The new European corporate market has got off to a flying start, with record breaking deals and volumes ensuring the sector has grabbed the headlines this year.
But how long can the honeymoon last? Investors are ready to boost their holdings of corporate paper further, but as the market matures and investors become more credit savvy, buyers are likely to think twice before rushing headlong into the market as several have done this year.
Neil Day examines the changing dynamics that are already beginning to affect the way investors regard, and banks price, corporate debt.
If anyone had suggested last year that an Italian triple-B rated computer turned telecoms company would have been able to support a bid for a former state monopoly five times larger than itself with a Eu7.9bn floating rate note, they would in all likelihood have been committed to an asylum.
But, incredibly, overwhelming demand for Olivetti's Tecnost floater earlier this month resulted in the bond issue being increased by a further Eu1.5bn to satisfy interest from institutional investors.
Such has been the speed and size of the euro corporate market's development that Eu1bn is now seen as the minimum size necessary for a benchmark issue.
The day after trading began in the euro, Deutsche Telekom comfortably increased its DM2bn 5.25% May 2008 issue to Eu2bn, creating the largest ever corporate bond in euros or a legacy currency.
"Its success bodes extremely well for the corporate market," said one banker at the time. "Everyone believes in the potential for corporate debt and there are going to be a lot of corporate deals in the months ahead."
Five months into the new market, such optimism could be viewed as something of an understatement. Hardly a week has passed without a new landmark being created and records have tumbled as the market has deepened.
It was not until one week in mid-May that the market neared its limits: German telecoms group Mannesmann launched a Eu3bn deal, the largest ever fixed rate bond in a single tranche in any currency; Spanish utility Repsol beat the German company's claim to the largest ever corporate bond by launching a Eu3.25bn floater; and Olivetti won its battle for Telecom Italia, opening the way for the creation of its Eu7.9bn Tecnost floater.
The frenzy of corporate issuance coincided with credit spread widening as the market reacted to lingering fears about emerging markets and the US Federal Reserve's shift to a tightening stance. Nevertheless, spreads quickly recovered and after having widened from 70bp over to 82bp over, Mannesmann's 10 year jumbo had tightened back to near its launch spread two weeks later.
While Mannesmann's deal highlighted the appeal of the new market to European blue chip companies, in particular those from the telecoms industry, a host of other new corporate credits have demonstrated the corporate bond market's broad appeal.
From the tobacco industry, the UK's BAT and Philip Morris of the US launched Eu1bn benchmarks; retail favourites such as Gillette and BMW tapped the broader investor base; non-European utilities including Enron and Tepco built a presence in the new currency; and companies such as Germany's Claas and Italy's Finmeccanica saw the advantages of moving away from the bank market.
Corporate issuance in euros leaped from Eu6.7bn in the first five months of 1998 to Eu51.8bn in the same period of 1999, according to Capital Data Bondware. Compared to 1998's corporate issuance in euros and legacy currencies, issuance jumped from Eu24bn. Corporate borrowers' share of the market increased from 8.7% in euros and legacy currencies to 14%.
Yet the market remained buoyant and many of the year's deals tightened after launch. Both issuers and investors were left smiling about their new relationship, while bankers active in the market have been happy with the new source of fees.
The early success of many corporate transactions can, to a large extent, be attributed to the careful strategy banks and borrowers have taken in approaching the new market. As most investors and issuers are still finding their feet in the new world of credit, negotiated pricing has been the way that many banks have balanced the two sides of every deal.
"The days of the bought deal are over," says one banker. "Investors have too much choice and unless you show them something that is extremely compelling, they have a lot of power to say no. Therefore the key point is the way in which an issuer approaches the market. The ones that have worked have been those that have been executed on a negotiated basis."
The banker adds: "Success is not necessarily predicated on price. If the way that they are sold is like an auction, even deals that come at sensible prices don't necessarily work, whereas negotiated deals have been launched at quite aggressive levels."
