With the oil price surging and interest rates climbing, conditions looked difficult for fixed income markets in 2005. Then Standard & Poor's fired both barrels at the bond market, downgrading Ford and General Motors to junk. Participants were afraid the credit market would crumble, but as Toby Fildes and Jon Hay report, the shock was a salutary experience and the market can look back on a successful year. With M&A coming back and the corporate sector releveraging, there should be plenty of action to look forward to in 2006.
Twelve months ago the fear hanging over the international bond market was that Standard & Poor's might put General Motors and Ford's BBB- ratings on negative watch, bringing them to the brink of the cliff that separates investment grade from speculative grade.
The two car companies — and their $450bn of consolidated debt — being downgraded to junk was a disaster that many investors still considered avoidable. No one knew if the credit market would be able to withstand such a blow.
Today, both firms have junk ratings and the risk for 2006 is that one or both of them could file for bankruptcy. But curiously, that prospect inspires less fear in the capital markets than Ford and GM's precarious position did a year ago.
In 2005 Standard & Poor's — and then the other rating agencies — acted faster and went further than most credit analysts had expected.
GM's profit warning on March 16 brought the downgrades a lot closer, but investors were still taken by surprise when S&P cut Ford and GM to junk on May 5.
Lehman Brothers had already softened the blow to index-driven US investors by changing the rules for its Corporate Bond Index to allow companies to remain in as long as they had two investment grade ratings from Moody's, S&P and Fitch, rather than needing both Moody's and S&P.
But S&P's rating move was an unmistakable sign that high grade investors should forget about seeing Ford and GM as investment grade credits.
The two companies' bond and credit default swap spreads went haywire, but it quickly became clear that forced selling was not going to spread across the markets to unrelated issuers.
Attention then centred on the synthetic credit markets, where Ford and GM appeared in hundreds of portfolios for collateralised debt obligations (CDOs) and other structured trades.
Two such large credit events on the same day suggested that risk was much less correlated than many traders had calculated, and desks that were 'long correlation' — or long the equity tranches of credit pools and short the mezzanine — had to unwind their positions.
For a week there was panic that dozens of hedge funds might go bust, but most players were able to pick themselves up and brush the dust off their knees.
In many ways, the double downgrade of Ford and GM proved a very useful dummy run for a serious credit event. The cash bond market and structured credit markets wobbled all over the world, but recovered; and in the credit default swap market heads were bashed together and some much needed housekeeping was speeded up.
Until 2005, CDS trade confirmation had been an antiquated process, remarkably labour intensive and paper-based.
The average confirmation took around 15 days, with some trades taking three or four months to confirm. Lots of trades were never confirmed, some even maturing before they were processed. Mechanisms for novation — transferring trades from one counterparty to another — were particularly rough and ready.
These problems could have led to chaos if, for example, General Motors had gone into a restructuring, and there were 20,000 CDS trades referencing it that had not been confirmed.
The International Swaps and Derivatives Association announced in mid-September that 31 leading derivatives dealers had signed up to its Novation Protocol, which introduced a rigorous standardised system for transferring trades.
It was no accident that ISDA made its announcement in the same week that the US Federal Reserve, the Securities and Exchange Commission and five other US and foreign regulators summoned the 14 leading banks in the derivatives market to a meeting to discuss credit derivatives.
"The industry is putting its weight behind this issue largely to solve it, but as a corollary regulators should draw encouragement that no further guidelines are necessary," said ISDA's chief executive Bob Pickel — in other words, 'we've done enough to avoid further regulation'.
By the end of the year, 2,000 institutions had signed up to the novation agreement and the industry had also announced its intention to move towards electronic trade confirmation.
Banks coin it in
The car companies' travails — and the bearish direction of interest rates all year — did little damage to fixed income markets in 2005. For confirmation, one need only look at the investment banks' bottom lines.
Goldman Sachs, UBS, Deutsche Bank and Lehman Brothers all announced record results in 2005; based on the latest quarterly figures available, the top five global investment banks in the bond market league table earned $15.5bn in their investment banking divisions in 2005 — 20% up on last year.
They were able to do so thanks to the continuation of several broad trends that had begun in previous years.
Stock markets recovered and equity issuance increased; commodity prices were buoyant, thanks to economic growth in Asia; the growth of hedge funds gave banks a rich flow of prime brokerage fees; pools of Asian savings provided deep demand for many products; and sophisticated proprietary trading strategies allowed banks to make money across most of their markets.
