Fees only go in one direction – down. Bankers throughout the capital markets use the same phrase to bemoan the lack of money in their business. Maybe so. But they complain with less conviction than they have done in the past.
Fees on bond issues from frequent borrowers have never been generous and they are still under pressure. For frequent borrowers of all types, such as supranationals, agencies and Pfandbrief issuers, there is a continuing trend towards large, liquid deals which leave only thin margins for underwriters. These borrowers have also been the quickest to embrace electronic distribution and are keen to get their bonds listed on government bond trading platforms such as EuroMTS.
But bond volumes are increasing dramatically and most of the growth is not coming from these cost-conscious borrowers. Last year a record $1.4 trillion-worth of international bonds were raised. This year, in spite of a few quiet moments, is on course to be even better. “These are rates of growth one presumably associates with a new hi-tech market, not with something supposedly as mundane as Eurobonds,” notes John Winter, head of debt capital markets at Deutsche Bank in London.
The big transformation in the bond markets has been the appearance of jumbo corporate bonds. These are prestigious mandates which underwriters Fight hard to win, but they are not by any means low-margin business. Sure, Unilever paid fees of only Five basis points on its $7.4 billion equivalent issue in August, but that short-dated Floating rate note is not typical of the pattern of corporate issuance in the past 12 months.
The headline-grabbing deals of 1999 and 2000 have been different to the jumbo deals of the past. This isn’t the First time we have seen big deals in the market, says Charles Berman, head of European debt capital markets at Schroder Salomon Smith Barney. But in the past the big borrowers were supranationals, sovereigns and agencies looking to raise funding at a certain hurdle rate. Never before have we seen corporates mobilizing capital for strategic events in such large volumes.
Frequent names suffer
The Flood of corporate bonds is not necessarily good news for regular users of the international bond market. These frequent borrowers have been hammered on two fronts over recent months. First, heavy corporate supply is pushing out spreads for all borrowers. “For those issuers with Libor funding targets life has become more difficult this year,” says John Fleming, head of European debt syndicate at Credit Suisse First Boston in London. “A frequent issuer which traditionally funded itself at 10 basis points below Libor might now have to pay Libor plus.”
Second, since the beginning of last year European investors have been dumping highly-rated bonds in order to buy higher-yielding credit products and equity. “As European investors have switched from buying triple-A bonds into credit, the issuers who have suffered most have been European frequent borrowers,” says Paul Hearn, head of European debt capital markets at JP Morgan in London. “The US agencies, which historically traded worse than European triple-A borrowers, have started to trade significantly better than Europeans such as KfW and the EIB. This is clear evidence that the strategy the US agencies began to adopt a couple of years ago of issuing from big programmes is working.”
For the two biggest US agencies, Fannie Mae and Freddie Mac, the name of the game has been liquidity. They have been striving to turn their bonds into surrogates for ever scarcer government debt by doing regular and very large bond issues. No European non-government issuer has borrowing requirements on the scale of Fannie and Freddie. Borrowers such as KfW and the EIB have suffered from offering neither the liquidity of the US agencies nor the yield of corporate issuers.
Some bankers complain that the traditional skills of the Eurobond market – spotting opportunities for arbitrage and hunting out pockets of demand – are being undervalued. In their haste to do big strategic deals, some corporates, they say, are paying over the odds.
But others maintain that corporates are no less demanding than old-style Euromarket issuers. “Pricing is often just as important to corporate borrowers as it is to traditional arbitrage-driven issuers,” says Winter at Deutsche. “Being able to raise cheaper funding than its peers gives a corporate a real competitive advantage. A significant difference compared to an arbitrage-driven borrower, however, is that an attractive price is not necessarily determined just by the deal’s spread to Libor. A corporate is likely to be raising funding for acquisitions or expansion rather than lending it on to someone else, so the absolute level of interest rates or currencies may also be very significant.” If interest rates continue to move upwards, the primary markets may suffer. But that’s a worry bankers can put off for another day.
Year of the telco
Deutsche Telekom’s $14.6 billion equivalent offering in June was by far the biggest corporate bond in the First half of 2000 – in fact, it was the biggest bond issue ever. But WorldCom, Vodafone, KPN and France Telecom have all raised the equivalent of more than $4 billion in individual offerings.
What all these companies have in common, of course, is that they are large telecom companies. This industry has dominated the entire debt markets this year. There was more international bond issuance by telecom companies in the First half of 2000 than in the whole of 1999. If volumes are as high in the second half of 2000 as in the First six months – and many believe they might be higher – telecom bond volumes will have nearly trebled compared to the $49 billion that was issued in 1998.
