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Debt markets: What’s behind the divide between the US and European corporate debt markets?

Top corporates are the new kings of the debt markets. Many are trading through sovereigns. Investors are desperate for their paper. But while US treasurers lock in historically low funding, their European counterparts are simply sitting on their cash piles. Louise Bowman investigates why, additional reporting by Helen Avery.

CASH-RICH INVESTMENT-GRADE corporates are the last safe haven and investors are desperate for exposure to them. With the SSA market in turmoil – and dragging the FIG sector down with it – the natural structure of the market has been inverted. Many corporates are now trading well inside their respective sovereigns and some of their banks – a situation that would have been unthinkable until recently. "The risk transmission from sovereign to corporates was thought to be a classic pass-through mechanism," says Jamie Hamilton, institutional credit portfolio manager at M&G Investments in London.

Hamilton manages a range of segregated and pooled funds, including the M&G All Stocks corporate bond fund. "But there is a feeling that for certain areas the sovereign rating ceiling mechanism is broken," he says.

The problem, of course, is that most corporates don’t need any money. That hasn’t stopped them accessing the debt markets in their droves in the US. Their new safe-haven status has meant many US corporates have been able to fund at levels that have stunned even the most seasoned syndicate veterans.

Towards the end of August the US investment grade market printed 18 deals worth $20 billion in a single day – its busiest ever. Firms such as Walt Disney and Johnson & Johnson have tapped the market at record lows. And at the end of September, McDonalds issued $500 million of 10.25 year notes at a record low coupon of 2.625% through Citi, JPMorgan and RBS. And in July single-A rated industrial gas and equipment supplier Air Products and Chemicals issued $350 million in five-year notes at a coupon of 2% via Barclays Capital and Deutsche Bank, prompting one seasoned market observer to tell Euromoney: "Two percent for Air Products is just insane."

While the sheer weight of demand in the US for high-quality corporate paper continues to surprise, what does not is that at the same time as these deals were flying out of the door the corporate bond market in Europe was totally dead.

Not that any reinforcement was needed, but the performance of the bond markets on both sides of the Atlantic over the summer has only served to emphasize the depth and liquidity of one and the fickleness of the other. When BMW printed a €1 billion six-and-a-half-year issue in late July it was the first euro corporate issue for two weeks – and the last for a further seven.

It also underscored the different reaction of corporates in the US and Europe to the extraordinary funding environment they find themselves in. In the US firms are taking advantage of record low coupons in the bond markets; in Europe underwriters are grumbling that firms simply cannot see the opportunity that is in front of them.

The figures for euro-denominated corporate investment-grade volumes certainly make sobering reading. According to Dealogic, issuance stood at €76.1 billion year to date at the end of September, down 22% from 2010 and the lowest year-to-date volume since 2005.

Compare this with the US. As of September 20, in 2011 $155 billion in bonds had been issued in US dollars by US corporates with a rating of single A and above. Other than in 2009 such high volumes on a year-to-date comparison have not been seen this century. Last year up to September 2 only $88.7 billion was issued by those corporate borrowers.

"The Eurobond markets for investment grade corporates in Europe have been disappointing," says Anthony Bryson, head of corporate DCM, Europe at BNP Paribas. "Far too often we are still having new issue premium discussions with issuers as though we have orderly markets. BMW opened and shut the market in July but in the US market behaviour is a lot more rational. The investor base is more organized which is why we have seen an avalanche of oversubscription in the US and little in Europe until very recently."

Both the US and the eurozone have experienced prolonged sovereign debt crises and both have banking sectors beset with problems. Therefore the difference in investment-grade corporate behaviour must be attributable to market mentality, argue underwriters in Europe.

"The US dollar market is more consistently open – and this is exaggerated during times of crisis," says Dominic Kerr, head of European corporate origination at HSBC.

