US and European bond markets are suffering. July was the weakest month for US bond issuance in seven years and the situation in Europe is no better, though the true state is obscured by the August slowdown.
The primary equity business shows no sign of picking up, and it may be months before corporates accept the new price of equity. Suddenly investors and corporates see risk everywhere. The former are in the midst of a flight to quality and the latter are retreating into conservative strategies.
All this feeds back through the banking industry and leads to a repricing of assets.
Investors are unwilling to take on more credit exposure unless they are fully confident in an issuer’s credit story. But the markets have not closed entirely. David Marks, managing director for debt capital markets at JPMorgan, says: “If you look back at the typical market crisis, such as emerging markets in 1997 or Russia in 1998, the markets as a whole implode. Illiquidity becomes the dominant theme – spreads widen but there isn’t much actual trading at these levels.
“There is a flight to quality and all credit products suffer. At the moment we find ourselves in a different situation, with huge discrimination between perceived ‘good’ credits and ‘bad’ credits. The latter have had their spreads widened a lot, but there are still reasonable trading volumes, it isn’t just a case of defensive bid levels. The growth of the credit default swap market has had a big influence on this, since it lets trading desks go short credit.”
Despite the amount of negative credit news, the markets have not entered a credit crunch. Not yet, at least. Nevertheless, liquidity has become expensive. While the very safest borrowers may even have found their spreads pushed in by the flight to quality, for others the cost of funding has become punitive. “A lot of money has been moving into two-year treasuries, short-dated Bunds, that sort of thing,” says a syndicate desk manager in London. “Even agencies have not felt much of the benefit, since they tend to trade in line with swaps, which have themselves been widening versus govvies – five-year swap spreads have come out by 17 basis points over the past 60 days.”
Rigorous analysis
Rob Standing, head of rates at JPMorgan, says: “Credit markets are expensive, but we have also seen aggressive easing, so clients are trying to lower their cost of funding. Companies should really have planned for today’s challenging liquidity environment. Those that did are in a position to wait until the market improves; for others, the cost of backstop credit has increased dramatically and the only option left is to issue at extremely expensive levels.”
Even within sectors the market is distinguishing between issuers more than ever. Spanish banks are being punished for Latin American exposure, while the stronger European banks are facing funding levels that have widened but are by no means punitive. Heavily indebted telecoms operators are finding the market closed to them at the same time as it is open to those of their competitors that resisted the temptation to spend billions on 3G licences.
Marks says: “Issuers have a kind of Rubik’s cube challenge in terms of the structures and approaches they use. They have several occasionally opposed groups to placate – shareholders, creditors, rating agencies, regulators. They can spin the Rubik’s cube to placate the rating agencies, for example, but this may not please shareholders. It’s in balancing these different interests that banks need to help issuers by providing integrated service across product lines.”
In more complex markets, activity is somewhat brisker, but probably not enough to comfort bankers. The equity-linked markets, after astonishing growth in 2001, have slowed dramatically this year. The equity slump has put most outstanding convertibles way out of the money, and made issuers unwilling to sell shares, even at a premium. Such issues as the Fortis deal, which created a new way for financials to raise subordinated undated capital that receives an equity-like treatment from rating agencies and credit analysts, show there is still room for innovation in the market. But the good times of 2001 are over, and too many originators are fighting for too little business.
Structured finance is still growing, particularly in the US, even though several banks and investors have been burnt by ill-advised purchases of products that may have been attractive on a yield basis but were imperfectly understood at the time. Buyers have learnt the need for a more sophisticated and rigorous analysis of risks involved in baskets of assets. These include complex issues such as correlation risk between different credits, which can mean it only takes one or two names to run into trouble for the overall value to plummet. “Structured deals will often have a rating, but that doesn’t mean they behave like comparably-rated corporate bonds,” points out Tom Garside, director of risk management at Oliver Wyman.
Despite fears in the wake of the Enron scandal that the whole market would face punitive over-regulation, growth is still robust. Standing says: “Without doubt, there is a more conservative approach to checking that individual financing vehicles are sound. But asset-backed finance is growing strongly – caution isn’t deterring complex deals, as long as there are the cashflows to back them up.” A banker in structured finance agrees. “Regulation can constrain or encourage growth, but national regulators’ powers are limited,” he says. “The market’s growth is not driven by regulation but by the need to finance on a non-recourse basis.”
If an issuer has the flexibility to hold off coming to the bond markets, it may well be advisable to do so. If not, there are a number of alternatives available – asset sales or securitizations for example. But there is a limit to this flexibility. Ultimately issuers can find themselves compelled to do a rights issue if the alternatives aren’t sufficient. KPN and BT ended up in exactly this position, and both are seen as being on their way to recovery. Peers such as France Telecom refused to issue equity at what they considered unacceptably low prices. Now valuations are even lower, and leverage remains unhealthily high. France Telecom, for one, may need government assistance to survive.
Some issuers for which the debt markets were not closed decided to go ahead with bond issues even though spreads were at historically wide levels. Names perceived as comparatively defensive, such as Australian telecom Telstra, UK retailer Safeway and Portuguese utility EDP, have managed to tap the sterling market relatively successfully.
Other issuers have not been willing to accept their altered levels, and have delayed or cancelled bond deals – the list includes Bertelsmann, Vinci, Deutsche Post, Accor, Zurich and Transco. “Treasurers have a price that they feel reflects their company’s true value,” says a syndicate banker ruefully. “At the moment this is often quite a way off what the market thinks. The market may be open but it’s hard to persuade these people to pay that extra five or so basis points.”