In the loan market too, big telcos are consuming liquidity at a rate never seen before. Telecom companies received more than 21% of all syndicated lending in the First half of 2000, compared to just over 14% in 1999. Borrowing on this scale is fantastic news for those investment banks which can extend large bridge loans at short notice. It also favours those Firms with special expertise in telecoms – notably Schroder Salomon Smith Barney, which has dominated the telecom bond league tables this year.
With telecom companies needing to raise large amounts of cash to pay for acquisitions, capital expenditure, and now the phenomenally expensive UMTS licences granted by the UK and German governments, a fearsome pipeline of borrowing is looming for late 2000 and early 2001. By mid-August, BT and Telefónica had announced plans to issue some $15 billion between them in the second half. And plenty more announcements are expected.
Not everyone believes that this pace of corporate borrowing is sustainable in the long term. Some believe that if the telecom industry falls from favour in the equity markets, or if Europe’s frenzy of M&A activity starts to Fizzle out, the international bond market will return to what it has always been – a business dominated by frequent, highly price-sensitive borrowers.
“If the wave of acquisitions slows, we will see the balance of power in the market shift back towards frequent issuers and away from corporates,” says Simon Meadows, head of international debt capital markets at Credit Suisse First Boston. “That will bring us back to distribution and basis points. The houses that do best then will be those which can do the best deals for issuers.”
Loans get shorter
Part of the reason for the M&A boom in Europe over the past couple of years is that companies suddenly have access to a much greater pool of money. “The reduction of government debt has created a tremendous wave of money going into both equity and credit,” says Erich Pohl, global head of global markets at Dresdner Kleinwort Benson. “And the restructuring of pensions policies throughout Europe has added to the demand for assets.” But the shift of money out of government bonds has also brought much greater liquidity to the loan markets. European banks have securitized large portions of their loan books in recent months, freeing up capital which they can put against new loans.
“The loan product is increasingly being used as a bridge to the bond market,” says Richard Ramsey, head of European acquisition Finance at Dresdner Kleinwort Benson in London. “Additional liquidity comes from the bond market through products such as collateralized loan obligations. The banks’ role is consequently becoming more focused on arranging deals.”
Banks have become ever more reluctant to see their capital tied up in long-term commitments. “Long-term lending has become a scarce commodity,” says one banker. As a result, the syndicated loan market has been transformed from a provider of long-term Finance into a source of short-term liquidity.
The average maturity of loans has fallen dramatically. Loan facilities of one year – including 364-day facilities – accounted for just under 38% of all syndicated loans in 1999 according to Capital Data. But in the First six months of 2000 the proportion had soared to nearly 48%.
The perfect short-term loan for banks is a corporate acquisition facility, put together at short notice and intended to be taken out with longer-term Financing in the bond market. The loan which broke the mould was for Olivetti in early 1999. It demonstrated that even lowly rated companies could borrow huge sums at the right price. Olivetti’s loan was followed by a string of jumbo facilities which offered relatively generous terms for loans which were sometimes never even drawn.
“There is a trend away from the traditional three-to-seven year bullet loan,” says Patrick Jacob, joint head of global debt origination at Dresdner Kleinwort Benson in London. “Increasingly, we are seeing shorter-dated loans. The 364-day facility is an ideal platform for a borrower who needs the money quickly or who wants to diversify his sources of funding at a later date.”
Since the days of the Olivetti and Repsol loans, prices for big short-term corporate facilities have fallen. But even with less generous margins, loan arrangers insist that this can be a much more profitable business than the long-term lending of old. “If you can use each dollar of capital three or four times a year in short-term loans that can be a much better use of capital than having it tied up in a long-term commitments,” points out Jacob. Banks are not simply responding to the demand for acquisition Finance, they are fuelling it. “Certain very large deals, both in bank debt and bonds, have demonstrated to borrowers that there is a massive depth of money available,” says Jacob at Dresdner Kleinwort Benson. “That debt can be used for acquisitions, for expansion or to gear up balance sheets in order to improve return on equity.”
As the bond market’s appetite for corporate credit has grown, and as the loan market has shifted towards shorter-term lending, the two markets have quickly become complementary, providing different types of funding for the same borrowers. This means that it makes little sense for investment banks to run Fixed-income and loan underwriting as two separate businesses.