In the US, the decision to take advantage of cheap debt financing window is, at present, a simple one. Hewlett-Packard raised $4.6 billion in bonds in September when it already has $15 billion in cash on its balance sheet according to earnings reports in July.

Market conditions in the corporate investment-grade sector have made it one that simply cannot be passed by. Single-A and higher-rated US corporates are witnessing some of the cheapest funding environments they have ever seen. For example, the Merrill Lynch Investment Grade Index at the end of June 2007 was 6%; it is now 3.7%. The index tracks yields for all US investment-grade corporate bonds.

"The coupons on many issuers’ bonds being issued are the lowest that they have ever issued. It is certainly great right now to put five-, 10- and 20-year debt on the balance sheet," says Nigel Cree, head of debt syndicate for North America at Deutsche Bank in New York.

Pent up demand

So is the lack of issuance in Europe a result of issuer or investor intransigence?

There can be little doubt that there is substantial pent-up demand for euro-denominated corporate paper given the issuance drought over the summer. "The universe of countries that is being tested by the market is a moving target," says Tomas Lundquist, head of corporate DCM at Citi in London. "Even with spreads on financials at all time wides investors have no inclination to buy: they all want to buy corporates."

"Investors have built up a lot of cash and there is a willingness to invest"

Huw Richards, JPMorgan

Huw Richards, head of high grade DCM for Western Europe at JPMorgan


And they were frustrated in that aim throughout the summer by the issuance drought. "Investors have cash to put to work," says Huw Richards, head of high grade DCM for Western Europe at JPMorgan. "Issuance has been below average over the last few months, so investors have built up a lot of cash and there is a willingness to invest."

The issuance hiatus was broken in early September with euro deals from KPN and RCI Banque and a sterling issue from SSE. The triple-B plus rated KPN deal was launched on September 8, a €500 million, 10-year bond through ABN Amro, Bank of America, Merrill Lynch and RBS at 193 basis points. The trade attracted an order book of €1.6 billion.

"When we did our recent bond issue the window was just one day," says KPN’s group treasurer Richard Veffer. "It should be weeks but it is only days. All-in rates may be attractive but access to the market is not obvious anymore. Availability is not easy and tenors and size available are typically less than those in the US. Corporates cannot trust the euro bond markets to be there for them," he says.

This is something that underwriters ruefully admit. "We don’t want to bring the courageous borrowers to the market and find that investors don’t play ball," says Bryson. He points to the recent Daimler Finance Yankee trade (which BNP Paribas co-ran with Deutsche Bank, HSBC and JPMorgan) which came on September 7 – just one day after the Dow Jones Industrial Average suffered a 300 point post-Labor Day slump. Despite the market jitters Daimler attracted almost $8 billion of orders for a $3.25 billion deal. "Daimler didn’t have an over-engineered new issue premium and they fully understand the market," he says. "I wish there were more issuers like this."

Deals of this size are still a distant dream in Europe – although triple-B rated Compagnie Saint-Goban did manage to raise nearly €2 billion in the week of September 23 through Crédit Agricole, JPMorgan, RBS and Société Générale. A deal of this size for a high-beta cyclical company such as this would not have been possible a few weeks earlier and the market took heart from the trade. But confidence is still so fragile that it can evaporate overnight.

This might be because of changes in the nature of the buyers themselves. "If you look at the order books of recent investors, total-return investors have been absent," says Jeff Tannenbaum, head of European syndicate at Bank of America Merrill Lynch, which by the end of September had been involved in every Eurobond deal since the summer. "These accounts are evaluating value in both CDS and cash across sovereign, bank and corporate risk in a particular region. But for corporate bond funds and certain insurance companies that are restricted by their mandates the choice is between cash or a corporate bond." These investors can have a very hard time extrapolating the right price from the anaemic secondary market – and grumble that the range can be 20bp to 25bp from different bookrunners on a deal. But while the fast hedge fund money might be off chasing returns in the sovereigns market (see Sovereign debt: Credit specialists dive in as SSA investors take frightEuromoney September 2011), there is still sufficient appetite for coupons in Europe as well as the US to be hitting record lows.

