Who would have thought that a market regarded by most investors two years ago as a curiosity would undergo such a transformation? After years of twiddling their thumbs on the sidelines as equity capital markets hogged the limelight, suddenly debt bankers are getting a piece of the action. In fact, most of the action is coming their way these days. “I doubt we’ll see this kind of shift in dimension in our careers again,” says Chris Van Niekerk, head of European corporate debt capital markets origination at Barclays Capital.
But a happy ending for what is ostensibly a success story is by no means guaranteed. Although investors are certainly hungry for the new asset class, their enthusiasm is tempered by frustration at the lack of sector diversity and a stagnant secondary market. What’s more, credit still hasn’t shaken off its lingering legacy of underperformance.
Since credit took off in Europe in 1998, the market has expanded at a phenomenal rate and is still growing fast, despite the slowdown elsewhere. The birth of the euro brought about a switch from multi-currency funds focused on one asset class to single-currency funds with a taste for multiple asset classes. Pension fund reform, particularly in the UK and Germany, triggered a need for higher-yielding paper to meet liabilities. Equity market returns are at historical lows. And CFOs in Europe, helped by their investment bankers, are realizing that their companies are probably underleveraged compared with US peers.
With all of these factors on its side, it is unremarkable that credit has taken off. But some of the most experienced debt bankers admit that the ferocity of the explosion took them by surprise. What was expected to be a slow, steady drip of money into credit has turned out to be a flood. “Not even bulls like us anticipated the degree of the swing and the diversity of investors who switched into credit,” says Charlie Berman, co-head of European credit markets at Schroder Salomon Smith Barney. “There’s a wall of money out there.” But right now, investors must feel that they are banging their heads against that wall.
The flood of money into fixed-income funds has created a structural shortage of paper in the market. Demand has outstripped supply by a long way and a lot of the cash destined for credit just can’t get invested.
What makes matters worse is that, because of lacklustre performance, investors aren’t getting the returns they had expected and hoped for. “Growth has been fantastic over the last two and a half years but performance has been patchy,” says Gary Jenkins, global head of investment-grade research at Barclays Capital. “For most of 1999 and the first nine months of 2000 it has been extremely poor. Spreads have been wide and there has been a lot of event risk.” And don’t investors know it. “Since the end of 1998 we’ve had a very up and down ride,” says Michael Turner, head of global fixed income at Edinburgh Fund Managers.
One of the biggest downs is the fact that, despite the trumpeted growth – volumes are up 80% on this time last year – the market has become skewed by uneven supply. Together the telecom and auto sectors make up 52% of total issuance so far this year according to Dealogic Capital Data. Telecoms paper increased to e33 billion ($27 billion) in the first half of 2001 compared with e23 billion in the first half of last year as these companies looked to refinance their 3G licence commitments via jumbo deals. Growth in the auto sector was even more pronounced, rising from e9 billion to e31 billion. Take these sectors out of the equation and volumes actually look pretty flat.
Once senior AAA rated bank debt is discounted – many investors don’t really consider this to be corporate bond material anyway – the choice of credits becomes even narrower. “The ability to diversify isn’t there and so investors are having to run portfolios far from where they would ideally like to be,” says Niall Cameron, head of debt capital markets at ABN Amro. Michael Markham, head of fixed income at Investec, agrees. “If you were starting to build a portfolio today and looking at the available supply, you would be severely constrained,” he says.
Managers under pressure
Despite this, fund managers are under increasing pressure from clients to put the money entrusted to them to work. This means that they are bulk buying in the primary market. And the only borrowers as yet tapping the bond markets in any significant size are telecoms and auto manufacturers. Smaller industrial companies, the ones investors are most keen to get their hands on, are beginning to issue but are not doing e5 billion or e10 billion deals. More typically, they are issuing e500 million or e1 billion of bonds – deals that barely make a ripple today.
Though investors are loath to admit it, it’s plain that they still feel compelled to buy more or less every deal that comes to market.
Euro-denominated deals are routinely oversubscribed and most of those orders are new money. In Europe, 90% of new issues are against cash, as opposed to the US, where 60% of almost every deal is against switches out of alternative credits or different maturities.
