The euro corporate market has this year exceeded all expectations. Strong demand for credit product and historically low absolute yields have produced the most favourable conditions since equity markets began to fall in March 2000. This has allowed corporates to not only meet pressing financing needs but also test the depth and breadth of the market with new products. Neil Day reports.
It wasn't meant to be this easy. At the beginning of the year sentiment was finely balanced. Although the spread tightening into the end of 2002 had raised hopes of a continued credit market rally, economic and geopolitical uncertainty cast long shadows over the corporate bond market.
Would the global economy enter a deflationary spiral? Would Bush's threats to Iraq lead to World War III?
This year, neither of those questions has been fully answered. However, most investors appear to have satisfied themselves with an ambiguous "not yet".
The result has been a corporate bond market in Europe more buoyant than anyone could have confidently predicted at the beginning of the year. Even the revelation of an accounting scandal at a major European issuer - Ahold - and the outbreak of the Sars virus, on top of the dual threats to global prosperity failed to hold back the market.
One deal that illustrated this as much as any other was the debut bond issue for EADS, the world's second largest aerospace and defence company. Led by Barclays Capital, BNP Paribas and HypoVereinsbank, at first glance the credit appeared to be just what the market was not looking for. Although the company's defence business might have been a hedge against a prolonged Iraq conflict, EADS had huge exposure to the ailing airline sector - over 70% of its revenues - through its subsidiary Airbus.
|Bookrunners of Corporate issuance - 2003 (June 10, 2003)|
|Rank||Lead manager||Amount Eu m||No of issues||Share %|
|Total in data set||91,038.50||188||100.00|
|Source: Dealogic BondWare|
"We launched the deal right in the middle of the run-up to Iraq," recalls one banker who worked on the issue. "It was a brand new name in an extremely difficult sector, the world's airlines were on their knees, and, with the potential war out there, nobody knew what was going to happen to civilian passenger traffic and hence the demand for aircraft."
But launched on February 20, as a war in Iraq was looking ever more likely, the A3/A deal nevertheless attracted Eu1.8bn of orders and was increased from Eu750m to Eu1bn. The pricing was also tighter than initially expected, at 97bp over mid-swaps compared to guidance of 100bp over.
EADS' ability to achieve such a result was a measure of the demand for corporate bonds that has been the driving force behind both the level of issuance and performance of spreads this year, and which has allowed last year's problem credits to score some of this year's most notable successes.
In mid-January, France Télécom launched the largest euro corporate bond of the year, a Eu5.5n three tranche issue that took out almost all of its bond financing needs for the year. The company issued Eu1bn of five year paper, Eu3.5bn of 10 year and Eu1bn of 30 year bonds - the last hot on the heels of Olivetti, which had a week earlier opened the 30 year part of the euro credit market (see separate article). All three tranches tightened in the aftermarket, confirming the success of France Télécom's comeback.
"The company has managed in one month of the announcement of its restructuring plan to turn France Télécom into a credit that is one of the must-have names of the corporate market," said an official at one of the leads - BNP Paribas, Citigroup/SSSB, Deutsche Bank, HSBC and Morgan Stanley.
"This was a dream trade in many different ways, but most importantly for France Télécom it endorses the 2005 plan outlined in December. The management are to be applauded for their foresight, and for taking advantage of favourable early year market conditions."
France Télécom's transaction also confounded those who had expected the prospect of a war in Iraq to stymie issuance and highlighted the technicals supporting the market.
"Most people had expected flat supply and very tough market conditions, but what we saw was, to an extent, the reverse," says Eirik Winter, head of European corporate debt capital markets at Citigroup. "Firstly, because of the impending war, quite a lot of issuers came to market ahead of its likely start. And secondly, the technicals were very strong. People were still heavily underinvested in the credit markets, but considering that equities were still expensive and government bond yields were too low, they had to buy corporate bonds."
Fallen angels redeemed
Investors' appetite for yield and confidence in the market not only enabled the opening of the 30 year sector and a big increase in 15 year issuance, but also allowed lower rated credits into the market. Among these were fallen angels that only 12 months ago were facing a bleak future.
Vivendi Universal in April was able to launch the largest ever high yield issue for a European corporate, selling Eu1.2bn of a six times oversubscribed deal at the tight end of price talk, via Bank of America, Citigroup, Goldman Sachs, JP Morgan and Royal Bank of Scotland.
The transaction was split into $925m and Eu325m tranches, the dollar being priced at 9.25% and the euro at 9.75%. "These coupons are in line with the company's best expectations," said a Vivendi Universal spokesperson.