The recent €500 million Schneider Electric deal through Bank of America Merrill Lynch, Crédit Agricole, Deutsche Bank and Société Générale was, at 3.5%, the lowest seven-year coupon year to date in 2011. The lowest 10-year coupon was also set in September, by Suez Environnement at 3.875%.

But the sovereign debt crisis is inevitably the elephant in the room for any investment-grade eurozone bond issue at the moment. A team of analysts at Citi headed by Hans Lorenzen recently published research looking at the relationship between corporate and sovereign spreads and how the former have reacted to the blowout in the latter (When sovereigns dominate corporates, September 8).

Comparing the corporate credit market’s reaction to the sovereign crisis to a person enduring the five stages of trauma experienced in a psychologist’s Kübler-Ross model (denial, anger, bargaining, depression and finally acceptance), they conclude that corporate sensitivity rises by a multiple of two to three times when sovereign spreads breach 100bp to 150bp. The extent to which there is acceptance is, however, entirely dependent on the domicile.

In April this year triple-B rated Greek telecoms group OTE (which is 30% owned by Deutsche Telekom) cemented a €500 million three-year crossover transaction that yielded 7.375%. That trade attracted €1.8 billion of orders from 195 accounts through Alpha Bank, BNP Paribas, EFG Eurobank, HSBC and Morgan Stanley.

At the time the deal was hailed as evidence that investors were distinguishing between the corporate and the sovereign. No longer. "We couldn’t have got that deal done now," admits one of the leads.

In considering any corporate an investor will look at how much exposure is domestic, what the chance is of the government intervening in the business, how anticyclical and immune from recession it is and what the impact of a distressed event on the sovereign would be. "The circle is closing," warns Lundquist at Citi. "The banks have been impacted by the weakness of the sovereign and corporates are now becoming impacted as well for instance – Telefónica has been hit and 70% of its revenues are outside Spain. There is a lot of merit in the individual companies but in an initial sell-off investors will be risk averse."

Other deals, such as the Amadeus trade in July, demonstrated that some large diversified corporates can still transcend sovereign woes. Headquartered in Spain, the travel logistics firm tapped the market with a debut €750 million five-year deal that attracted €2.3 billion of orders. "Amadeus is a diversified, global business and was able to access strong investor appetite," says Francois Bleines, head of corporate syndicate at Deutsche Bank, which was part of the bookrunner group. However, another large global name associated with Spain, Ferrovial-owned BAA, put on hold a potential four-year €500 million senior-secured deal led by BAML, BNP Paribas, HSBC and Santander in early September.

Other corporates associated with a troubled sovereign, such as France’s Schlumberger and France Telecom, have opted for the yankee market. Indeed, the reception for KPN’s Eurobond deal was helped by the fact that single-A minus rated France Telecom had opted to tap the yankee market shortly beforehand, leaving the euro market clear for the Dutch firm.

France Telecom issued $1 billion of five-year paper and $1 billion of 10-year notes through BAML, Citi and JPMorgan. The deal attracted $5.5 billion of orders and priced at 195bp/220bp over treasuries – an indication of the appetite for the name. It also illustrated how much more attractive the yankee market can be for corporates. France Telecom has no need for dollar funding but did the trade purely to take advantage of the pricing available and the basis swap.

This is the kind of thing that underwriters want to see happen in Europe. "It would be healthy for sophisticated borrowers to take a US-style approach and take advantage of the situation," says Bryson at BNP Paribas. Several bankers grumble that corporates in Europe are too focused on the spread level rather than the coupon level and being obsessed with new issue premiums.

Bleines says: "There is less activity from European issuers because they do not want to pay the current new-issue premium. In Europe corporates have historically used bank facilities more than in the US and are more margin-driven. In the US, corporates focus more on coupon levels, which results in higher levels of volume."