Despite the soaring price of oil, the world economic outlook remained largely benign, with strong growth in Asia and many emerging markets in Latin America and eastern Europe.
President Bush's much feared double deficit bubble obstinately refused to burst, and even looked a little less swollen when the US announced a surprise increase in tax revenue and China gave the renminbi a few more inches of leash on which to roam.
But perhaps because financial market participants find it a little hard to see where robust growth in developed economies is going to come from, long term interest rates remained low, no matter how much the Federal Reserve, the Bank of England and eventually, in December, the European Central Bank, raised short term rates.
One of the more worrying developments in 2005 was the failure to bring European government finances under control. The debt of countries like Germany, France and the UK is rising relative to GDP, five of the 15 longer established EU nations are running budget deficits of more than 3% of GDP, and for the first time since 1999, commentators have questioned the long term viability of the euro.
For the moment, however, the unwinding of EMU or a sovereign default in Europe are remote risks and many investors are more concerned by the US housing market, where prices have risen 66% in the last six years.
A sharp correction there could damage US consumer demand and put the brakes on global growth.
M&A revives at last
Of the trends in the fixed income market that noticeably accelerated in 2005, perhaps the most important was that the long-predicted revival of mergers and acquisitions finally happened.
Five banks are reported to have made more than $1bn each in M&A fees in 2005.
Spain's Telefónica is taking over O2, the UK mobile phone company, while still digesting Cesky Telecom; France Télécom acquired Spanish cellular operator Amena; Telenor took over Vodafone Sweden.
Illustrating the growing power of Middle Eastern companies, Dubai's state port operator DP World is to buy P&O, the UK shipping and ports firm, for £3.3bn in cash.
Many of these deals will generate financing business, in the loan, bond, equity and occasionally the convertible bond or securitisation markets.
The syndicated loan market is often the first financing sector to benefit from M&A — Citigroup, Goldman Sachs and RBS are arranging an £18bn loan for Telefónica, for example — and lenders were delighted by the upsurge in acquisition financing in 2005.
For the past three years the loan market has been dominated by refinancings, in which companies renew their facilities at tighter pricing. That continued just as hard in 2005, but at least now there should be some higher-paying acquisition facilities, offering better prospects of ancillary business, to leaven the mix.
But because banks have been starved of this type of business for so long, they are in no mood to miss out on M&A mandates. They are therefore cutting their prices, meaning the vaunted acquisition premium is likely to be squeezed this year.
Banks have little left to be squeezed on — they have already given way on extending maturities out to seven years and dropped covenants.
Leveraged party jumping
However, one area where they are still making money and expect to do so again this year is leveraged finance. As a result, the leveraged loan market has become a crowded place, with more banks than ever touting themselves as mandated lead arrangers. More investors joined the party in 2005, including CDO managers and hedge funds from the US.
With so much debt on offer, private equity funds — themselves almost indecently cash-rich — were able to raise their sights and shoot for ever bigger takeover targets, especially if they teamed up in consortiums.
The European leveraged buy-out record was smashed in June when Weather Investments — a consortium led by Egyptian entrepreneur Naguib Sawiris — bought Italian mobile phone company Wind from Enel for $14.2bn.
Then in December, Danish telecom company TDC fell to a consortium of Apax Partners, Blackstone Group, Kohlberg Kravis Roberts, Permira and Providence Equity Partners for $15.3bn.
Private equity funds were also able to refinance debt on existing deals at tighter margins or higher leverage multiples, paying themselves extra dividends. They extracted Eu11.4bn of dividends from recapitalisations in the first nine months of 2005 — more than double the Eu5bn in 2004.
There is little doubt that recaps and deal sizes will grow again this year, judging by the amount of private equity still to be invested and the amount of debt — senior and subordinated — that banks and investors are willing to bolt on to it.
But there are clear signs of excess. Debt multiples are rising and recaps are occurring sooner after the initial buy-out than ever before. And while mezzanine debt has proved itself a more reliable source of subordinated money than the European high yield bond market, few bankers are predicting a big year for payment-in-kind notes and second lien secured loans.
Emerging debt in bull mode
It was a remarkable year for emerging markets debt, marked by the successful restructuring of most of Argentina's $82bn of defaulted debt and unprecedented credit quality and access to debt for emerging market governments and companies around the world.
By the end of the year, the best Latin American companies, such as Mexico's Pemex and Telmex, were trading tighter than similarly rated US issuers.
