Yield hunt triggers short-lived stampede

THE 30-YEAR euro-denominated corporate bond market suddenly rocketed into life at the start of this year but its sparkle faded just as quickly.

The first e400 million deal from Olivetti, with a 7.75% coupon, hit the market on January 10. Just five days later France Telecom followed with its first benchmark, raising e1 billion. What followed was quite remarkable in a new and potentially risky market: a surge of issuers rushed to take advantage of investors’ desperate thirst for yield in a low-interest-rate environment. It seemed that even triple-B issuers had it made – seeing unprecedented demand for a maturity that would have been impossible to achieve a few months ago – with every bond two or three times oversubscribed.

This stampede culminated in e1.85 billion of issuance in the first week of February. But by February 7, the euphoria was replaced by what looked like an attack of investor paranoia as corporate spreads on the 30-year bonds began to seesaw worryingly and to underperform the 10-year sector. Issuers started to pull upcoming deals. Within just four heady weeks, and after e4.9 billion of issuance, the euro 30-year corporate market appeared to have sunk as swiftly as it had appeared.

Corporate spreads pulled in substantially during February. Telefónica is the only one of the new 30-years that ended the third week of February wider, by just one basis point. But even so, no company has dared enter this market since February 7.

What went wrong? Bankers, typically, are blaming other syndicate desks for the market volatility, saying some handled the distribution badly and sold too much of these issues to hedge funds. Early deals from telecoms companies Olivetti, France Telecom and Deutsche Telekom were built on reverse enquiry from Dutch and German insurance companies with 30-year liabilities. Government paper yields too little to meet the guaranteed rates of return of up to 6% that they have offered: hence their desperation. “The first few issues mostly went to genuine real-money investors, but by the time the next issuer and the FT and Olivetti taps came around, more of the securities appear to have ended up being held by hedge funds and trading desks for now,” says Felix Kaiser, executive director, fixed income, currency and commodities at Goldman Sachs.

Selling pressure Anthony Barklam, executive director, head of corporate syndicate, at Morgan Stanley in London, says this caused selling pressure as issuers flooded the new and illiquid market. “The underwriters placed too many bonds with investors who did not have a natural need for the product, so when they tried to take a profit and the natural insurance and pension bid wasn’t there, spreads widened and negative momentum ensued.” The prospect of more companies such as Vivendi Environnement issuing further exaggerated the problem.

Technicals were turning against the market even before the last of the 30-year corporates, such as Telefónica and Electricité de France, launched their deals. “The market turned towards the end of the first week in February, when there was significant selling from professionals and hedge funds, partly because this came shortly after a new 30-year Bund auction which left the market significantly long of 30-year paper,” says Paola Lamedica, senior credit strategist at BNP Paribas. “Investors probably got more of this than they thought they would, so when the new corporate supply came to the market there became even more of an incentive to short 30-year corporates.”

Some issuers have not helped. Borrowers have become rather desperate themselves to secure any source of funding at a time when equity markets are closed, asset sales difficult and creditors and ratings agencies obsessed with corporate liquidity.

Both France Telecom and Olivetti decided to tap their first issues in this market, capitalizing on vast investor interest the first time around. France Telecom’s first 30-year deal was more than three times oversubscribed. But holders of France Telecom’s first e1 billion 30-year tranche issued on January 15 were livid when the issuer came back to the market to tap it for another e500 million just three weeks later, particularly as the company had promised that it wouldn’t.

The France Telecom tap caused 13bp of spread widening in the existing bond and a lot of investor disquiet throughout the market, although the bond had regained this ground by the end of February.

“Neither the Olivetti nor the France Telecom taps were well received,” says one analyst. “I heard from one important investor in FT that he was going to call the company directly and knowing the relationship they have, he probably wouldn’t have bothered with the IR guy but gone straight to the treasurer. He was pissed off.”