Most Firms now claim to run all debt capital markets as a single business, at least in terms of origination. All are keen to point out that they now co-ordinate their contacts with borrowers and no longer have a succession of different product specialists calling on the same corporate treasurers.
Protection providers
Bonds and loans may now be complementary markets, but they are by no means moving in tandem. While the price of acquisition facilities has fallen, bond investors are demanding ever higher prices. Corporate bond spreads have moved out dramatically in the past 12 months.
And the Fixed-income markets are much less consistently open to borrowers than the loan market. Early in the second quarter, for example, the market was all but closed to corporate borrowers. There has usually been less liquidity in euros than in dollars; most jumbo corporate bonds this year have had larger tranches in dollars than in euros. “It is true that this has been a year of tremendous growth in corporate issuance,” says Hearn at JP Morgan. “But the euro market is still nothing relative to the dollar market in terms of depth and liquidity.”
Investors’ biggest worry is about deteriorating credit ratios. As European companies have leveraged up to make acquisitions, there have been many more credit downgrades than upgrades. This has produced perhaps the most commented phenomenon of the corporate bond market in the past 12 months, the appearance of ratings protection for bond buyers.
This takes two main forms. Covenants have long been a feature of the sterling bond markets. These clauses typically force a borrower to redeem the bond at par if it breaches certain ratios. The other form of ratings protection, credit-sensitive step-ups, link the coupon of a bond to the borrower’s rating. In Deutsche Telekom’s recent jumbo bond, for example, the coupon steps up 50bp if the company is downgraded below single-A. In August, the company reiterated its commitment to maintaining at the very least a single-A rating, even after taking on more debt to pay for the acquisition of VoiceStream.
Berman at Schroder Salomon Smith Barney draws a distinction between clauses designed to help investors get past a particular worry and credit sensitive features designed to stay in place for the life of the bond. “Vodafone’s $5.25 billion global had some limited credit sensitive language to deal with the uncertainty over Mannesmann at the time,” he points out. “But those step-ups were designed to disappear after a predetermined and relatively short period. Some other issues have had permanent event-sensitive language, which can be OK for short-term investments, but should not be used for longer-maturity Fixed-rate bonds.”
Berman believes such pricing techniques damage a fundamental principal of the bond market. “This language is not necessarily in investors’ interests,” he says. “What investors need and should be given is transparency over corporate strategy and sufficient disclosure so they can do their homework and decide for themselves if the bonds are being sold at the right price and with the right terms.”
While some worry that the market will be saddled with these practices now that the precedent has been set, others believe that covenants and the like are a temporary phenomenon which crop up only when there is pronounced trend towards rising leverage. “In any environment where event risk is high, it is only natural that bondholders should ask for their interests to be taken into account,” says Winter at Deutsche Bank. “We saw something similar in the US in the late 1980s where many issuers included poison put language in their bonds.”
Underwriters are taking comfort from the fact that these features have so far been used mainly on telecom bonds. “Telecom companies that have needed to raise a lot of money have had to pay a large premium or oVer investors some kind of protection,” says Fleming at Credit Suisse First Boston. “But so far we have not seen issuers other than telecom companies need to provide this sort of protection.”
No clear leader
With last year’s introduction of the euro and the recent boom in telecom issuance, it might be natural to expect a profound shake-up in the league table of leading bond underwriters. European Firms certainly began 1999 with high hopes that they could dominate the business of arranging eurozone bonds.
“European institutions such as ourselves were very well prepared for the euro,” says Pohl at Dresdner Kleinwort Benson. “We saw that it would give a huge boost to the capital markets. By contrast, I think many American Firms were taken by surprise at the speed at which things changed.”
Pohl claims that his bank was on course to reap the benefits of this advantage when the aborted merger with Deutsche pushed Dresdner’s debt business off course. Paribas too began last year with high hopes that it could build on its reputation for leading Ecu bonds. But the French bank has also been distracted by merger plans, and BNP Paribas’ showing in the league tables can only be described as disappointing.
That leaves Deutsche as the only major European Firm which has substantially improved its position in the rankings following the launch of the euro. But neither have US investment banks wiped the board. Merrill Lynch, Goldman Sachs and Morgan Stanley have all lost a little ground, though their absolute volumes are up substantially.
In fact the two most striking patterns in the league tables are how little the rankings have changed since two or three years ago and how fragmented this business remains. “Whether you are number two or number four in the league tables doesn’t make a lot of difference,” says one banker. “Nobody has a dominant share of this business. The leader doesn’t have much more than 10%.” And there is little sign of that changing. The combined market share of the top Five bookrunners of international bonds has remained at a steady 40% or so for several years.
