Taking more from a shrinking market

Most investment bankers were delighted to see the end of 2001 – a truly terrible year in which many lost friends and colleagues in the World Trade Centre. Work itself provided little consolation. M&A and equity capital market volumes declined precipitously, robbing firms of earnings in their highest-margin businesses. Most cut staff and bonuses. Those investment bankers who have held on to their jobs returned to work in January praying that an economic recovery would reignite the equity markets and prompt corporations to finance new investments and mergers&acquisitions. Most of them are looking forward hopefully to 2002 on the simple grounds that it can’t be as bad as 2001.

There was one group of bankers, though, that didn’t want 2001 to end – the primary and secondary debt markets teams that profited mightily last year from a happy combination of falling interest rates and surging corporate new-issue volume. Having spent December grumbling that their bonus pools would be less generous than was justified after such a great year – because profits would be diverted to bail out underperforming divisions – debt markets teams now worry that while other departments are looking forward to an improvement this year, for them 2002 cannot possibly be as good.

Analysts at Dresdner Kleinwort Wasserstein estimated at the start of this year that euro corporate bond supply for 2002 might be e125 billion to e150 billion ($133 billion), down 25% to 30% on 2001, and that net issuance, after redemptions, might be down even further, perhaps as much as 40%. They expect the decline in dollar issuance by corporates to be even steeper than in Europe.

Not all debt strategists or debt capital markets teams agree with the details of this analysis but even the optimists accept that new-issue volumes in the US market will be around 20-25% down on last year. The global credit strategy team at Goldman Sachs predicts a more moderate decline in euro investment-grade bond new issues of 10% to 20% this year.

A huge boost to the primary market last year in both dollars and euros came from auto makers turning away from the commercial paper market to bonds and from telecom companies refinancing acquisition-related bank loans. In 2001 the big US auto companies tested the capacity of the CP market, the traditional mainstay of their financing, as their ratings declined in October. Seeing the danger that they might be shut out from CPs, they turned to bonds. The top 10 auto companies collectively raised a record $140 billion in bond markets last year, with volumes up two and half times over 2000 in euros and one and a half times over 2000 in dollars.

Although auto companies were still active in the bond markets in the first weeks of this year, the analysts at Dresdner Kleinwort Wasserstein expect no more than $80 billion to $100 billion in supply from them in 2002, depending on the demand for new car loan financing. The terming out of CP outstandings will be less of a factor this year. The same analysts expect that European telecoms will raise e25 billion to e35 billion this year, 45% less than in 2001. Many of them have already replaced bank loans with bonds and are now seeking to reduce debt further with the proceeds of equity sales and asset disposals. They will also seek to cut costs by share expenditure on UMTS network build-outs.

Little hope of a growth year

Such reductions from the two biggest groups of borrowers will put a sizeable dent in this year’s new-issue business, assuming the analysts are right. “You can’t rely on the debt divisions to be an engine of growth in bank earnings this year,” says the head of debt capital markets at one firm. “Even if budget posturing leads some people to estimate low at the start of the year, it’s difficult to see how this can be a growth year.” And even if a V-shaped recovery brings back M&A volumes in the second half of 2002, there’s usually a lag of six to nine months until takeovers are refinanced in the bond markets. So 2003 could be a good year, but 2002 still looks tricky. Recovery might also allow companies to fund debt service and other financial requirements out of cashflow rather than via the capital markets. Such a recovery would bring the added complication of rising interest rates.

And if the recovery doesn’t come, corporate spreads might widen further on the threat of more bankruptcies. “Supply considerations aside, the outlook for credit spreads is still negative, given where we are in the credit cycle,” says Bruce Carnegie-Brown, managing director at JPMorgan. Debt market teams scarcely know what to wish for this year. But they all know they have to fine-tune their tactics to thrive.

“This will be a hunting, chasing year,” says Niall Cameron, global head of debt syndication and credit trading at ABN Amro. “Whereas last year the banks as institutions won a number of the trophy corporate deals, this year it’s down to the debt capital markets groups within their banks to be very alert and on their toes and be mindful of opportunities to provide opportunistic financing to borrowers.”

In 2001, many of the large bond market mandates went to banks that were also big lenders to the issuing companies. This was a boon for universal banks such as Citigroup/SSSB, JPMorgan, Deutsche – which lead the league tables – and to a lesser extent such firms as BNP Paribas, ABN Amro and DrKW. Many universal banks decided to concentrate scarce credit resources in lending to a smaller number of corporate clients in the hope of clinching other capital markets business from them.