Nevertheless, other analysts are not really surprised that companies such as France Telecom are attacking this market so aggressively, given their funding needs this year. “Issuers have to counterbalance potential investor disatisfaction caused by large amounts of issuance within a short period of time and the attractive cost of funds currently achievable,” says Kaiser. “If you look at the underlying risk premiums these telecoms and utility names can get now compared to all of last year, and with economic and geopolitical uncertainty high, who knows when they will be able to issue at these rates again?”

There are accusations of more reckless behaviour by some banks. All the bond houses that have emerged at the top of the bookrunner league table for these 30-year deals have been marketing them aggressively. This is hardly surprising when fees on a 30-year bond for an issuer are usually double that of a 10-year bond. For all the credit blow-ups of the past 18 months, debt capital markets teams have had a fairly good run, but now the business outlook is tougher in debt markets.

Some bankers say that in an effort to jump on the bandwagon and gain credence as bookrunners of these shiny new 30-year deals, some banks were pitching them to corporates indiscriminately, irrespective of the plausibility of those companies issuing 30-year money. “I get calls from bankers telling me that they have offered clients 30-year money fully underwritten, and frankly its laughable,” says one banker. “It just shows you the irresponsibility and desperation there is in the market. A badly executed deal is a PR nightmare.”

Quality control

A lot of these deals have come from triple-B rated credits, because investors were demanding a high yield on investment-grade paper. However, Ann Iveson, head of European corporate debt capital markets at BNP Paribas, says that to swallow this sort of rating, long-term investors are only interested in solid names with improving credit stories. “It’s not the obvious route for lots of corporates and its not going to be open to as broad a universe of triple-B credits as it is in the US,” she says.

Lamedica at BNP Paribas says that no deals for unsuitable credits have been done yet.”The 30-year bonds done by the telecoms and utilities all makes sense from a credit perspective, even if some of them have been on the tight side.”

That’s quite a claim considering that leading European telecom companies are just now crawling out from under a mountain of debt that nearly crushed the life out of them. But some of the other credits that have explored these deals look even more dubious. “Food company Parmalat is looking to do 30 years, but I really don’t know if there’s demand for credits with a lot of emerging market exposure to do 30-year deals in euros,” says one analyst.

Several deals, including one for Vivendi Environnement and one for Endesa, have been postponed or cancelled.

For the corporates that have got funding already, the rationale to lock away long-term funds at attractive rates is pretty clear.

A wide range of investors have been happy to part with their cash for 30-year corporate bonds. And the reasons for buy-and-hold investors to become involved are still compelling, say analysts, particularly for the pension funds and insurance companies matching 30-year liabilities. This need is likely to increase further with the growth of occupational pensions in Europe. “Insurance companies were talking to me about the Olivetti bond and saying it was irresistible to get such a high coupon, a return you couldn’t find on other investment-grade bonds or even in the equity market,” says Kaiser.

Iveson at BNP Paribas, one of the bookrunners on France Telecom’s first 30-year deal, points out that it went to 200 international accounts, many more than in a 30-year sterling bond. “Everyone was astonished about how fast interest grew in FT’s 30-year tranche. The distribution was impressive and in the end lots of insurance companies participated.”

Analysts also point out that fund managers have taken more than half of some deals such as RWE’s and are likely to participate more as bond benchmarks are changed to include the 30-year sector.

According to Stephan Michel, a credit analyst at Barclays Capital, 30-year bonds can offer accentuated spread tightening for total-return investors, so long as you choose the right sector. “If investors want to extend the duration of their portfolios, they will choose a sector where the credit profile is improving. Telecoms are this years safe-haven credits,” he says.

But that heightened sensitivity both to movements in interest rates and changes in credit quality can also work against investors. Some fear what will happen to these 30-year deals if the corporate bond market as a whole slumps as quickly as it has recovered over the past three months. Another analyst says: “If things do go wrong in the credit markets, or in the company, these deals will be some of the first to be hit, as volatility leads to bigger cash losses in such a long maturity, particularly when there is not much liquidity in the market.” Kaiser adds: “If you had to go to your boss and say I bought this two weeks ago at 100 and now it’s 96, then that’s a big loss.”

Fading attractions Unfortunately, holders of some of these 30-year deals have already got first-hand experience of this.