Mexico's government has already begun to prefund its 2008 borrowing needs, while sovereigns like Brazil made great progress in attracting foreign money in their own currencies, through globally marketed bonds in pesos or reais.
This year may be more difficult — no less than nine Latin American countries will be holding general or presidential elections, and investors are already nervous that Argentina's President Nestor Kirchner may be moving to the left.
No trend showed the bull market for Latin American credit better than the Asian retail investor's love affair with Latin corporate risk — to the extent of being prepared to take it in perpetual form.
Since Pemex placed $1.75bn of perpetual non-call five year bonds with Asian retail buyers in September 2004, those investors have poured $17bn of orders into $5bn of deals, mostly for Brazilian companies and banks.
In the emerging markets of eastern Europe and the CIS, the fixed income market showed its enthusiasm for these fast-developing economies by snapping up bank subordinated debt issues.
Russian banks began issuing lower tier two capital securities in January, when state-owned Vneshtorgbank brought a $750m 10 year non-call five issue.
Sberbank, Industry & Construction Bank and Bank of Moscow followed VTB's lead, and most observers expect lower tier two debt to spread across Russia in 2006 as banks beef up their capital to support expanding loan books.
In October Kazakhstan's Kazkommertsbank launched the CIS's first tier one capital issue, a $100m perpetual non-call 10 year deal. However, while bankers are hopeful of a Russian tier one deal in the first half of this year — Vneshtorgbank being the most likely issuer — the lack of central bank clarity over what constitutes tier one remains an obstacle.
Hybrid triumphs in Europe, US
Subordinated debt was top of the agenda in western Europe and the US, too. Innovations are still being made in hybrid capital structures for banks, and financial institution subordinated issuance set a new record of Eu150bn in 2005.
New structures were used to achieve regulatory treatment as 'core' tier one capital, notably the method, invented by Barclays Bank in November 2004, of selling perpetual tier one to institutions without a step-up coupon.
HBOS introduced that structure to the sterling market with a £750m deal through UBS and Barclays Capital and Barclays Bank took it to the US, with a $1bn self-led issue.
But the great development of 2005 was the application of hybrid capital to non-financial companies.
In February 2005 Moody's provided a framework for unregulated companies, by clarifying how much equity credit it would give for various kinds of subordinated debt.
The first deals to benefit came in a single week in June, from German sugar producer Südzucker, Swedish power company Vattenfall and Dansk Olie og Naturgas (Dong).
The deals are compelling for issuers: they are cheaper than equity, do not dilute earnings, and in the eyes of the rating agencies, raise financial leverage less than debt (or may even reduce it). For the moment, investors are happy to take the extra yield.
Analysts forecast about Eu15bn of hybrid issues in 2006 — Credit Suisse First Boston suggests that companies such as Carlsberg, Diageo, Wolters Kluwer, Telecom Italia, Thales, BMW and Lafarge are all potential issuers in Europe.
Investors in the US had to hold on until November for the technique to be born there. It was not an easy delivery: Citigroup, Goldman Sachs and UBS brought a $450m 40 year non-call 10 tax-deductible hybrid for tool maker Stanley Works that widened to 165bp over Treasuries from a launch spread of 140bp. However, it was not the fault of the structure; rather that the borrower had been named as a potential LBO target.
In December the US got its first corporate hybrid security that achieved the prized 75% equity treatment from Moody's. Merrill Lynch and Goldman Sachs brought a $500m 50 year non-call 20 preferred issue for railway company Burlington Northern Santa Fe that pulled in $3bn of orders.
Structured products roll
The other fixed income sectors that advanced impressively in 2005 were covered bonds and securitisation.
In covered bonds, Germany's new Pfandbrief Act came into force in July, creating an updated framework that will give Landesbanks a new means of efficient financing. The UK market broadened with the addition of Abbey and Nationwide Building Society; Italian issuance began with a cack-handed deal from Cassa Depositi e Prestiti; and Spain overtook Germany as the biggest source of jumbo covered bonds.
Securitisation is now firmly established as Europe's third largest bond market after government debt and financial institution paper. In 2005, the market grew another 36% to around Eu315bn of new issues, helped by a surprise November and December flourish of big deals from some of Europe's largest banks.
In 2006, the big uncertainty will be how Basel II affects securitisation. It is clear the new bank capital rules will change the market, but participants are increasingly confident it will not undermine it.