NEAR THE END of October, International Paper finally gave bond market participants something to cheer about. The triple-B-rated company launched a deal for $750 million which proved sufficiently popular for the underwriters to increase the size to $1 billion.
Six months ago this would have raised few eyebrows, but since WorldCom admitted to accounting fraud in June few deals for $1 billion or more have come to market. Most that have were for triple-A rated issuers such as Fannie Mae and Freddie Mac, or KfW in Europe, which issued $3 billion at the start of October.
The only other deal for $1 billion or more recently was for newly merged oil company ConocoPhillips, which issued $2 billion at the end of September a couple of weeks before finalizing a $2.5 billion bank facility.
Why these two could get deals of $1 billion or more done while others could not is easy to explain: they have simple and uncomplicated stories. Standard & Poor’s reaffirmed International Paper’s rating after the deal, noting that the company benefited from scale and product diversity. More important was that the firm also has what the rating agency terms moderate financial policies.
As for ConocoPhillips, it’s one of the few companies to be upgraded this year, from BBB to single A, and in the weeks preceding both its bond and bank deals had one of the most stable default-swap prices in the market, implying safety. The cost of buying protection rarely budged from 65 basis points. It might be a coincidence, but both companies chose to issue 144a Eurobonds rather than listing them with the Securities & Exchange Commission.
The bad news for large or frequent issuers is that simplicity and safety are what investors are looking for. They’re turning away from the big deals that have dominated the bond market since 1998, when investors’ thirst for liquidity meant multi-billion dollar transactions came at a premium.
But liquid deals are easy to sell and short and so underperform in bear markets. investors are reducing their overall exposures to the larger credits, and have shown a budding interest in buying deals that are either smaller or come from infrequent issuers such as International Paper, or both.
As a result the average high-grade deal size has shrunk: in the third quarter it stood at $485 million, down from $662 million in the first quarter and an average for 2001 of $705 million. Issuance in October has been so weak that the average size has dipped below $400 million.
It’s the first time since 1997 that deals smaller than $500 million have been in favour. “A $300 million deal for an infrequent issuer wouldn’t have had much support in the past,” says the head of debt syndicate at an investment bank. “Now the support is pretty broad, and high- to mid-rated smaller deals are usually very successful. There are days and weeks at a time where they come at tighter spreads than larger deals.”
They have performed better in the secondary market as well, according to research by Dennis Adler and Richard Salditt, credit analysts at Salomon Smith Barney. “For the year to date to the end of September, jumbo tranches have widened by 120 basis points, underperforming the index by 1.1% on a total return basis,” they write in a report issued last month. “Meanwhile deals less than $500 million have widened by 69bp, equating to a 1.87% of outperformance relative to the credit index. That implies a difference in year-to-date performance of 2.97% overall.”
Another barometer of pressure on the corporate bond market is a new, tradable index developed by Morgan Stanley called synthetic Tracers. It consists of a static pool of 50 equally weighted five-year credit default swaps offering exposure to the US investment-grade corporate market. It’s weighted towards industrial credits and away from bank and finance names. It doesn’t paint a pretty picture of the state of corporate credit in the US. Since its debut in late April the index has widened by more than double from 118bp over US treasuries to 275bp over, though by October 25 it was trading around 220bp over (see chart).
The large borrower underperformance is encouraging for the infrequent borrower, and certainly gives debt originators at the investment banks some targets to hound for business. But it’s not all that comforting either to the large issuers or institutional investors.
The former will have to work out how to raise new debt and refinance old without what once seemed to be unlimited access to the unsecured bond markets. Convertible bonds are one option, asset-backed securities another. One sector facing these problems at present is the auto sector, which we examine on page 62.
Investors face a different set of problems. The entire premise of credit investing is to be paid a premium based on the view of a company’s risk of default. Yet the high number of companies going very quickly – or immediately – into high-yield territory or even default has thrown a spanner in the works. “I’ve been a credit analyst or a portfolio manager for more than 10 years, and these are the most volatile markets I’ve seen,” says Lou Zahorak, head of portfolio management and trading for investment-grade bonds at Barclays Global Investors. He points to the rapid reversal in performance of the telecom sector as an example. “Last year the telecoms sector returned 13% and was one of the top-performing sectors in the Lehman Credit Index. But in 2002 the same sector has posted a negative return of 8.3%.”
