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Macaskill on markets: Jumbo bonds may reopen allocation questions

Apple has reopened the market for jumbo bonds as it steps up its share buyback plans and other borrowers are likely to follow suit as mergers and acquisition activity revives.

 apple jumbo bond
 Rich fruit for bond investors

Apple opened its new debt push with a $12 billion bond that was smaller than its $17 billion issue of April last year, but debt capital markets bankers are already wondering whether they can talk another borrower into a much bigger deal – perhaps one to exceed the Verizon $49 billion bond that set a new record for corporate debt issuance last September. Depending on how new deals are priced, they could prompt further scrutiny of the interaction between dealers and big investors when plum corporate bond allocations are determined.

The Verizon bond dwarfed last year’s Apple deal that held the record for the biggest corporate debt issue outstanding for just over four months. Verizon placed its deal, which helped to pay for the $130 billion acquisition of Verizon Wireless stock it did not already own, with ease, in part because it took a starkly different approach to pricing than Apple.

The Apple bond was priced keenly, after lead managers Goldman Sachs and Deutsche Bank reported back on investor demand to the corporate. The multi-tranche deal was comfortably over-subscribed and sold with no demand problems, but soon after issuance the price of the debt fell on an absolute basis and spreads to Treasuries widened sharply from launch levels. A year after the bond priced, its key long tranches are still trading well below par, though Apple did not have any trouble returning to the market with a $12 billion deal within 12 months.

Verizon, by contrast, offered a big new issue concession to investors that ensured a frenzy of demand and delivered over $2 billion of instant paper profit to investors. With more of a curve of existing debt than Apple, Verizon was able to gauge how much of a new issue premium it wanted to give to investors and it decided to err on the side of generosity, with a long end tranche pricing at a hefty 90bp premium to outstanding debt.

There was a rationale for this give-away: Verizon had increased the total size of the deal from its initially mooted level after hearing about potential demand from underwriters led by JPMorgan and Morgan Stanley. The firm wanted the bond issue to succeed without causing any distraction from its key objective of concluding the purchase of Verizon Wireless stock and seemed to feel so giddy about the launch process that it even agreed to pay higher fees to its bond lead managers than it might have done, for a total of over $250 million.

Everyone seemed to be a winner, especially the big asset managers who managed to land large portions of a deal that is still trading roughly 100bp tighter than its launch spreads for key tranches. But an instant gain of well over 30% in spread terms for big investors (the 30-year tranche of the Verizon deal priced at 265bp over the comparable Treasury) can be viewed as a suspiciously easy profit.

The deal seems to have raised some regulatory antennae, as this year it emerged that US banks have been questioned by supervisors about their fixed income allocation policies.

The relationship between dealers and the biggest buyers of bonds is likely to be the focus of this investigation. The Verizon deal, with its massive size and sharp price appreciation, highlights how much can be at stake for buyers that secure a large portion of a new deal.

There were unconfirmed reports at the time of the Verizon deal that Pimco was allocated $8 billion of the new bonds, or roughly 16% of the total issue, while BlackRock got $5 billion, or around 10%. The strong performance of the deal delivered roughly $2.5 billion of paper profit to investors, so if the allocation numbers are correct, Pimco might have been able to book a gain of $375 million or so and BlackRock a profit of $250 million. That’s a nice return for a glance at a screen to confirm that a new issue premium of almost 1% to existing debt was on offer for select tranches and a few calls to remind lead managers who ultimately ensure they can collect their fees, and later their bonuses.

The fees (and bonuses) are the main motive for banks, which creates potential grey areas surrounding allocation policies when a borrower is found that is willing to offer a big concession to ensure the success of a bond.

Verizon was happy to pay up last year and other borrowers may soon be persuaded to follow suit, especially if a debt issue is ancillary to a goal such as a transformational merger – or the current vogue for a restructuring that shields global revenues for a US company from the corporate tax rate levied back in the US.

Corporate treasurers are generally thrifty individuals who take pride in pushing down borrowing costs, but chief executives and many CFOs take a more expansive view and some of the firms considering jumbo debt issuance operate in sectors that now function on a much bigger scale than investment banking.

Apple, for example, generated $170 billion of revenue in 2013 and is not raising money because it needs cash.

The main players in the investment banking industry between them produced less total revenue last year – with a Coalition index estimate of $153.3 billion for the top 10 banks that handle most business. Coalition arrived at an estimate of $18.6 billion for the proportion of this amount that came from debt capital markets issuance, though other analysts have higher totals, with a report from Oliver Wyman and Morgan Stanley released in March pegging DCM revenues from a bigger pool of banks at $22 billion.

For most of the first quarter of this year, as concern mounted over emerging markets, then the Ukraine crisis, expectations were that DCM revenues for banks would at best hold flat to last year’s totals.

But unexpectedly strong issuance at the end of the quarter has been followed by renewed talk of jumbo deals, led by the Apple announcement on its earnings call on April 23, and an increase in M&A activity. Much of the potential merger-related issuance is in the sweet spot for deals that do not disrupt spread expectations for other more routine bond sales, by featuring borrowers that can raise substantial amounts of money without over-leveraging. And even theleveraged debt markets are performing strongly, as demand for a record-setting high-yield bond of almost $11 billion equivalent for Numericable demonstrated.

This could all combine to push DCM revenues comfortably above $20 billion this year, while credit trading revenues may match the $21 billion of 2013 (according to MS/Oliver Wyman). Flow credit trading revenues have been under pressure in recent years as dealers cut bond inventories and secondary market liquidity declined. But there are pockets of opportunity –Deutsche Bankposted stronger credit revenues than expected for the first quarter, in part due to distressed credit trading gains, for example. And single name credit default swap trading volumes are healthy.

Credit trading is at least proving resilient this year, compared with other fixed income areas such as rates and FX, where revenues are falling off a cliff. Banks will regret spoiling the nearest thing to a fixed income party if any corporate bond allocation abuses are eventually uncovered that put a dampener on the market for issuing and trading credit.