The first deals all carried pretty attractive yields for investors to compensate for this risk, but then RWE came to the market with a e750 million 30-year deal led by ABN Amro, HypoVereinsbank and Morgan Stanley with a coupon of just 5.75%, at 107bp over mid-swaps. EdF edged a bit lower with its e850 million deal a few days later, with a coupon of 5.62%.

“Everyone was saying that this was a market more appropriate for yieldier names such as telecoms, which wasn’t the case at all,” says Barklam at Morgan Stanley. “RWE’s issue came at the time when there was a discussion going on about whether this was a higher-yield fad market, but this was a well-known euro market issuer where the bulk of investors have lines available.”

Such a low yield was a great coup for the issuer. Yet despite only 5% of the RWE issue having been sold to hedge funds at launch, the bond has experienced one of the most volatile rides in the secondary market, widening 31bp in one week, suggesting that investors are still not sure what represents fair value in the 30-year market.

The spread premium that these deals have offered compared with 10-year bonds from the same issuers varies dramatically. According to data from Nomura, in the middle of February Olivetti offered just 13% more than its 10-year spread over government bonds, RWE offered 49% more and EdF offered 109% more. “I was talking to one very conservative investor that only bought one of these 30-year bonds and that was EdF,” says an analyst.

The yield curve in euros has since steepened for these credits. “I’m not sure there was much risk-reward analysis going on from some investors,” says Duncan Sankey, head of credit research at Nomura.

Sankey thinks that investors should be more demanding: “The duration certainly amplifies the risks in these credits and when you look at the telecoms and utilities names which are doing these deals, in deregulating sectors, investors should be looking at some sort of covenants,” he says.

Companies can change an awful lot in three years, never mind 30. Sankey suggests some form of negative pledge or covenants governing asset disposals, merger restrictions or restrictive payments. “They won’t protect you against fundamental credit deterioration but they will afford you a degree of control over and a voice in what the management can and cannot do.”

Investors agree that analysis is tricky. “I think we all want to see more bonds out there so it’s easier to do the relative value,” says Martin Reeves, director of European and Asia Pacific credit research at Alliance Capital. “When you value a small number of bonds, there are always going to be anomalies in there, but I think it’s a bit too early to draw conclusions about the feasibility of the 30-year market. I don’t think there’s anyone who would dispute that it’s a good thing for the development of the euro market, irrespective of potential volatility over the next few months.”

The market certainly offers new options for bank traders and other shorter-term investors. “It offers new trades between dollar or sterling and euros, between utilities and telecoms, France Telecom’s 10-year and 30-year euro-denominated bonds and so on, so it would be a shame to disregard the market,” says Lamedica.

Banks keep pushing them Banks are still viewing these bonds as a good line of business. Barklam at Morgan Stanley says he will continue to recommend them to the bank’s corporate clients and that RWE will not be the last of tightly priced 30-year deals in euros. “You’re going to have deals that work and deals that don’t, otherwise spreads would just grind in tighter and tighter and tighter.” Issuers won’t want to be hitting the market now, but Barklam says: “Any industrial borrowers that are prepared to engage with their core investment base about the correct price could consider it at some point.”

The chance for opportunistic issuance is gone for the next few months, as it is in any maturity with the threat of war looming. Whether the primary market for 30-year deals will reopen soon is a difficult call. Kaiser says: “I think we will see a break for a couple of months with more sporadic 30-year issuance in euros, but eventually rates might not be so attractive for issuers any more or investors may be tempted to return once more to the equity markets by then.”

And, as he also points out, there is still a lot of uncertainty about who is the target buyer for this sort of investment. “Investors will be carefully monitoring the aftermarket performance of these bonds. The jury is still out as to whether these bonds will be high-beta assets that are favoured by investors that have strong short-term views on a credit, or will become illiquid after a while with a credit spread volatility that is lower than in the more common ten-year segment.”

Meanwhile, analysts recommend that investors treat this sector with caution and view it very selectively. Those that did not follow this approach from the start might have already lived to regret it.