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Short-term on telecoms
Investors were hardly keen on telecom credits last year; they’d already been causing enough pain in 2001. But they tried to buy at the bottom. It was just too much of a temptation when offered a multi-tranche, multi-billion-dollar issue from France Telecom, for example: the seven- and 10-year tranches were priced at what were basically high-yield prices for what was then a single-A credit. “A lot of investors aren’t buying this because they like telecoms,” one syndicate head told Euromoney in the spring of 2001. “They’re buying it because if they don’t and the spread then tightens to high-grade levels they’ll have to explain why they underperformed their index and their peers so badly.”
The utilities and auto sectors are the latest to suffer a stark reversal of fortunes as a result of the profits meltdowns and corporate scandals as well as large debt loads and, in the case of autos, a slowdown in business and huge underfunded pension plans.
It’s not these particular company or even sectoral problems themselves that have investors concerned, though. “Based on the calls we’ve been getting it’s the fact that the market is weakening that investors are finding so perplexing,” says Louise Purtle, analyst at independent research firm CreditSights. “It’s the sheer speed of the price moves and in many cases the inability to predict them by any traditional fundamental credit analysis.”
Spread volatility used to refer to movement over a period of weeks or even months. Take Korea’s $4 billion rescue-mission bonds back in April 1998. Within two months the five-year paper, which had been issued at 345bp over US treasuries, had traded as tight as 285bp and as wide as 400bp. That was regarded as extreme volatility.
Today that’s just a day’s work in the US high-grade corporate bond market. Bonds issued by Ford and its finance subsidiary Ford Motor Credit became the popular lightning rod over the summer for large spread widening: in June Ford’s 2012 paper was trading at around 200bp over treasuries; it hit 600bp over last month, getting there via a mixture of steady widening but also daily swings of 100bp.
Bombardier provides an even starker example. On October 10, in response to concerns about the company’s approach to asset sales, among other matters, the Canadian triple-B rated aircraft manufacturer’s bonds widened 320.8bp to 943.8bp. That took the total widening of the 2012 paper to 782.8bp for the year, for bonds that were launched with a coupon of 6.75%. A few days later they tightened 174.7bp.
These are not isolated credits. Two months ago CSFB started publishing daily the top-10 spread moves for issuers in its Liquid US Corporate Index, affectionately dubbed Luci. Single-digit moves are rare, and when they do occur are almost always confined to tightening spreads. What is also rare is a day without at least one credit widening by 100bp or more. And Bombardier is hardly the worst. Some of the telecom and utilities credits have widened by 500bp in one day.
The upshot is that more and more bonds issued by investment-grade companies are being traded on a dollar rather than a spread basis, as if they were high-yield credits. And it’s not just Ford bonds, although they’ve been in the spotlight. Purtle says: “Scanning the investment-grade index for all credits trading north of 400bp yields a list of names that is growing both in absolute terms and in terms of sectoral diversity.” And it includes a large number of the top 20 issuers by volume, which between them account for nearly 30% of the major credit bond market indices run by Lehman Brothers and Salomon Smith Barney.
That has prompted investors to search for quick exits in the hope of avoiding another Enron, Adelphia, WorldCom, Conseco – or even just of avoiding names whose spreads might widen markedly and cause investors significantly to underperform whichever index they might be measured against.
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Lou Zahorak |
Strictly limited exposures
The easiest way to guarantee a quick way out is to cut exposures. That is exactly what many institutional investors have done. “The campaign most insurance companies and money managers have been waging to avoid a repeat of WorldCom and Enron involves strictly enforced percentage name limits,” says Dennis Adler, credit strategist at Salomon Smith Barney.
It is, says CreditSight’s Purtle, a sign that “value investing is now being tempered by disaster avoidance – and even job preservation. It’s much harder to justify betting the house given the number of times in the last 12 months that the bets have been placed on a house of cards.”
Investors are generally coy about admitting to doing this. One who isn’t is Zahorak at Barclays Global Investors, perhaps in part because he feels too many people assume that since his fund is an index fund it must be underperforming, much like Vanguard’s total market return fund. BGI’s fund is, he says, actually outperforming the Lehman Index by 3bp.