Over the past two years, there has been a huge increase in the number of buy-and-hold investors. This means that when a new issue is launched, the paper tends not to come back to the market. “We’re finding that investors still need to buy credit,” says David Munves, head of credit strategy at Lehman Brothers. “They often complete the buy half of a switch idea but not the sell part.” The small number of trades that do take place are usually done because a dealer needs to close a short position or a hedge fund wants to make a quick profit.
“Issues below e500 million rapidly become illiquid,” confirms Bernard Hunter, director of fixed income at Merrill Lynch Investment Managers. “It is difficult to find any bonds a couple of weeks after issue, even with the lead manager.” Or, if a broker can find the paper, it isn’t always available at a price that is tempting to the fund manager. This is extremely frustrating, says Hunter, particularly when spreads are widening but there is no way of taking advantage of this.
Bankers respond that portfolio managers sometimes have unrealistic expectations about how easy it is to buy credit – a hangover from their experience of buying and selling government paper. Because investors are used to trading government bonds, which are so much more liquid, they find it difficult to accept that the same supply dynamics don’t apply in the corporate market.
Lack of supply is a particular problem for fund managers buying for global portfolios. Depending on how a deal is structured, they don’t always have the option of buying in the primary market. Investors based in the US cannot buy euro, or Reg S, issues until the bonds have been seasoned, that is, until Securities&Exchange Commission clearance has been granted, 40 days after the issue.
By this time, they have little chance of being able to track down a sizeable stake. Some borrowers are trying to broaden the appeal of their deals by issuing one tranche under rule 144A, which means it is exempt from SEC approval. Others choose to register with the SEC and undertake a fully global issue.
Investors such as Christian Roth, portfolio manager at Morgan Stanley Asset Management, are particularly keen to see more companies taking up the 144A or SEC option. “There isn’t a broad enough recognition among companies that global asset managers are investing in credit for portfolios all around the world,” he says. Even some quite sizeable issuers occasionally ignore US investors. Companies selling large amounts of paper, such as Vivendi, Deutsche Telekom and National Grid, have all recently launched pure euro issues.
That is at least partly because making an issue acceptable to US-based investors is hard work. “Increasingly, it would be almost ideal if companies went down the global route,” says Peter Charles, head of corporate syndicate at Schroder Salomon Smith Barney. “But it’s really a question of timeliness and cost. Reg S is much cheaper, and an SEC shelf can take an additional two or three months to do.”
Besides, SEC registration isn’t just a one-off process. It places onerous obligations on companies to file regular reports. If borrowers feel that there is sufficient demand for their paper in Europe they have little incentive to take on that burden.
Even if regulatory issues don’t prevent investors from buying a bond, there is another reason to think twice about some new issues – increasingly aggressive pricing by bankers who know that bond funds are willing to pay more highly for rarer credits. “Investors are facing a diversification dilemma,” says Munves at Lehman Brothers. “It’s tempting to buy telcos and autos because the spreads are attractive. The alternative is to diversify but at a significant cost.”
Some of the bonds that have come to market recently have certainly put fund managers in a tricky position. For example, despite its rock-solid AA rating, German industrial conglomerate Siemens’ e4 billion issue in July was considered by many investors to be too expensive, yielding just 19 basis points on the five-year bond and 34bp on the 10-year. Initial price talk had been low 20s and high 30s, respectively. There were rumours of several top-quality investors pulling out because the deal was too tight. It didn’t perform well in the after market either, drifting 5bp on the first day of trading.
Bankers say that deals wouldn’t get done at these levels if investors didn’t support them. “This is a market driven by supply and demand,” says Charles at SSB. “If issues are coming tighter it’s because there is demand at that price.”
But fund managers claim they are being squeezed by borrowers and their banks. Many blame the pot system, which is now used in almost all corporate deals, for issues coming at such tight prices. “Using a pot is intended to prevent the series of bluff and double-bluff games that were sometimes used to disguise the fact that a deal wasn’t working at all,” explains Sean Park, global head of syndicate at Dresdner Kleinwort Wasserstein.