European corporates have been ready to take a flexible approach to the market for several reasons: to broaden their investor base away from their domestic markets; to finance mergers or acquisitions; or to find a competitive source of funding away from the bank market.
"Despite continued liquidity, pricing in the loan market has gone up for the first time in over a decade," says Sean Park, head of European syndicate at Paribas. "People are no longer lending for lending's sake as banks are under so much pressure to deliver on RoE (return on equity)."
Justin May, head of Nordic origination at ABN Amro, agrees. "Corporates throughout Europe are realising that the bank market no longer provides the cost effective levels of funding that used to be achievable," he says.
"Banks are also becoming more reluctant to lend money through the traditional bank market, and instead are promoting the merits of tapping the international capital markets as a more viable financing solution."
Consolidation in the European and global banking industry has added to the pressure on banks to achieve higher returns. When banks merge, the size of their combined loan books is often less than the sum of their parts. Although many companies still enjoy preferential rates from their house banks, few bankers expect this to continue.
"A lot of people are in a position where they are not yet seeing pressure on capacity or pricing in the bank market," says Andrew Dennis, a director in Warburg Dillon Read's debt capital markets division responsible for corporate origination. "However, they see that it is ripe for change and they are keen to build a relationship with a second group of capital providers."
This is particularly true of companies engaged in, or wanting to leave open the possibility to participate in, the M&A spree that has grown alongside Emu.
This flexibility explains why German agricultural machinery manufacturer Class launched a Eu100m seven year issue in March via bookrunner Dresdner Kleinwort Benson and joint lead JP Morgan.
"Corporates are keen to keep credit lines open as there is so much restructuring and M&A activity that companies need to be ready to participate in, should they decide to," said an official at Dresdner. "That is why this exercise ended up as a bond issue, rather than the loan that was initially discussed."
The bond markets also carry fewer restrictions than the loan markets, according to Ralph Berlowitz, head of syndicate at Deutsche Bank. "If you look at the corporate world and all the M&A activity that is going on, a lot of companies are not keen on syndicated loans because of the covenants that are often involved," he says.
"You don't have those restrictions on a bond issue, so even if the loan market provides you with cheaper funding, a lot of corporates will take the bond route."
This flexibility, combined with the growing sophistication of the European investor base has, according to ABN Amro's May, made the euro corporate bond market a viable alternative to the Yankee market.
"In the past, the temptation was to access the Yankee market because the appetite for higher yielding credits was greater in the US," says May. "Investors in the US had to focus on buying credit to enhance the yield on their portfolios, and an additional advantage of the Yankee market was the longer dated tenors available."
Paribas' Park sees the increased flexibility for European companies in the euro market as helping to level the global corporate playing field as the companies involved can now access capital almost as easily as their US competitors.
"If, a year ago, the chairman of a European company asked his CFO if he could raise $1bn of 10 year funding to make an acquisition, the CFO would have to say 'not unless we do a Yankee bond, which takes time and will be expensive'," suggests Park.
"Now the CFO can call a few banks and give the chairman an idea of price and turnaround time almost on the spot."
Ironically, the surge in M&A business has led to some of the tightest margins seen in the loan markets in recent times - but only when such financing holds the prospect of further business, particularly in the bond markets.
"The banking relationship business is extremely important," says the head of syndicate at one European bank. "On a lot of deals, especially M&A related ones, you will see the advisers appearing as lead managers.
"And nearly all the deals that have been launched on a negotiated basis, with the leads having the opportunity to earn all their fees, were mandated for relationship reasons."
Ulrich Küster, Mannesmann's finance director, underlined this fact when explaining why he had chosen three German banks - Deutsche, Dresdner Kleinwort Benson and Commerzbank - to lead manage the company's Eu3bn deal.