While the dollar tranche was larger, the response from European accounts was encouraging. Bonds were placed in the UK, France, Germany, Spain, Italy and Scandinavia, alongside the US and Asia. "We had several hundred investors in the book, on both sides of the Atlantic," said Timothy Flynn, head of high yield capital markets at Goldman Sachs. "The book was comprised mostly of traditional high yield funds, but we also had a number of investment grade accounts, particularly in Europe."
Interest in sub-investment grade credits was again in evidence when another fallen angel, Rhodia, raised around Eu1bn equivalent in May via Goldman Sachs, Bear Stearns and BNP Paribas. And unlike Vivendi, the chemicals company, rated Ba2/BB, was able to issue similar amounts in dollars and euros, launching two Yankee tranches, totalling $585m and two euros for Eu500m.
"We saw substantial participation in the transaction by traditional investment grade accounts, particularly in the euro senior notes," said an official at one of the leads.
30 years: halfway there
When Olivetti raised Eu500m through a surprise 30 year transaction in the first full week of the year, it sparked a stampede into the long end of the credit market. Within a month France Télécom, Deutsche Telekom, RWE, Telefónica and EdF had, with Olivetti, issued almost Eu4.5bn into a maturity that had previously been a twinkle in the eye of DCM bankers, who, alongside investors, rushed to take full advantage of the new market.
"The Olivetti deal is a genuinely groundbreaking transaction," said Jonathan Hoyle on the fixed income syndicate desk at JP Morgan. "The achievement is all the more noteworthy as the issuer was a triple-B credit and a holding company. We were genuinely surprised by the depth of demand for the 30 year tranche."
Olivetti's transaction - led by Caboto IntesaBci, Goldman Sachs, JP Morgan, Lehman Brothers and Mediobanca - had not originally been designed to have a 30 year tranche; the long dated issue only emerged on a reverse enquiry basis to be included alongside Eu1.75bn five year and Eu850m 10 year tranches.
As a result, borrowers due to come to the market in the coming weeks or looking for opportunistic funding put out feelers into the European investor base about whether further supply would be welcomed. The first to take advantage of the demand that surfaced was France Télécom, which launched the first Eu1bn 30 year deal, as part of a Eu5.5bn package, the largest bond issue of the year.
"We had been considering testing the market with a long dated tranche on a reverse enquiry basis, but at first we only believed that a maturity in the 15 to 20 year area would be possible," said France Télécom group treasurer Michel Poirier. "That we could have this kind of a book [Eu3.25bn] on a 30 year transaction, and so international, was amazing."
However, as other issuers entered the market, the shortcomings of the new maturity became clear when the spread of the 30 year issues proved volatile in the secondary market. The Eu750m issue that ABN Amro, HypoVereinsbank and Morgan Stanley launched for RWE, for example, was priced at 115bp over mid-swaps but traded as wide as 151bp over - although it has recently traded at around 97bp over, 18bp tighter than at launch.
Such volatility and the reaction it provoked from investors even forced Vivendi Enironnement (now Veolia) to shelve plans to launch a Eu500m 30 year issue. Investors considered the combination of the name and the maturity too risky.
"At the moment, it is difficult to know what is the correct spread for any 30 year deal," said one investor. "RWE tightened 15bp, but then widened 30bp. There is a lot of volatility in 30 year bonds. If Vivendi Environnement were to be downgraded, then it would be dangerous to be exposed to the name in 30 years."
At the heart of these problems was the question of who was buying the paper, and why. "We know of real money accounts that bought into the long tranches of both Olivetti and France Télécom," said one syndicate manager. "But the hedge fund community is also buying this long dated product and we wonder whether it is sustainable."
Investors backed up the view that hot money had found its way into the transactions. "German insurance companies are the main end buyers of the 30 year issuance, but, like us, many fund managers are just looking to make money quickly out of these deals," said one.
Bankers who were involved in the flurry of issuance now acknowledge that overenthusiasm might have got the better of them. "Everyone wanted the 30 year market to be established," says one. "It was sort of the missing link as previously anything longer than 10-15 years had been very tough to do.
"The fact that some of the deals did not perform particularly well showed that the market had gotten ahead of itself. People wanted this market so badly that they didn't notice there was not much substance behind it."
Since the last of the month-long series of 30 year deals, there has been no further supply of any size in the maturity. However, some DCM officials say that the market has learned lessons from the experience that will stand it in better stead when 30 year supply returns.