But investors aren’t convinced that it brings any more transparency to the table. “I don’t like the pot system,” says Michael Markham, portfolio manager at Investec. “It adds an unnecessary layer of complication by making orders seem higher than they are.” What that means is that investors don’t get the allocations they are looking for. “When deals used to have just one bookrunner, we could put in an order and ask for protection. With a joint lead there is little way of getting that protection, which is frustrating,” continues Markham.
Some portfolio managers are going about solving this in their own way by putting in for double or even three times the amount of bonds they really want. Many are prevented from doing this by internal risk management procedures. “Some houses do put in for more than they need and then make money later by flipping the deal,” says Toby Nangle, investment manager at Baring Asset Management. “That’s not our policy.” But there are enough investors – particularly hedge funds – doing this to inflate the order books.
If deals are too expensive, investors say, then there’s no room for the value of the investment to appreciate as credit quality rises. “We spend a lot of time debating how to handle these credits,” says the head of fixed income at one UK institutional investor. “Do you stay out of them altogether, buy and then flip because you know it will tighten in the after market or buy and hold for the purposes of diversification?”
The dangers of winding up with a highly concentrated portfolio by not buying rarer paper speak for themselves. Similar credits behave similarly under stress, as might be expected, whether that is caused by a profits warning, regulatory hurdle or a ratings downgrade. It’s far preferable to have a well-balanced selection of non-cyclical credits than a stable of closely correlated bonds. “You are better paid to hold telecom paper but it would be nice to have more variety,” says John de Garis, director in fixed income at Credit Suisse Asset Management. “You never win by putting all your eggs in one basket.”
This is also a waste of valuable resources. Over the past 18 months, the buy side has been steadily building up and reinforcing its research capabilities and most major institutional investors now boast an in-house credit team of credit analysts, highly sought after individuals often poached from ratings agencies or the sell side.
But what is the point of recruiting these people if they don’t have a wide range of names to analyze? “We have a large research capacity and we want to use it,” says Bernard Hunter at Merrill Lynch Investment Managers. “It would be great to see more mid-sized industrials, which weren’t so widely followed and so would have to come to market at wider spreads, where we could really dig deep and form a view that is not widely held.”
As far as investors are concerned, the spread of credit across industries falls far short of the ideal. But suggest to a banker that there isn’t enough diversity in corporate credit and the response is usually a shrug. They much prefer to talk instead about how far the market has come in such a short space of time. “People are looking at the bond market and seeing a glass that is half empty instead of half full,” says Berman at Citigroup.
Van Niekerk at Barclays believes that conditions are now ripe for an increase in new borrowers. Despite the current lull in activity, there’s an underlying trend towards globalization and focusing on key businesses and the forces of restructuring will help ensure that the dearth of supply in some sectors is only a temporary aberration. “Investors would welcome a bigger diversity of corporate bond offerings and our role is to do what we can to facilitate the process” he says. “But companies have to come to the bond market in the fullness of time.”
Bank lending still strong
It could be a while before the impact of all of this starts to filter through to the new-issue market, though, so fund managers probably shouldn’t hold their breath. There are those market participants who say that the extent of bank disintermediation so far has been overstated. For most borrowers, this view argues, loans are still the most economical form of financing, and banks are still willing to provide them because lending brings in other business. “Until we see more rational prices in the loans market, bank disintermediation isn’t going to be a major driver of the markets,” says one credit analyst.
Originators try to encourage CFOs into the bond market sooner rather than later by explaining that it’s fundamentally a good thing for a business, but that’s just not true. Unless a borrower has a large number of homogenous peers, which really only applies to the banks and agency-type issuers, then there is very little intrinsic benefit. For most corporates, the priority continues to be getting funding at the right price. If money is available in the bank market for 40bp over Libor and a bond will cost you 200bp over, it’s really a no-brainer.
Furthermore, there’s a very practical reason why more corporates aren’t tapping the bond markets. Issuing debt is a complicated and involved process, from gaining a rating – from two different agencies – to putting together a roadshow and providing information to analysts. In order to go through all that, a company has to feel a pretty strong incentive. There’s also a psychological barrier to be overcome. “If corporates are used to the bank market then the bond market is a lot to take in,” says Park at DKW. “Companies can easily take a year just to get used to the idea.”