Some of these bankers, who were congratulating themselves on their clever strategies last year, have now glimpsed the downside. Most obvious is the risk of overexposure to a few big corporate clients, a danger highlighted by the Enron debacle. Hedging concentrations of loan exposure is costly. A more subtle risk is that companies will rotate bond mandates among all lending banks – now feeding other hungry lenders at the expense of those firms that led successful deals last year. That’s a particular danger for banks that have reduced the number of clients they intend to do business with. If your favoured corporates switch to other lenders it’s going to be tough to turn back to the companies you cut off last year.

And it’s also becoming tougher for firms to distinguish themselves from the competition in their execution capability in what are now commoditized debt markets. Most firms follow similar market practices; even European firms tend to be manned by bankers who learnt their trade at the US houses that dominated the rankings in the early and mid 1990s. The use of a centralized pot system for orders on many bookbuild deals has made it harder for banks to establish claims for significant captive placing power. As orders are placed centrally, it’s hard to see which firms’ salesmen or analysts, among two, three or four joint bookrunners, drive demand.

ABN Amro hopes to benefit from the decision last year to put its credit traders right at the centre of the business and hopes that they, as much as corporate financiers and other origination officers, will provide leads not just on profitable trading opportunities but on any build-up in demand for certain products and credits that might be crucial to bringing a new issue. “We’ve lined up a number of deals already this year that came from secondary trading ideas,” says Cameron.

A slower primary market is not bad news for everyone. The reduction in new supply of corporate bonds provides a decent technical support for secondary market performance. That’s good for investors. Indeed this is the point the DrKW analysts were striving to make in their analysis of the outlook for new supply in 2002. For all the high-profile corporate failures last year, the trend for money to move into credit remains intact in Europe.

Last year euro-denominated investment-grade bonds provided investors with reasonable returns of 7.2%, according to Goldman Sachs on its aggregate index. But within that there was high volatility, with periods of pronounced spread widening between February and April when telecoms continued to be downgraded and from August to September. At times the prospects of hefty new-issue volumes was a drag on performance, causing spreads to widen. New issues had to be priced at big discounts to prevailing secondary market bond prices. Yet these periods of widening were intercut with dramatic spread tightening: from late April to June, as telecom companies deleveraged, and from late September to the end of the year when coordinated interest rate cuts inspired a confident rebound from the terrorist attacks. The key to making money last year was what investors did in late September: those who sold credit probably lost money for the year; those who stayed in the market or bought came out ahead.

Market participants hope for a smoother ride this year. Spreads are wide to swaps and most strategists suggest that modest spread tightening and reasonable yields offer good prospects for investment-grade bonds to outperform government bonds, where rate movements are hard to predict. Avoiding the worst-performing sectors and the worst names will be crucial to performance.

Demand will create supply

So while bond salesmen hope lack of new supply will tighten spreads, capital markets teams hope strong demand and good secondary market performance will then tease out new and opportunistic issuers. “There’s such a bid for credit at the moment that demand will create supply,” suggests Mark Bamford, head of new issues syndicate at Goldman Sachs in London. “I think you’ll see more first-time borrowers in the market in 2002 than in previous years.” He adds: “Absolute financing needs may be low for companies in 2002, but a lot of companies have refinancing to do and if markets are strong, companies will pre-fund some of their 2003 refinancing commitments in the second half of this year.”

Robert Rooney, head of European syndication at Morgan Stanley in London, is also hopeful. Multi-billion dollar, multi-currency global bonds may be out this year but, he says: “there will be lots of e1 billion to e2 billion exercises by corporates we have never seen before in the bond markets.”

Rooney’s colleague, Mike Weston, European head of debt capital markets at Morgan Stanley, suggests that for the first time there will be greater corporate debt issuance from non-US issuers in 2002 than from the US, where he agrees volumes may indeed fall by 25% to 30% on last year. Europe remains the key battlefield. Its bond market is still growing as banks are disintermediated. Investors are still moving into credit. Returns in bond markets have been nowhere near as volatile as in equities in the past two years. While some investors – such as UK pension funds – are moving out of overweight allocations to equities, many continental institutional investors have reduced overweights in government bonds. Credit still looks attractive to both camps, offering a decent risk/reward ratio and negative correlation to other assets. Increasingly fixed-income investors are measuring performance against aggregate bond indices that include some credit, rather than against pure government bond indices.