"What we saw initially was that some investors participating in these deals were looking to make a quick buck," says Justin May, global head of corporate DCM at ABN Amro. "While all of the transactions that we lead managed were heavily oversubscribed and broadly distributed, we did witness some volatility in the immediate period after pricing.
"Certainly a number of the more active trading accounts who were looking for the fast buck soon realised that 1bp in 30 years is worth a lot more than 1bp in five years. Those investors who were genuine buy and hold investors have been rewarded given the subsequent spread performance for holding on to the paper.
"But, in a way, that volatility was a good thing for the market. Going forward we are likely to see only the genuine buy and hold investors involved, the insurance companies and pension funds. We have already seen this in recent issuance in the 15 year sector."
A recent example of this was Volkswagen's Eu4.5bn transaction in May - led by BNP Paribas, Citigroup, Dresdner Kleinwort Wasserstein, ING and JP Morgan - which included a Eu500m 15 year tranche alongside Eu2bn six and 10 year tranches.
"Shortly after launch, the whole auto market widened 25bp-50bp on the back of bad news from the big three," says Eirik Winter, head of European corporate debt capital markets at Citigroup. "But while the six and 10 year VW tranches came under pressure, the 15 year tightened. That was a clear signal to us that there is real quality buying in the 15 year maturity."
Supply in 30 years was also hit by the shape of the yield curve. The differential in swap rates between 10 and 15 years is around 44bp. But between 15 and 20 years it is only 25bp, and between 20 and 30 years a mere 17bp. Investors therefore receive only roughly equal compensation for extending from 15 to 30 years as going from 10 to 15 years.
And the extra pick-up that issuers would have to pay to tempt investors into 30 years has been a deterrent.
There are no such barriers to issuance in the 15 year sector, as is clear from recent issues from Enel and Veolia. Enel was able to issue at 60bp over mid-swaps and Veolia at 107bp over in 15 years, both only 12bp higher than the swap spreads they paid on simultaneous 10 year tranches. In the secondary market, some utilities have even traded tighter against swaps in 15 years than in 10 years.
But not only are attractive Euribor levels prompting corporates to issue further along the yield curve. The historically low level of yields is forcing an increasing number to consider taking the fixed rate liability outright.
"In the US market, treasurers and CFOs have always looked at absolute levels," says ABN Amro's May, "whereas in Europe corporate issuers have traditionally used the bank market as their primary source of funding, so have been much more Libor driven. But what we are seeing is that a number of European issuers are now not swapping the proceeds, but taking advantage of the historically low yields to keep it fixed."
Meanwhile bankers are confident that with yields expected to remain at historical lows or fall even further, investors will be once again tempted to move back into the long end of the curve.
"The 30 year sector really went off with a bang and has now paused for breath," says one. "But I do believe that we will see the return of 30 year issuance, especially if yields continue to fall, because investors are clamouring for yield enhancing assets."
It was this that helped Rhodia tilt the relative issue sizes of the tranches away from the dollar bias of many previous European high yield deals. "At Eu500m it is a larger deal than we are used to seeing in the European high yield market," said one banker.
"In the past euro deals have been strongly supported by US demand, whereas this deal can truly qualify as a euro transaction, and as such is an important benchmark."
The return of such credits to the market shows that the deleveraging and restructuring plans put in place by many companies in the past couple of years are starting to yield concrete results.
"There has been quite a lot of deleveraging going on in the last 12-18 months," says Paul Hearn, global head of primary markets at BNP Paribas. "We have seen some pretty spectacular failures, but a lot of these fallen angels have been able to return to the market. And alongside names such as Vivendi and Rhodia, we have also seen the likes of Alcatel accessing the capital markets, albeit through a convertible."
Citigroup's Winter, meanwhile, says that it is important to realise that despite the strong demand from investors, they have not lowered the bar when it comes to picking credits.
Rather, it is corporates that have raised their game. "Even if there are few asset classes offering attractive alternatives, and investors therefore are being forced to look at corporate bonds, it is not that they are less critical when looking at new issues," he says. "The companies that have been able to succeed have had something new and interesting to say."
An example, says Winter, is Bertelsmann. Almost a year ago, in June 2002, the German media company, had been hoping to issue a Eu1bn seven year issue when the WorldCom scandal erupted just ahead of the deal's launch. When the company made a second attempt to issue its bond in October, however, factors within its control combined with market conditions to force another postponement.
When the company returned to the market this May, conditions at last proved right and Bertelsmann was able to raise Eu650m of seven year funding at 120bp over mid-swaps via Citigroup, Deutsche Bank, Dresdner Kleinwort Wasserstein (DrKW) and JP Morgan.