When Mannesmann arranged a Eu7.95bn loan in April to acquire Olivetti's interests in Omnitel and Infostrada should it succeed in its takeover battle for Telecom Italia, only German banks were willing to accept the tight terms which led one banker to describe the funding exercise as, from a borrower's perspective, one of the loans of the decade.
But the three German banks were the real winners when they walked away with the mandate for the largest ever fixed rate corporate bond in one tranche in any currency.
"The reason we didn't have any foreign banks in the top bracket was because when we arranged the loan we felt committed to the participating banks," said Mannesmann's Küster. "We said that when it was possible there would be more business available for them and when the bond came along we said let's support the banks involved in underwriting our credit line."
But alongside the many successful corporate bonds to have been launched this year, several difficult deals have highlighted a tendency for banks to guard their home markets jealously.
"Some of the smaller domestically focused banks have no chance of getting international deals so they want to keep the domestic mandates for themselves," says one syndicate manager. "They haven't adjusted to the new market and are bidding for deals at crazy levels."
Bankers critical of domestically targeted transactions do, however, acknowledge that many are successfully placed, albeit more slowly and to a more narrow investor base than negotiated deals. The French market, for example, is attractive for French names tapping French investors, particularly in the seven year sector where OATs trade tighter than Bunds.
Total took advantage of this situation when it launched a Eu300m seven year issue in early April via Crédit Agricole Indosuez. Priced at 38bp over OATs, the issue was condemned as aggressively priced. The swap spread on a recent Elf transaction, which carried the same rating, was trading at around Euribor plus 15bp and Total hit the market at around Euribor plus 2bp.
But CAI said that 38bp over for a similarly rated shorter dated issue was justified by the 39bp over OATs spread of the Elf issue. "Many investors benchmark against swaps, against which the deal is expensive" said a CAI official, "but most still concentrate on spreads against government bonds."
As the market evolves and the single currency leads to an ever more unified market, competition between funds is likely to reduce such issuance.
"Borrowers can still get much tighter funding when they target their domestic investor base," says one syndicate official. "But these differences in funding level will disappear as investors develop their credit research capabilities and that is going to be a driving factor in the future."
Such changes in behaviour have already been noted. "There is no question that investors have had to become a lot more savvy on credit as the available range has widened," says WDR's Dennis.
"A lot of investors are taking a more pan-European approach than they did in the past and the level of domestic support for borrowers is beginning to fall."
The growing size of new issues and the increasingly regularity with which corporates tap the market will also reduce the ability of some borrowers to take advantage of their name recognition, particularly with retail targeted transactions.
"There undoubtedly remains a very big retail market that drives some deals and allows tighter pricing for excellent retail names," says Deutsche's Berlowitz.
"But this advantage is diminishing more and more as the size of most deals is too big to be absorbed by retail.
"You need to get a mix of retail and institutions involved so it is harder to get away with retail pricing."
The continued institutionalisation of retail and its increasing sophistication will be a further factor in a levelling of the corporate playing field. "The retail bid per se is gradually disappearing and the amount you can sell to them is limited," says Paribas' Park.
"They are also increasingly looking for value in new issues so retail is no longer big enough or insensitive enough to take down large amounts of paper."
Park adds: "That said, there is still a name premium in Europe - both for retail and institutions - but the premiums are lower than they used to be. In a certain industry sector you may have a 10bp differential for similarly rated companies, whereas in the past that differential could have been over 20bp."
Two issues for carmaker DaimlerChrysler highlighted this trend. The borrower made its first foray into the euro sector with a Eu200m issue in January, a January 2004 transaction, then returned to the market for a further Eu600m in February with a March 2004 issue.
Whereas the January 2004 issue had tightened to around Euribor flat by the end of May as it was absorbed by retail, the March 2004 deal was trading at around 11bp over. But the advantage enjoyed by A1/A+ DaimlerChrysler in targeting its home investor base is underlined by the level of A1/A rated Ford's July 2004 deal, which was trading 16bp wider against swaps at around Euribor plus 27bp.