Olivier Khayat, head of debt capital market at SG, is hopeful that the euro market will exert increasing allure. “One intriguing question is to what extent US borrowers will seek to tap the euro investor base. Last year was the first real year of maturity in the euro credit market. Now US borrowers may see it as a single market that offers real size. We are also talking to some large UK issuers which are beginning to feel constrained by the size of the sterling market and may be willing to pay a modest premium to establish their name in the euro market. Overall issuance may be down this year, but we’ll see more diversity among issuers.”

In the first three weeks of January there were mixed signals in the new-issue market. A series of bond deals from smaller auto issuers – those outside the big three of Ford, GMAC and DaimlerChrysler – appeared, including a tightly priced e750 million from BMW. This attracted good demand. But a later two tranche e2 billion issue for Volkswagen suffered from investor disquiet following Ford’s restructuring announcement.

In the telecom sector, Deutsche Telekom was quickly out of the blocks with a series of smaller transactions raising over e2 billion at various maturities in the first two weeks. When the first sizeable benchmark deal in the sector appeared a £375 million and e1 billion issue for mmO2 (the mobile arm spun off from British Telecom), it quickly attracted a huge book of orders. Bookrunners reported e6 billion of demand for the euro tranche and were frustrated that they could not persuade the issuer to increase the deal to more than £1 billion. One banker wails: “When borrowers don’t need the money, you just have to pull the plug on the order book.”

Multi-sourcing strategies

Bankers lost no time in emphasizing the strong performance of most corporate new issues at the start of the year. “Suddenly we’re finding borrowers becoming interested in doing deals they may not previously have considered,” says Cameron. But few came to market.

In fact new supply came to a sudden halt. “January has been very quiet in terms of corporate bond supply,” says Carnegie-Brown. “That’s a concern as the first quarter has been the busiest in each of the last three years.”

Corporates may yet return for strategic reasons. Most see the need to replace bank loans with bonds – banks are becoming less willing to lend and companies are keenly aware of the danger of over-reliance on any single form of financing – be it bank loans, US CP or even a single group of bond investors.

Maintaining access to various financing markets is now a core part of the strategy of most large companies, especially those in volatile sectors. It is even a concern for highly rated borrowers. So KfW, for example, the German government guaranteed entity, recently paid a modest premium to US agency spreads on its $3 billion global bond simply to establish a greater visibility in the dollar bond market. It is well known as an issuer of euro government bonds and now hopes that large benchmark issues will improve its access and reduce its costs in dollars.

Ultimately cost is the driver for most opportunistic issuers. One banker says: “Last year we had bond originators offering deals to corporates at Libor plus 100bp, when many had bank lines at Libor plus 45bp. That’s not an easy sell. Now if bond pricing comes into Libor plus 60bp, the borrower might be more interested. And for those looking at fixed costs, even with credit spreads wide, government rates have come in such a long way. Even with a steep yield curve, the chance to lock in 10-year money at 6.5% might look attractive to a treasurer taking a longer-term view.”

Acquisitive tendencies

Issuers in certain sectors will be taking particular note: utilities is one such, where acquisitive groups such as E.ON and Vattenfall may launch bond market refinancings of acquisition debt. Utilities companies in Europe are searching for the most appropriate capital structure: many are expanding, seeking to position themselves more as growth stocks and are happy with lower credit ratings. “My sense is that there may be more M&A related activity than many estimate,” says Sean Park, head of debt syndicate at Dresdner Kleinwort Wasserstein. “We’re working on a number of potential opportunities which could involve large bridge financings to capital markets take-outs in a number of different sectors.” For now, few buyers have come forward to acquire cheap corporate assets in Europe. Leveraged buy-out sponsors seem more concerned to manage the problems in existing portfolios than to acquire new assets at historically low multiples of historically low earnings. Corporate acquirers too seem cautious about acquiring assets ahead of any economic recovery.

Even amid the rush to repair balance sheets, overleveraged corporates don’t want to become forced sellers at the bottom of the market if they can help it. So for now, Europe’s corporate restructuring is providing few crumbs for debt capital markets bankers.

There might be more consolidation among financial institutions where the hybrid capital market is a niche sector in which acquisition finance is often raised. And Park sees other possible new issuers – the medium-size private European companies that even now are keeping most banks ratings advisory groups busy as they move slowly closer to the public capital markets.

The German Mittelstand has been the holy grail for capital markets bankers for years. It has been almost impossible to persuade companies borrowing from banks at Libor plus 40 basis points to issue securities at Libor plus 200bp. Many large, private firms are capitalized as non-investment grade companies and yet have borrowed from banks at slim margins over Libor for years, easily rolling loans over. Public-sector and quasi-public-sector banks have supported such loans through their own subsidized cost of capital. Few such companies see any upside to opening up their accounts and accepting the stigma of non-investment-grade ratings.