"Bertelsmann has undergone many changes, including a change in CEO," said an official at one of the bookrunners. "The company has been monitoring conditions since last summer, and after the recent rally in spreads and release of results which exceeded expectations, they decided to bring their deal back to the market."
Corporates are also taking advantage of developments in other markets to diversify their sources of funding, such as the ABS market. One trend that bankers expect to continue is that of corporates securitising parts of their operations both to rationalise their balance sheets and to secure new funding sources.
Stora Enso's spin-off of 600,000 hectares of Finnish forests, along with the rights to harvest the forests, is an example of the concept. Morgan Stanley and co-manager Sampo Bank arranged the Eu370m securitisation for the spun-off company, Tornator Timberland Oy, last December. The process released some Eu440m of capital for Stora Enso, equating to a realised capital gain of Eu24m.
And as this report was going to press, a new market for corporates was in the process of being opened. Citigroup and Deutsche were preparing a capital security issue for Linde. Although subordinated corporate issues have been sold to Spanish and Dutch retail accounts in the past, officials at the leads say that the deal is the first to have been given equity credit by the rating agencies and structured to appeal to institutional investors.
The transaction is aimed at allowing Linde, which was recently downgraded, to strengthen its balance sheet, show investors its commitment to its ratings, and lengthen its maturity profile at the historically low yields available.
"This is something that makes us very excited," says one banker working on the deal. "We've been talking about this for as long as I can remember and now we are finally there and it could be the starting point for something."
An offer they cannot refuse
While issuers such as France Télécom, Vivendi Universal and Bertelsmann have launched deals to meet liquidity needs, other borrowers have been tempted into the market by the attractive funding opportunities on offer. Analysts at DrKW summed up the rationale for accessing the market in a report in May.
"Euro corporate yields have rarely looked so attractive for potential issuers," they said. "Low government yields, historically tight swap spreads and the recent rally in corporate bond spreads have all combined to send the non-financial iBoxx average yield to its lowest level since the launch of the euro in 1999."
Analysts at Morgan Stanley, meanwhile, have highlighted the continuing need, or at least attraction, for European corporates to take advantage of this year's conditions. While the euro corporate market has allowed many companies to diversify away from their traditional bank financing, bank loans still account for 80% of all euro zone corporate debt obligations, compared to 20% for bonds. This, say Morgan Stanley's analysts, accounts for the much shorter debt maturity profile of European corporates versus their US peers, which has actually been decreasing further.
"The case for a company terming out its debt obligations is, to be quite frank, pretty clear cut," they said. "In doing so, a company clearly affords itself greater flexibility, being much less dependent upon short term liquidity and current capital market conditions."
A further argument in favour of terming out debt has been a fall in the differential between bond and loan funding - to one of the narrowest levels since December 2000, according to Morgan Stanley. While credit spreads in the bond markets have diminished this year, margins on loans have not moved - and, if anything are experiencing upwards pressure. Morgan Stanley's analysts therefore concluded that the time for terming out short term debt was right.
"While recognising that our sample extends back only as far as December 2000, we note that with the exception of June 2002, the bond-loan spread is as tight as it has ever been," they said. "In lay-speak, the cost of terming out is relatively low from an empirical standpoint."
Taken together, all these factors have led to a growing number of corporates tapping the market and gaining fixed rate, rather than floating rate exposure. "European treasurers are increasingly now also looking at the all-in cost in terms of absolute rates instead of just the credit spread," says one banker, "and regardless of how you look at it, the conditions are very attractive. You have record low coupons and if you compare spreads with where they have been historically, it is a compelling argument.
"Although many of these companies don't actually need the liquidity, they have found three or four reasons why they should come to market. And that's a wise thing to do because you never know how long these conditions are going to last."
However, bankers are optimistic that the benign environment will persist. Hearn at BNP Paribas says that his confidence comes from the fact that the two most likely macro-economic scenarios should both be supportive of corporate bonds.
"The first scenario is that economies rebound," he says. "While that may not be particularly good for fixed income product as a whole - and you could start to see some movement into equities - more buoyant equities should help support credit spreads.
"If, however, there is no real rebound, economies remain mired, and equities go nowhere, that is good for fixed income securities. But with risk free yields as low as they are, investors have got to look elsewhere for extra returns. So even if you can argue that a stagnant economy is hardly good for credit, in an environment where there is nothing else worth putting your money into, the overall situation is quite positive for corporate bonds."
But Hearn is careful not to be overoptimistic. "That, of course, assumes that there is no exogenous shock, which could be a very dangerous assumption if you look at what has happened in the past five or six years," he says.