Such anomalies are likely to disappear as the corporate market becomes deeper and, having filled their corporate portfolios, investors begin switching in and out of different issues within industry sectors, and between sectors. "We are still some way off from the US market where there is direct comparability for almost every issue," says WDR's Dennis. "After all, we are only five months into the new market."
So far, the European investor base has been the main target for euro denominated issuance as the falling euro has deterred US accounts from entering the new market. But once US investors, long acquainted with credit markets and relative value, enter the market, the pricing differential between European and US based issuers should fall.
"We expect there to be increasing convergence between the euro and dollar markets," says Guillaume Bonpun, director of debt syndicate at Dresdner Kleinwort Benson. "When more US investors are buying euros, you will see more global bonds in the currency, and there will be arbitrage driven convergence between spreads in dollars and euros."
Along with the deepening of the corporate market, a more sectoral approach to credit has been encouraged by the new indices that have been introduced to give a better representation of the euro market.
"From a theoretical point of view, a benchmark should generally represent the portfolio universe that is chosen to match defined investment goals," said HypoVereinsbank analysts in a recent edition of the bank's 'Spreaditor' research publication.
"Consequently, investors who extend their portfolio universe increasingly toward credit products such as collateralised or corporate bonds, should correspondingly adjust their portfolio benchmark to allow proper risk-adjusted return maximisation and performance measurement."
Investors tracking the new indices are therefore keen to buy chunks of new issues that are likely to be included in their benchmark. "Indices are becoming increasingly important," says Dresdner KB's Bonpun. "A fund manager needs some kind of benchmark and that means there has been a 'must buy' element of demand for issues such as Mannesmann."
Corporates tapping the market in its early days have benefited from this trend as relative value has been less important than it would be if investors were already full of corporates and only buying deals on a switch basis. "The size and number of corporate portfolios is certainly still growing, but those corporates that were quickest to tap the market benefited from the initial portfolio reallocation at the beginning of the year," says ABN Amro's May. "As portfolios fill up investors can be more choosy and that may translate into increased funding costs to borrowers looking to tap the market later in the year."
However, as the euro corporate market is still in its infancy, the shift towards benchmarking against a broader bond index has been slow and many accounts are only adding corporate bonds to their portfolio to outperform government bond indices.
"The benchmark effect of indices may have been a little overestimated," says Deutsche's Berlowitz, "as very few funds are benchmarking themselves against a corporate bond index because the market is not yet developed enough.
"Most funds still benchmark against a government index."
The limits of the corporate market are borne out in the new indices themselves. The corporate element of new indices from Bear Stearns, Lehman Brothers, Merrill Lynch and Salomon Smith Barney, for example, all have low industrial and utility weightings.
The highest weighting is in the Merrill Lynch Emu broad market index, which has a 3.07% weighting for industrials and utilities, and the Salomon Smith Barney euro broad investment-grade bond index has a mere 0.79% combined weighting for the two categories.
Part of the reason for the low corporate weighting in the Salomon Smith Barney index is the low liquidity of many corporate issues. To qualify for inclusion in the Salomon Smith Barney index, corporate deals must have a minimum size of Eu500m.
And the low weighting given to weaker rated deals, of single-A or lower quality, further lessens the index-driven buying of corporate deals: out of the four indices, the highest weighting for such issues is in the Lehman Brothers index, of which such issues make up only 3.29%.
But the stated intentions of investors suggest that the market is ripe for change. In a recent survey of fund managers, Paribas found that 26% of investors polled expect the credit risk profile of their investments over the next 12 months to change by as much as one rating category (such as from double-A to single-A).
The survey also found that 69% of investors were either actively changing the guidelines that limit their ability to move down the credit curve or were in the process of changing such limits.
And whereas, according to the Paribas survey, 52% of investors can buy credits rated triple-B or lower, only 38% do so. This should provide further fuel for the corporate buying spree that has already set the market alight.