He says that he and his team started cutting single-name exposures in the spring. “We started about seven months ago after we noticed an increase in volatility in the index. Although we were already quite well diversified we decided to reduce the magnitude of our maximum overweight positions.” He won’t, unsurprisingly, reveal exact figures.
The positive effect of making these adjustments is that the money does have to go somewhere. “Having realized that we needed to reduce those exposures we had to go and buy exposure in other names to make up for it,” explains Zahorak. And since there are a number of funds adopting similar practices “it has provided a strong technical bid for names and sectors that are less liquid”.
The real-estate investment trust sector is one beneficiary he mentions, as is the paper sector – no wonder that International Paper deal performed so well.
The downside, though, is that Zahorak is not alone in capping his overweight positions; many others are doing the same. And they’re all looking at the same names. “Let’s assume that an investor has $300 million of Ford paper,” says a seasoned bond trader. “And let’s assume he cuts that exposure in half. Now let’s assume that there are 200 funds trying to do exactly the same thing. That’s a lot of Ford paper up for sale.” It’s a hypothetical set of figures, but the effect is the same: liquidity only exists if there are two sides to each trade, not if everyone is trying to sell.
This suggests huge market shifts, especially if big fixed-income investors such as Pimco, Blackrock, JPMorgan Fleming Asset Management or Western Asset Management are involved. It is an often-repeated story, for example, that what started the rout in Ford’s spreads was an attempt by Pimco to sell $500 million of bonds in late July. “There were no fundamental changes in the company’s outlook to explain the widening,” explains Purtle. “The company had reaffirmed its third-quarter outlook and that sales were up.”
Such a large block would be hard to move in any market but at the end of July while equity and credit markets tanked it was a real challenge. The brokerage houses provided little relief. “When Ford’s spreads gapped out back in late July and early August you could only get two-by-two markets on the paper,” says Purtle. That means that the brokers were only quoting $2 million-worth of paper at a time and at a spread of two points, unless they ducked out completely and only broked on an agency basis. The practice has since spread to many of the other credits trading at wide spreads. “We call it the Noah’s Ark syndrome,” says Purtle. “The street isn’t committing as much capital as it was four or even two years ago.”
It’s Wall Street’s equivalent to cutting single-name exposures, and while it has reached its most extreme in recent months it’s now an established phenomenon. The brokers have been cutting back their inventory levels since the Russian default induced a credit meltdown in August 1998. Spreads were tightening for much of the 1990s, so being long securities was a profitable business: a broker could provide a decent degree of liquidity to clients as required and record a positive carry on the inventory at the same time.
A major consequence of the Russian default was to force brokers to reassess how much risk they took in the form of inventory; almost all now hold less and turn it over much more frequently. Industry consolidation has worsened the situation, leaving fewer brokers actively trading, and doing so with reduced risk limits.
There are some exceptions. Morgan Stanley has a reputation for buying bonds it has underwritten back from clients if they can find no other exit route, while UBS Warburg and to a lesser extent Deutsche Bank are, according to insiders, being more proactive traders and often acting as the buyer of last resort as a means of building goodwill. The same might be true of Banc of America Securities, which has also been building up its trading presence in the past couple of years. “We see this as an opportunity,” says Jim Kelligrew, head of global high-grade fixed income. “Issuers and investors want us to step up and provide more flow and liquidity. Our trading volumes are up 50% recently.”
But none of these firms appears to have stuck its neck out to capture new trading business for such names as Ford; they, too, appear to be suffering from Noah’s Ark syndrome. From the perspective of the brokers’ shareholders – and bondholders – they’d be mad to do so. “Since 1998 the whole mantra at brokerage firms has been capital at risk,” explains one bond trader. “And that figure is four or five times higher than it was back then. So they’re looking at their positions and saying that even with just one-third of the inventory they used to hold a couple of years ago they’re still carrying the same risk.”
CreditSights’ Purtle says: “Even inventories of $10 million or $20 million can now be problematic. If the bonds suddenly lose half their value it can translate to a loss for the desk for a year, and could lose someone a job.”