Some bankers express the view that investors must take some of the blame for the reluctance of corporates to issue bonds. “Part of the lack of diversity is the fault of investors for not showing enough interest relative to banks in certain sectors,” says Anthony Barklam, head of European corporate syndicate at Morgan Stanley. “Some corporates have said why should we come to the market now when there is limited capacity and pricing advantage in the capital markets relative to the banking sector?”
Manfred Schepers, global head of debt capital markets at UBS Warburg, shares this view. “It’s a chicken-and-egg scenario,” he says. “Investors complain about lack of diversification and then you give them something new and they say ‘we don’t like this because we’ve never seen anything like it before’.”
Or maybe they have but they got stung. Remember SAir Group, the Swiss airline company that launched a e400 million deal in October? Investors who bought its bonds would probably rather forget. The company received a rapturous reception when it launched a e350 million deal in September. Scant issuance in the airline sector meant that funds were massively underweight and SAir Group’s 10-year A3 rated credit seemed like a perfect opportunity to begin to correct this imbalance.
Demand was predictably strong. During bookbuilding the size was increased to e400 million and the deal priced at 143bp over Libor. “The rarity of paper from the sector helped us build momentum behind the transaction because investors are keen to find paper that offers diversity,” said a syndicate member at one of the lead banks at the time of the deal.
Those who were disappointed to miss out on allocations must be breathing a sigh of relief today. In April, Moody’s downgraded SAir by three notches following a dismal set of annual results, the departure of SAir’s CFO and the announcement of a complete strategy reversal. Spreads widened to 500bp on the news.
Many market participants say that investors should stay tuned for more deals from the utility sector, which, they predict, is where the next wave of heavy issuance will come from. The sector is still relatively unconsolidated in Europe but the EU is putting pressure on member states to push through deregulation. Shareholders too want to see some activity and so, in response, a lot of the former state-owned utilities are now forming more ambitious strategies and gearing up to fund aggressive expansion plans.
All of which sounds eerily familiar. Is there a risk that utilities will turn out to be the next telecom sector? “There is a danger that some of these companies will stretch their balance sheets, leading to ratings downgrades,” concedes van Niekerk at Barclays “But, unlike the telecoms firms, they aren’t facing a substantial shift in technology. That’s a fundamental difference.”
A flawed template
Optimists in the market look to the US for a template for how Europe might eventually look in terms of amount of issuance and sector diversity but there are some important differences to note. The strength of the bond markets in the US is at least in part a reflection of the relative weakness of the banking sector which, as a percentage of assets, is roughly a third the size of Europe’s. There is also a predominance of small, family-owned companies in Europe which typically are not big users of the bond markets, whereas the US has a much bigger and diversified industrial base and a long history of public ownership. “When you look at the number of currently unrated companies that could get ratings in Europe it is nowhere near the number that are already rated in the US,” says Munves. Although he does expect the pool of rate-able companies to rise due to the cross-border mergers and consolidation that is underway.
So the question for investors in Europe is how to generate sufficient returns in the meantime. Can they afford to just sit and wait, as some bankers are advocating? Credit quality has been steadily deteriorating over the past 18 months and many investors have already moved further down the credit curve in response. But some fund managers are going further and being even more flexible about ratings to help overcome the lack of choice.
Roth at Morgan Stanley is encouraging clients to look at the credit market as a continuum and specify an aggregate amount of risk or an average rating for the whole portfolio. If investors insist on stipulating a minimum credit rating, he says, this increases the pressure on the fund manager, who is already struggling to generate returns. As soon as a BBB credit falls one notch, he has to sell immediately, even though this may result in a material loss. A more fluid approach would allow a manager to hold on to the paper until the direction the company was going to take in the long term became clear.
Other investors are also broadening their universe in terms of issuer nationalities. European-based clients understandably often want to focus on the European market but the restrictions they place on what they want to invest in means that they actually wind up with quite concentrated portfolios. So if Voda fone issues in dollars, or Wal-Mart in sterling, many investors in European credit will look at the deal.
What’s incredible is that, despite their efforts to adapt in terms of ratings and issuers most fund managers are still shy of credit derivatives, which seem to be an ideal solution to the problem of sector concentration. By buying credit default swaps, for example, they can gain exposure to sectors in which they haven’t been able to buy bonds, allowing them to tailor-make a portfolio regardless of what paper is available in the market.