Eventually this system will crack, probably through bank sector restructuring. State-subsidized banks, such as the German Landesbanken, face pressure from Brussels to finance private-sector lending through separately capitalized subsidiaries away from their public-sector arms.

Pressures on state-owned banks will also provide opportunities in balance-sheet restructuring, including securitization. Securitization is increasingly important not just to banks but also to corporations looking to monetize receivables and even to sovereign borrowers. All firms with strong ambitions in the debt capital markets recognize the importance of being able to offer expertise in such fields as securitization. “Many borrowers now expect you to be able to do everything,” says the head of debt capital markets at a top-five firm. “You wouldn’t believe what you get beaten up for in meetings with borrowers – things like: ‘Why haven’t you shown me more in Polish zloty, why haven’t you done more structured products for me?'”

In the past two years banks devoted enormous energies to doing large corporate deals. Now they may see a resurgence in business among sovereign, supranational and other highly rated issuers. These are the most demanding of all participants in the capital markets and the most price-sensitive. Their deals often draw on banks’ most talented individuals but are rarely lucrative. Yet they provide the volumes and the flows that firms need to support execution of higher-margin corporate deals. “Far from relegating that kind of business, you want to do as much of it as possible,” says one banker.

The start of the year is always frenzied in debt markets. This year started with even more intensity than usual. “I’ve never seen firms willing to provide such subsidies for league table position,” complains one banker.

No-one wants to be left behind in what all predict will be a tough year. Charlie Berman, co-head of European credit markets at Schroder Salomon Smith Barney, agrees that new tactics will be needed this year. “To use a baseball analogy, last year was all about home runs and this year will be all about hitting singles. Banks will have to go out and fight for business every week and try and build market share by selling more to their existing clients. We each have to figure out how you extract more from a market where volumes are likely to shrink.”

Nomura builds up for non-yen demand from Japan

Nomura has been hiring high-profile bankers in London to build up its debt business for the past 12 months. These include Brian Lawson who came from ABN Amro to head syndicate, Stefano Ghersi who came from Merrill Lynch to head debt capital markets, Barry Nix from Bear Stearns to head sales and Tariq Rafique from ABN Amro to head securitization and asset finance.

Nomura has come and gone in the bond markets before. It dominated league tables in the mid-1980s, when Japanese issuers flooded the markets with dollar warrant bond deals. But its influence shrank as the Japanese stopped raising capital and the dollar and later the euro established themselves as the leading market currencies.

As it makes its most concerted push for a decade in the bond markets, what’s different this time? Simply, there’s a concentration on non-Japanese issuers and currencies other than yen.

“The absolute amount of liquidity from Japan that is now available for new investment is unmatched in any capital market,” claims Ghersi. “There is a huge concern among bank depositors over the status of their deposits, and that the government cannot extend unlimited guarantees.” In addition, with the yen weakening, Japanese investors are playing a larger role in non-yen markets.

With two developed capital markets, the US and the euro market. “That leaves the question of what happens in Asia,” says Ghersi. Nomura hopes that marginal liquidity in Japan and non-Japan Asia will increasingly attract issuers from elsewhere, seeking new investors and competing demand on global deals. The lesson of recent months is that markets are volatile and can sometimes be closed off to certain issuers, or only provide funding at a distressed price. All sorts of borrowers would be attracted by a third significant capital market.

Nomura’s ambition is to build on its dominant position in Japan by adding strong distribution in non-Japan Asia and in the eurozone. It’s been expanding its sales forces rapidly in Asia and Europe. But Japan is crucial. Ghersi says: “Japanese investors are now buying foreign securities in foreign currency and you only need a 1% reallocation by Japanese investors to open up $100 billion of liquidity. We believe liquidity is ready to be moved and we want Nomura to be leading the charge.”

Nomura’s new team now has to deliver. Ghersi points to its contribution to placing the $3 billion deal for the European Investment Bank deal in early January. “For the first time on such a deal we’ve seen $300 million blocks at a time going to Japan. By the time of pricing we had built a very significant book.” Ghersi also mentions a sole-managed $400 million issue for BMW late last year which it placed 100% with Japanese retail. “We provided pricing to BMW well inside the secondary market levels of its existing bonds.” He adds: “Japan is a very brand-conscious society and we can distribute well-known US and international names.” The trouble is that, following their losses on Enron bonds, Japanese investors may not be so keen on foreign corporate debt.