It has created a vicious circle. The asset managers, which have themselves consolidated and amassed larger portfolios and therefore make larger trades, want more liquidity to fulfil their orders at a time when each of them is pursuing similar goals via a brokerage industry whose own risk limits hamper liquidity. The result is a plethora of supply and little or no demand. So spreads widen even more, and cause even more bond holders to want to sell.
Broking with the devil
The state of the secondary markets is hardly ideal but, says Zahorak: “Bonds don’t widen out in isolation. There’s real credit deterioration here.” The dysfunctional secondary market, it seems, has made matters worse. The question is: what happens next? On a longer-term basis, one ought to expect a return to a degree of normality, if only because asset managers are, for good or ill, index junkies. They all have index benchmarks to adhere to, and their single-exposure caps fly in the face of that. “Essentially, by sticking with name limits and simultaneously using an index benchmark, portfolio managers have brokered an agreement with the devil,” says Adler at Salomon Smith Barney, which happens to maintain one of the two main bond market indices. “The strategy works very well if the credit deteriorates. However, it causes massive underperformance should the credit return to grace.”
For example, the US auto sector has effectively just three companies, so if investors impose 1% name limits, says Adler, “the most auto paper they can own is 3%, well below the 7% which the auto sector takes up in the index”.
It might not be as simple as that: Zahorak talks about cutting overweight exposures, which could imply that he, and others, are simply cutting back to the bare minimum they need to own for the sake of the index. They might also find exposure in smaller names that might be in the same sector, such as auto suppliers whose bonds trade well within those of Ford. Or, says the head of syndicate at an investment banks: “Investors can get hold of debt which is maturing in the next year or so and redeem it.”
It’s unclear what the brokers can do on their own to improve the market. “Throwing in another couple of market makers won’t solve anything,” says the syndicate head. Based on the liquidity Banc of America Securities, not a small bank, is bringing in, that’s certainly true.
It would seem that the market as a whole is screaming out for something it has already rejected: a central marketplace. At least a dozen different electronic anonymous trading platforms were set up in the late 1990s to try to establish a central marketplace but, says one participant in the rush: “The support from the buy side was almost zero”. The most famous was BondBook, set up by some of the major investment banks. Two weeks after last year’s terrorist attacks BondBook’s CEO asserted that his firm’s model was perfectly suited to the dislocation of liquidity the turmoil precipitated. Two weeks later BondBook was shut down. The only trading platform of note now is MarketAxess, but it’s not using an anonymous platform (though it did buy one last year, just in case). Investors and brokers like it, but it remains unproven as a market force.
The other option investors have is to wise up and learn from the commercial banks. Anecdotal evidence points to the banks entering into a significant amount of buying protection in the credit default swap market in the days before and after they close syndicated loan facilities. That has its own knock-on effect on bond prices because the default swaps, says Purtle at CreditSights, “are partly hedged by shorts in the cash market. This falls disproportionately on large-cap borrowers, which tend also to be big users of commercial bank lines.”
Few investors take advantage of credit derivatives. Most dealers estimate that they account for less than 5% of the market; banks account for just under 50%. It’s anathema to some investors, as it invites the development of a decent repo market that will allow short selling, and that can only increase volatility.
Stock markets are much more used to that, but even big institutional investors still complain about hedge funds causing all the problems. There were rumblings in July that some credit investors were pondering stopping lending securities for short selling. Nothing happened.
It takes a long time for funds to get approval from each of their plan sponsors to use default swaps. “As we visited clients throughout the year we have found that a great number of money managers are very sophisticated,” says Lisa Watkinson, executive director and credit derivatives strategist for Morgan Stanley. “A few have already received approval from over half their plan sponsors to trade credit derivatives. It has taken some time, but the process is underway and is certain to continue.”
By the time more funds are able to use credit derivatives, they might find more user-friendly tools. Several banks have discussed, jointly or separately, setting up exchange-traded funds for credit products. Morgan Stanley’s synthetic Tracers is one such possibility.
While rally in the second half of October has relieved some of the pressure on the credit markets, volatility still reigns. And, says Steve Penwell, the head of North American credit sales for Morgan Stanley: “We’re not going to return to a period of low volatility and low spreads in the credit markets. Increased volatility is going to be a factor for the foreseeable future.” The only way to reduce its impact is for earnings to improve, investment to increase and appetite and ability to tap the markets to return. Few are expecting that within the next six months.
