds to right before pricing.”
Joint bookrunners don’t always work well together, can offer conflicting advice and, on tricky deals, fall out with each other. The key is providing a smaller number of syndicate banks with a greater incentive to research and trade corporate bonds. That means much larger allocations. The syndicate manager of one US bank recalls narrowly losing out on a competitive bid for a recent German deal and being rewarded with a special-bracket syndicate status and an allocation of €20 million bonds. “To be honest,” he says, “even for that it was scarcely worth cranking up the research and trading effort.” He would like to see greater use made of selling groups composed of regional securities firms. They are allocated bonds on a take-and-pay basis with no underwriting commitment and no underwriting fee. Some firms already cover these smaller regional brokers in Europe with dedicated sales desks, almost as if they were end-investors. Some smaller European banks used to oppose this practice but, seeing the way the market is heading, have in recent months tempered their objections to being relegated to selling-group member status.PL
