When German pharmaceutical group Merck came to the bond market in March to raise part of the funding for its $6.2bn takeover of US rival Millipore, it cannot have imagined just how popular it would be.
The company, looking to print no more than Eu3.2bn, raised over Eu26bn of orders, the book being one of the biggest ever for a German corporate bond.
The enormous appetite for the deal reflected the low supply of corporate bonds at the time, particularly from blue-chip companies. Unfortunately for investors, the Merck transaction did not lead to a wave of further issuance from Germany, M&A-related or otherwise. Activity from the countrys non-financial blue-chips has remained muted throughout this year, especially in comparison to 2009, when they sold a record Eu80bn of bonds, according to Dealogic. By contrast, 2010 volumes for the first 10 months totalled Eu30bn.
But while Germanys big businesses have been quiet, mid-cap companies are helping to fill the gap. Several have tapped the bond market this year, often selling benchmark-sized deals those of at least Eu500m in size. This is demonstrated in the high proportion of supply from lower rated names. By mid-October, 38% of German corporate issuance had come from unrated or sub-investment grade credits, says Dominik Huhle, a director in Barclays Capitals debt capital markets team in Frankfurt. The figure was only 8% in 2009, while in the preceding two years it was negligible.
Much of the Mittelstand firms foray into the public debt markets is a result of them wanting to diversify their funding bases. In the past they have financed themselves almost entirely with bank debt, either in the form of syndicated loans or Schuldscheine, private debt instruments that are structured like bonds but mostly bought by savings banks, or Sparkassen. But events in the last two years have emphasised the need for firms, even mid-cap ones, to look beyond loans. "Mittelstand companies are relying less on bank debt than before," says Olaf Sarges, global head of DCM corporate origination at UniCredit in Munich. "Theyve learnt from the crisis to diversify their funding base. They realise that using loans for 80%-90% of their financing can cause problems."
Equity investors, much like rating agencies, have been pushing German companies to vary their funding. Whereas before they hardly looked beyond a firms growth prospects when deciding whether to buy its shares, capital structures and access to liquidity have become equally important.
Mittelstand firms have also moved into the bond market because bank funding has been harder to come by. While the syndicated loan market has strengthened in the past 18 months, conditions have eased more for blue-chip companies than smaller ones. "You have to differentiate between the high rated, large cap and multinational credits, and mid-cap borrowers," says Dirk Hentschel, head of loan distribution for Europe, the Middle East and Africa at WestLB in London. "For the former, support from the banking market is more or less back to normal. But for the latter, liquidity on some transactions and specific sectors is still tight. This segment of the market is still a way off how it was in 2006 and early 2007."
Part of the reason for mid-cap firms difficultly raising loans is that non-German lenders are less active in the country than they used to be. This is hardly unique to Germany, with banks throughout western Europe mainly restricting their lending outside their domestic markets to large-cap credits with high ratings and plenty of ancillary business. "There are fewer international banks active in Germany, especially in the mid-cap space, than three years ago," says Richard Hill, head of loan syndication for EMEA at WestLB in London. "Even the ones that are lending are more conservative, thanks to a bias for reserving capital for lending to clients closer to their home markets."
If you cant get a bond,
we wont give you a loan
Mittelstand firms are by no means shut out of the loan market, and liquidity for them is increasing. But the cost of their debt is more expensive than that of blue-chip borrowers, mainly because they tend to have weaker credit metrics and are often in cyclical industries. Also, thanks to their operations being smaller, they cannot offer as much ancillary business. Lenders insist on higher margins as a result. "Its more expensive for the Mittelstand companies to tap the loan market, because they have less side business," says Matthias Gaab, head of Deutsche Banks global lending group for Germany, Austria and Switzerland, in Frankfurt.
Changes to bank regulations, particularly the upcoming Basel III proposals, have also made borrowing tougher for the Mittelstand sector. With lending to lower rated credits becoming more expensive for banks, it is perhaps inevitable that mid-cap firms have turned to public debt instruments more frequently. "Basel III regulations will push many mid-cap borrowers from the loan market to the bond market," says Matthias Glückert, global head of debt syndicate at UniCredit in Munich.
He adds that many banks are more willing to lend to companies that have proved they can tap a range of funding sources. "Ironically, if a borrower can show its relationship banks that it has access to the bond market, then it will get much better terms on its loans," he says.
Bond investors have been only too happy to buy deals from mid-cap firms. With underlying rates at record lows and supply from blue-chips down, investors have had to look beyond the usual suspects when seeking attractive returns. "With absolute yields and spreads coming down, investors have looked to buy longer bonds or those from lesser-rated credits," says BarCaps Huhle. "This has really helped second and third tier borrowers. Three years ago they probably wouldnt have looked at the bond market."