The rise of Salomon
Perhaps the most notable change in the league tables has been the rise of Citigroup. Salomon Smith Barney climbed from ninth place in the league table for bookrunners of international bonds to fourth in 1999 and for the First half of this year was second behind Deutsche Bank. This strong showing partly reflects the high volume of issuance by the telecoms industry, where Salomon has clear leadership. The Firm led almost one-quarter of all telecom bonds in the First half of 2000.
But Berman pins the credit for this good performance squarely on the merger of Travelers and Citibank. He likens it to taking a top racing driver (Salomon Brothers) out of an old jalopy and putting him into a formula one racing car.
“At Salomon we didn’t have loan capacity, retail distribution or an adequate credit rating as a derivative counterparty,” he says. “Now we have the full range of debt products from commercial paper to preference shares. There are no gaps.”
The convergence of the bond and loan markets has certainly thrown up a few surprises in the lower reaches of the league tables. Take, for example, Bank of America’s appearance in the top 20. This is largely thanks to its credit as lead manager on a May bond deal for KPN, a company Bank of America has worked with in the loan market.
But leadership of the bond underwriting market may have changed more than the league tables suggest – at least in terms of which Firms are making most money from the business. In the past, Firms found it fairly easy to jump up the rankings by leading a lot of bonds on which they make little or no money.
The growing importance of corporate bonds – which generally pay decent fees – have made this practice more difficult. “The league tables probably give a pretty good reflection of who is actually making the most money,” says a banker at a Firm which lies quite a way from the top spot. “In the past they certainly didn’t.”
Deutsche Telekom raises a few eyebrows
No deal better demonstrates the bond market’s new-found capacity for corporate credit than Deutsche Telekom’s June blockbuster. In terms of sheer size it could hardly have been more impressive. The deal was increased from $8 billion and Finally came in at the equivalent of $14.6 billion.
The offering comprised eight bonds with maturities of between Five and 30 years. There were three dollar tranches totalling $9 billion, e3 billion in Five year and 10-year euros, a yen tranche of ¥90 billion and two sterling bonds together raising £925 million. “You would have to say that Deutsche Telekom was clearly the deal of the year so far,” admits a banker who was not on the syndicate.
But despite being the world’s biggest ever bond offering, most bankers do not expect it to keep that title for ever. “This was a record transaction,” says John Winter, head of debt capital markets at Deutsche Bank, one of three lead managers on the deal along with Morgan Stanley and Goldman Sachs. “Deutsche Telekom’s bond was the largest one-off Financing in the bond markets thus far, but that record may not last long.”
This deal may prove that the market is now capable of absorbing volumes 10 times greater than it would recently have choked on. But it also provides a good illustration of the measures companies are having to take to reassure investors about event risk.
Investors were clearly not convinced that double-A rated Deutsche Telekom would stay anything close to that rating during the lifetime of the bonds. The coupons on all the bonds will increase by 50 basis points if either Moody’s or Standard&Poor’s downgrades the debt to below single A.
Investors’ belief that Deutsche Telekom is heading inexorably towards single-A or lower may also account for the high spreads on the bonds: the 10-year dollar tranche, for example, paid 195bp over treasuries.
Some bankers carp that the deal could have been done more cheaply. “Deutsche Telekom didn’t need to pay up,” says one. “It set a dreadful precedent. The company left 5bp to 10bp on the table. That’s a huge amount in a deal of this size.”
Others say that the company lost money because of clumsy efforts to swap the dollar proceeds back into euros. “The moves in swap spreads were pretty dramatic,” says one banker. “The lead managers were like a bunch of elephants. Everyone saw them coming and said ‘thank you very much.'”
But it is perhaps inevitable that a deal of this size and complexity will attract some controversy. And in the context of Germany’s e50 billion UMTS auction, a few basis points here or there – even on a deal of more than $14 billion – may not make a lot of difference to Deutsche Telekom.
More importantly, the deal forms an important part of the company’s efforts to open a diverse range of funding sources. The company is also in the market with a large loan, which will be its debut in the syndicated loan markets. Says Patrick Jacob, joint head of global debt origination at Dresdner Kleinwort Benson in London: “By accessing the loan markets Deutsche Telekom is making an important statement that it will have multiple ways of raising capital at a time when people are worried about the availability of Financing for telecom companies.”