Kerr at HSBC agrees. "New-issue premiums are at record levels," he says. "But in this period of renewed volatility issuers need to pay a premium to get investors comfortable." Veffer at KPN reckons that the firm paid a premium of around 13bp on its September trade.

"US corporates have always been more focused on fixed rates," says Tannenbaum. "European corporates historically have been more Libor focused so it has taken longer for them to react. But they are waking up to the fact that even if spreads are wider and new-issue premiums higher, yields are at record lows. I expect to see more corporates coming to the market."

Although it is no surprise to see bond underwriters arguing for more bond issuance, not all corporates are likely to play ball. The argument that firms should tap the market purely because the yields on offer are at record lows does not answer the more pressing question of why companies should raise funds that they do not need.

"The issue for corporates is that even though rates are low, excess cash means a negative carry for them," says Richards. "European corporates with no immediate use of proceeds have embarked on liability management exercises. Firms have taken their nearer term maturities and pushed them out to 10 years or even longer – this is a good non-cash way of taking advantage of the interest rate environment."

But for some corporates the problem of having cash on the balance sheet overrides the opportunity that the present funding environment offers.

"All-in price is just about the only silver lining in the debt market right now," says Veffer at KPN. "We made the decision to manage our cash balances down because of the lack of places to use it. If we raised further funds we would initially have to put them on the balance sheet, which is negative carry for us."

But maybe corporates should start to look at the bigger picture. Richards at JPMorgan says that the market is driven by short windows of opportunity and European corporates should be ready to take advantage of stability in the market to issue debt.

"The cost of prefunding liquidity needs is expensive," he says. "But if you look at it as an insurance premium against future market dislocations then the cost does not appear to be so high. The market is considering a broad range of outcomes in Europe with some very big tail risks. This puts the cost of insurance into perspective given that the range of outcomes has widened dramatically."

And the overwhelming demand for investment-grade corporates might prove as unstable as the sovereign and financials turmoil on which it is based. "It is too late to be diving from financials to corporates now," observes Hamilton. "Investment-grade corporates have held in relatively well and the value is not desperately obvious any more. Now the value is in secured parts of the financial sector and high yield."

The retail option

Retail investors have always seemed a mixed blessing to investment-grade issuers. However, as the market volatility persists more firms might start to investigate their potential. UK power network operator National Grid issued a 10-year inflation-linked bond in September through Barclays Capital and Evolution Securities that demonstrated what can be raised for issuers that persevere. Some £260 million was raised in the largest UK retail bond to date. "Retail investors take a longer view," says Toby Croasdell, director of MTNs and structured note trading at Barclays Capital in London. "Retail is more immune to the intra-day volatility that institutional investors have had to deal with. This market continues to gather momentum for good domestic names with good credit stories."

This is the first inflation-linked bond to be offered by a corporate in the UK retail market. The structure is ideal for National Grid as its regulated asset base is linked to the retail price index. But it could be applicable to other issuers. "The sterling market is more isolated from the eurozone sovereign distress and the National Grid deal is a very interesting trend," comments one banker away from the deal. "The retail investor base is less spooked by volatility in the market but these deals take a very long time in preparation."

Size has always been a limiting factor for retail deals but there have been some benchmark-sized issues. Places for People, a property management development and regeneration company, raised £140 million from retail investors despite not being a well-recognized household name. "Issuers have underestimated the size of this market," says Croasdell. "This is a market that is more accessible in difficult times. Issuers can see the benefit of a more sticky investor base."

Croasdell concedes that it is difficult to quantify the benefit to the retail market of the volatility in the institutional market but notes that when the public markets get very volatile the MTN and private placement markets get very active. National Grid’s global tax and treasury director, Malcolm Cooper, has stated that the firm would have been unlikely to issue an institutional deal. "The retail market will evolve and we will see diversification," Croasdell predicts. "This is a way for retail investors to invest further up the capital structure than equity."

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