Several German companies, from a wide range of sectors, have issued debut bonds this year. Among the borrowers have been Celesio, the pharmaceutical group that printed a Eu500m 4.5% five year deal in April; chemicals firm Symrise, which sold a Eu300m 4.125% seven year bond in October; and renewable energy company SolarWorld, which issued Eu400m of 6.125% seven year paper in January. All three borrowers were unrated. But that had little negative effect on their deals. Bankers say that borrowers looking to raise no more than Eu500m annually can rely on domestic accounts, which tend not to insist on ratings, to buy their debt. A rating is only a necessity if they want to issue bigger volumes and thus need to tap international investors, who will be less familiar with their credit profiles.
Blast from the past
This year has also seen the comeback of rare German issuers. In September, Rheinmetall, the defence firm rated Baa3/-/BBB, sold a Eu500m seven year note, its first bond since 2005. And last month Sixt, the car rental company, issued a Eu250m six year deal in what was only its third visit to the public bond market.
Sixts transaction typified the issuance in Germany this year by mid-cap firms. The borrower appealed to investors thanks to it being a strong credit bankers say it is mostly viewed as an investment grade issuer. Being unrated, it also offered a coupon of 4.125%, juicy at a time when blue-chip deals with maturities up to 10 years are routinely priced closer to 3%
Sixt was also helped by being a well-known brand, especially within Germany. "Household names do benefit from strong retail intermediary and retail distribution both in the primary and secondary markets," says Joachim Heppe, head of DCM bond syndicate at Commerzbank in Frankfurt.
Bankers have been struck by the size of the deals printed this year by Mittelstand firms. "Theyre regularly selling benchmark transactions," says one in Frankfurt. "Its no longer strange for them to raise order books of Eu1bn or more. This is something very new to the German market. Before, anything above Eu300m was considered the preserve of the biggest companies."
The development is unlikely to be short-lived. While German mid-cap borrowers will doubtless remain big users of bank debt and it is unlikely they will copy the US model of tapping bond markets for almost all their term funding they will not revert to relying as much on loans as they did before 2009. Instead, their recent use of a combination of bonds and bank debt will persist. "Well see a continuation of this theme whereby debut or infrequent issuers are making use of the bond market much more often than in the past," says UniCredits Sarges.
Bond investors high demand for mid-cap credits has meant that Schuldschein issuance in the last few months has largely been confined to the smallest companies, with deals tending to be no more than Eu100m. This is in contrast to 18 months ago when even Dax 30 companies including Adidas, Lufthansa and software firm SAP were selling the instruments, the bond and loan markets being volatile at the time. Now, for borrowers seeking more than Eu100m, it is easier to issue a public bond than a Schuldschein, says Sarges.
But for those who do tap the Schuldschein market, demand is robust and growing. "There is stronger competition for Schuldschein mandates right now, as rated, well known borrowers tap the bond market and there are fewer deals in the Schuldschein market," says Jamuna Ganesh, head of corporate loan syndicate for Germany, Switzerland and Austria at WestLB in Düsseldorf.
Germanys biggest borrowers have been quiet this year mainly because they funded so heavily in the bond market in 2009, as they went about reducing their bank debt and extending their maturity profiles. They are yet to start increasing their leverage again, which is similar to what is happening elsewhere in Europe. According to Heppe of Commerzbank, European non-financial companies reduced their average net debt to Ebitda ratios from 2.5 times at the end the first quarter to 2.3 times at the end of June.
The lack of urgency to fund is also down to the strength of Germanys economy, which has outpaced the rest of western Europe this year and grew 2.2% in the second quarter alone. Many borrowers that were expected to have to turn to debt markets to boost liquidity have been able to rely on increased sales instead. The car industry is a case in point, with BMW, Daimler and Volkswagen usually among Germanys biggest borrowers having issued little debt this year. "Since 2008, the car companies have performed much better than expected, with demand from China being especially strong," says Huhle. "Their cashflows have been robust."
Companies reluctance to take on more debt was demonstrated in late September when RWE, a utility and also usually one of Germanys most active borrowers, issued Eu1.75bn of hybrid debt. RWE printed the deal, its only bond this year, mainly to protect its A2/A ratings, both of them being on negative outlook. The ratings agencies treat hybrids as equity-like instruments, especially those which, like RWEs, have perpetual maturities and deferrable coupons.
The trend has been similar in the loan market, with borrowers raising little new money debt. Instead, refinancings have dominated this year. The blue-chip companies have focused on rolling over backstop revolvers, often used to support commercial paper programmes and which are hardly ever drawn.
In part because of the lack of supply, investors have lapped up Germanys blue-chips whenever they have tapped the loan or bond markets. RWEs hybrid, which raised over Eu5bn of orders, typified this, as did Mercks Eu3.2bn deal. The only other M&A-related bond of note SAPs Eu1.2bn transaction in July helping to finance its $5.8bn takeover of US firm Sybase also proved highly popular.