In fact, few investors have developed any sort of comprehensive strategy for how to use credit derivatives. Most say that they just haven’t seen enough demand. “A lot of clients aren’t interested in credit derivatives unless they’re used for hedging purposes,” says de Garis at Credit Suisse Asset Management. “We do see the use of credit derivatives becoming more common but, until now, it’s been difficult to get hold of data on the credit default market. It’s all very much done over the counter and for that reason is a lot less transparent.”
Another difficulty is availability. The default swap market is closely linked to the new-issue market and so without new bond deals there will be no new derivatives. The two markets also have the same liquidity problems. “Credit derivatives are a good hedging mechanism but it is difficult to buy them in any material size, particularly relative to the average bond issue,” says Barklam at Morgan Stanley. Bid-offer spreads also tend to be high, which means it is more efficient to buy and hold derivatives than to trade in and out.
| Potential issuance in Europe | |||
| Number of Companies | |||
| Country/Region | Rated* | Unrated** | Total |
| Benelux | 13 | 10 | 23 |
| Nordic Region | 25 | 15 | 40 |
| France | 25 | 25 | 50 |
| Germany | 9 | 14 | 23 |
| Italy | 3 | 13 | 16 |
| Iberian Peninsula | 11 | 5 | 16 |
| UK | 113 | 50 | 163 |
| Others | 15 | 10 | 25 |
| Totals | 214 | 142 | 356 |
| *Fixed-rate investment grade issuers included in the following Lehman Brothers indices: Euro-Aggregate corporate, Sterling Corporate, US High Grade Corporate and Eurodollar | |||
| **Publicly listed companies with book equity >$500m and operating income> $150m | |||
| Sources: FactSet/Worldscope, FT-S&P Global Equity Index, Lehman Brothers | |||
Also putting some off is the fact that adding credit derivatives to fixed-income portfolios is an administrative nightmare. Fund managers have a fiduciary duty to treat all their clients equally. So they can’t put derivatives into one or two portfolios without doing the same for all the rest. “Trying to give every portfolio the same exposure via derivatives would be cost prohibitive and extremely complex,” says Roth at Morgan Stanley. “If we were running one giant mutual fund, then great. But it’s much harder when you have many segregated portfolios.”
Bankers are optimistic that over time this reluctance will lessen, particularly if borrowers remain so concentrated. Cameron at ABN Amro says he’s aware of a couple of institutions that are actively using the credit derivatives market to enhance returns from their fixed-income portfolios and fully expects that, within a year, the vast majority of big funds will be joining in. According to Schepers at UBS Warburg, a sub-section of the investor community is awake to the benefits of credit derivatives. “People at the smarter end of the market are already using derivatives. The traditional bond funds are the ones scrabbling around for paper.”
Market participants are also predicting an influx of asset-backed securities, which provide fixed-income investors with an alternative source of investments. According to analysts at UBS Warburg, there are between e15 billion and e20 billion of ABSs in the pipeline for the third quarter of 2001. However, that growth has been touted for some time now and so far there’s been little evidence that this optimism is not misplaced. “Securitization will be a big story,” says van Niekerk at Barclays. “Increasingly, it is on the agenda for companies.” But if and when ABSs do gain ground, the most active borrowers in this market are likely to be precisely the ones that have been most prominent in the bond market.
Sit tight and wait
Most debt bankers seem to feel that time spent worrying about whether or not to buy credit derivatives or asset-backed securities is probably time wasted. All fixed-income investors have to do, they say, is to sit tight and batten down the hatches. Many new companies in a variety of sectors are lining up to come to market this year and things can only get better.
Besides, they say, investors have already made the decision to be in fixed income, in the knowledge that they don’t have a very wide selection of credits to choose from, because that’s where the best returns are to be had. In the first six months of 2001, credit has outperformed not only government bonds but also equities. Big deal. Stock markets globally have fallen to levels not seen for three years and beating government bonds – which have the lowest yields of all fixed-income investments – hardly sounds like much of an achievement.