When borrowers have issued, they have benefitted from low underlying rates and been able to obtain among their lowest ever coupons (spreads, however, are largely unchanged from last year). VW, rated A3/A-, sold a Eu1bn three year note in August with a coupon of just 1.625%.
Pricing in the loan market is still comfortably higher than it was in 2006 and early 2007. But margins are contracting quickly. E.On, the utility rated A2/A/A, demonstrated this when it signed a Eu6bn five year backstop revolver paying 47.5bp over Euribor in October such a deal would have had a margin of well over 100bp 12 months before. RWE, rated A2/A/A+, is trying to push the boundaries even further. Pricing on its Eu4bn loan is much the same as E.Ons, but it wants a five year plus one plus one tenor, which would be the longest in western Europe since the start of the financial crisis. If it gets its way, bankers worry that a straight seven year deal will emerge as soon as the first quarter of 2011.
When will pricing bottom?
Bankers say that the low volumes this year, particularly of new money loans, meant pricing was inevitably going to narrow. But some lenders are uncomfortable how far it has fallen. "The pricing contractions weve seen in the loan market dont seem in synch with Basel III," says Deutsches Gaab. "If it carries on, one would expect that banks will put up some resistance."
Many bankers fear pricing has not troughed, however, not least because in other parts of western Europe, which Germany tends to keep in synch with, there is little sign that the terms being offered to borrowers are becoming more investor friendly. "Already at current pricing levels, some lenders will be making less than their return on equity requirements," says Hentschel of WestLB. "But based on whats happening in countries like France and Switzerland, it wouldnt be surprising if margins do drop even further."
A key factor determining supply of bonds and loans next year will be M&A activity. German companies, like most others in Europe, are still reluctant to carry out big debt-funded acquisitions. BASF, the chemicals group, Merck and SAP have been the only ones to do so this year. But there are signs that a new M&A cycle could soon begin, thanks to Germanys economy, both its exports and, to a lesser extent, domestic consumption, proving robust. If this does happen, blue-chip companies are unlikely to be the only ones hunting for assets. "Loans volumes could pick up quite a lot at the beginning of 2011, partly because companies are once again looking at acquisitions," says WestLBs Ganesh. "We are currently in concrete discussion with a number of midcap companies for acquisition financings."
There is likely to be plenty of appetite among banks and bond investors to back large and mid-cap M&A deals, should they emerge. BASF, Merck and SAP, that were easily able to obtain debt funding for their acquisitions, demonstrated this. All three initially obtained respective loans of Eu3bn, Eu4.2bn and Eu2.75bn. BASF used its one year facility, which backed the takeover of Cognis, as a bridge to commercial paper issuance. The other two syndicated their facilities, but quickly took big chunks of them out in the public bond market.
Banks are less averse to committing to long term drawn facilities than they were 12 months ago. But most think that M&A funding will continue to take the form of short-term bridge loans underwritten by a small number of banks and, perhaps, sold down to a select few relationship lenders that will be rapidly taken out with bonds.
For borrowers it is a logical strategy. The loan market is still the best for raising large commitments discreetly essential for carrying out big takeover bids while the bond market offers cheaper long term drawn debt, making it apt for refinancing bridge loans once acquisitions have been accepted. "Companies that have access to debt capital markets will probably continue to turn to bonds for their drawn debt and use banks more for backstop facilities," says Gaab. "I dont imagine companies issuing much funded debt in the loan market unless pricing comes down vis-à-vis that for bonds."
Bankers are divided over whether German firms will increase their funding next year if M&A activity remains muted. Some say there are already signs that Mittelstand firms will boost capex as their outlooks improve with the growing economy. Others argue that German companies, particularly the blue-chips, have enough cash on their balance sheets to cover any extra funding needs in 2011 without taking on more debt. "German blue-chips are pretty well funded for the time being and benefit from strong operating performances," says a senior bond originator in the country. "In the absence of event-driven financing, there doesnt seem to be any particular reason why there should be tremendous issuance from them soon."
He points out that while borrowers in other parts of Europe, not least France, has been busy carrying out liability management exercises buying back short-dated bonds and issuing longer-dated, but cheaper, ones in their place German firms mostly shunned them. "Theyre sitting on so much cash that they want to repay a lot of their debt as it comes due, not extend it further," he says.
Emphasising this point, Fitch said in early November that it expects European corporate bond issuance, forecast to total Eu214bn this year, to fall to Eu170bn-Eu192bn in 2011, with the highest quality credits decreasing their proportion of supply.German companies are in an enviable position should they decide to raise big sums in the loan and bond markets next year, however. The eurozone sovereign crisis has led to greater demand for their paper relative to borrowers from elsewhere. "With the eurozone sovereign debt crisis, issuers from core Europe are more in vogue and getting better pricing than issuers from peripheral Europe," says Huhle. "German borrowers have been among the beneficiaries." Investors will be keeping their fingers crossed that deals similar to Mercks earlier this year will soon become a lot less rare.