The prognosis for the next six months doesn’t look too rosy either. In a recent report, Moody’s predicts that the decline in credit quality seen in the first half of 2001 – ratings downgrades outnumbered upgrades by more than three to one – will persist. “The best of the year is undoubtedly behind us,” says Jenkins at Barclays.
Historically, credit performs less well in the second half of the year because investors become wary of allocating funds to it as the time over which returns can be measured decreases. Rumbles of discontent in Argentina have meant that the spreads of companies with any business in the region have widened considerably.
The potential slowdown in economic growth in Europe could have a big impact in both real and psychological terms. If manufacturing growth continues to decelerate, that could have a knock-on effect on the corporate market, which some economists believe is lagging behind. However, if economic deterioration does continue, the expectation that the ECB will cut interest rates should prevent swap spreads widening too much.
Although Jenkins expects to see less event risk in the latter half of the year, telecoms and autos are not yet out of the water. For example, Vodafone, regarded as the safest among the telecom companies, has just admitted that it has been forced to delay rolling out its third-generation network and NTT DoCoMo is currently recalling the small number of 3G handsets it has issued.
According to analysts at Barclays, 39% of the corporate credit market in Europe is exposed to the new economy – which they define as telecoms and technology – and 20% to autos. Both of these sectors have credit issues and both continue to trade wider than other corporates. “There are concerns when the overall sentiment of the market is so heavily influenced by two such sectors,” says the Barclays note Analysis from KMV, a US company that measures the expected default frequency (EDF) of corporates worldwide, makes for even gloomier reading. KMV looks at a company’s current market value, the extent of its obligations and the vulnerability of the market to change and uses that information to calculate the likelihood of a firm defaulting over the next 12 months.
According to Tim Kasta, KMV’s managing director and product manager of the EDF credit measure, the median default risk for European companies overall hit a five-year high in June, at 1.06% probability compared with 20bp in 1997. This is the blue line E50, which represents the median. E75 shows the default probability of the top 25% of companies, i.e. 75% are doing less well, E25 the worst quartile and E10 the bottom 10% – 90% of companies are faring better than those at this level.
The average default probability has increased largely because of greater leverage, an increase in financial obligations relative to market value and volatility in the sector in which the firm operates, all of which imply a deterioration in credit quality. “Unless fund managers are selling down these credits and substituting them with less risky bonds, or higher returning assets, they aren’t getting paid for the risk they are taking on,” says Kasta.
Though Kasta admits that an increase in the EDF from 20bp to 1.06% is hardly likely to devastate a fund, over time it could substantially alter its health. Moreover, the picture for certain sectors to which portfolios are heavily exposed looks even bleaker.
According to KMV, credit deterioriation has been most rapid in telecom firms. The likelihood that a quarter of these will default this year has reached 20%.
It’s clearly high time fund managers became geared towards more active management. And if the Sharpe ratio of a fund – a measure of calculating whether portfolio managers are making money through well-considered investment decisions or because of excess risk – becomes part of the marketing process, as some experts are predicting it will, they’ll have little choice.
A tardy reaction
A good example of the current tardiness among European portfolio managers is their reaction to the problems at UK telecom equipment supplier Marconi, whose bonds have widened to 400bp over Libor. Fund managers should have seen this coming long before they actually reacted.
Kasta’s worried not only by the low level of credit rotation but also the tendency of European investors to hold heavily concentrated portfolios. “Most popular equity funds, such as the index funds, contain several hundred or even thousands of names, but we’re seeing credit portfolios having as little as 50,” he says. “We will look back in a few years and be amazed that anyone would create such poorly diversified portfolios.”
Whether or not fund managers should be trading in and out of credit equity-style is another matter. The majority of investors are still going into investments with a 24- to 48-month timeframe in mind but perhaps they should be revising that approach. “It’s all about the maturity of the cycle,” says May Busch, head of credit origination at Morgan Stanley. “We started off with people buying and flipping, now there’s been a move towards buy and hold.”
“What we would like to see going forward is a predominance of buy and hold investors but also a willingness to use the secondary market to generate higher returns.” One of the necessary factors – high-quality buy-side research – is already pretty much in place. The other – sufficient varied issuance for this to be a viable option – may be some time in coming.
