“Last year we saw plenty of unrated bond transactions,” says Karin Arglebe, director, corporate bond origination at Commerzbank in Frankfurt. “There is a market now, but it is more difficult. Investors are challenging unrated issuers and asking why they do not have a rating.”
There used to be two main reasons why an issuer might not have a rating before going to the bond market. The first was if the issue was a one-off, or if the borrower did not expect to be a frequent visitor to the markets.
The second was for unlisted, family owned companies or those with a history of family ownership, such as German car rental company Sixt and compatriot retail group Otto.
However, a trend developed for corporates to opt for issuing unrated bonds because they felt the rating agencies would not assign them the ratings they believed they deserved. Investors are becoming less willing to accept that as a valid reason.
“Only to answer that you don’t trust the rating agency is not enough,” says Arglebe. “With the traditional reasons, you can convince investors, but if you just say you don’t want it, then investors start to think that if the issuer did get a rating it may be sub-investment grade.
“As a result, if you are a new kid on the block, the groundwork is heavy and has to be done, otherwise investors will not fully understand the company and choose not to invest. If you have a rating, you have the report and opinions, so we have something in a nutshell to share with investors. Without a rating, the work investors have to do to familiarise themselves is much higher.”
Opportunity cost
The economics of rated versus unrated are less relevant arguments. The cost of a rating is estimated at between £75,000-£100,000, but that is dwarfed by the premium an unrated issuer has to pay compared to a rated peer.
“We always show unrated issuers the delta between rated and unrated issuers,” says Arglebe. “Currently it is around 80bp, which gives treasurers something to think about. It shrank to 40bp-50bp during 2017, and even less for some issuers, but it has widened as market volatility has returned.”
She adds: “Funding costs are much more attractive for rated issuers. But also the level of execution risk is much lower. If you have an unrated issuer, you have to find the perfect window and, right now, it is tricky to find that window. Even though a treasurer may feel a BBB- rating is not in the area he and his company believe it should be, it is still easier to execute with such a rating than without.”
Arglebe believes more treasures are understanding this dynamic and the number of corporates without a rating is decreasing.
“Take a name like Hochtief,” she says. “It sold bonds without a rating, but now has a rating and its next deal will be its first as a rated issuer.”
However, there is still plenty of demand for unrated bonds as investors look to diversify their portfolios. The extra pick-up in spread is obviously tempting in a market bereft of yields, so it is often a case of what the ticket size will be, rather than whether to invest or not. The bonds may get allocated internally to different pots, but it is still the same investor names in the order books of deals from unrated issuers as those from rated issuers.
Market share
“If you compare 2016 to 2017, volumes in the unrated bond market made good progress,” he says. “We went from €6.8bn to €19.1bn, nearly three times the volume. However, if you look at the share of the overall bond market, including IG and high yield, since 2013, the unrated portion of the market has constantly represented roughly 5% of total issuance.
“2018 has started quietly but the first quarter volumes still imply a 5% share of the overall market. We have seen around 13 deals with a total size of €2.3bn, which is roughly 5%. It seems a fairly normal situation.”
Given the investor demographic is very similar, with one notable exception, to that for rated bonds, pricing of rated bonds benefitted from the halo effect of the European Central Bank’s corporate sector purchase programme and Arglebe therefore believes the unrated market will not be affected to any greater or lesser extent than the rated market when the ECB finally ends its buying programme.
“When the ECB leaves the market, we believe the whole market will change to higher spreads,” she says. “And we expect the unrated spreads to follow suit. There is nothing else that differentiates the two markets in terms of documentation or regulations, so the two markets should move broadly in parallel.”
Schommer agrees. “I think the unrated market stays as it is. Some issuers will always migrate to getting a rating, but the effect of spread widening is not to push issuers to a public rating. If you want to tap the market on a regular basis, it makes sense to get a rating, but not just because spreads are widening.”
“For companies having their first participation in the corporate bond market it is often a case of publicity,” says Schommer. “To test the capability of the company to issue in the capital markets.”
Insurance companies are noticeably absent from the unrated bond market order books, but this has a simple explanation. The large majority of insurance companies have a requirement that their investments have at least one investment grade rating.
That may also be the case with certain mandates and funds that are managed by pension and other asset managers.
However, within those organisations, there are usually a number of pots of money that can invest in unrated bonds, and often do so to access a more diverse issuer base and to benefit from the enhanced yield the issuers pay, as well as often a premium for the likely lack of liquidity.
With a smaller pool of investors able to buy the bonds, that means lower secondary trading volumes and creates a perception of a lack of liquidity, even if benchmark size rated issues often offer little more liquidity. Investors will push for such a premium particularly when deal sizes are sub-benchmark.
Often unrated transactions tend to be sub-benchmark in size, normally due to the smaller funding requirements of the issuers. But as the size of an issue decreases, the unrated market faces competition from the private placement markets, such as Schuldschein, particularly in shorter maturities, which creates another limiting factor to the growth potential of the unrated bond market. And if such issuers want to look for longer dated funding, the larger and more flexible US private placement market is an option.
The US PP market opens up the insurers not accessible by the unrated public markets. Insurers in that market are large enough and sophisticated enough to do their own credit work and once the deal is priced, the National Association of Insurance Commissioners will assign its own rating which equates to those issued by the more mainstream rating agencies such as Moody’s or Standard & Poor’s.
That process gives unrated European issuers an opportunity to diversify theit investor base beyond that of the European public unrated bond market.
Hybrid growth
“We have seen more private placement sized deals in unrated hybrid format,” says Schommer. “I think there is a real opportunity to grow this area of the unrated sector. The BayWa deal has tightened a lot from where it priced and Egger showed how issuers from different sectors can use issue this product as unrated.
How the unrated market develops in more volatile markets — which look to be ahead as the end of quantative easing nears and interest rates start to rise — will be one of the corporate bond stories of the year.
While it is clear that there will always be a price, the crucial question is whether issuers will continue to be willing to pay it, given the other options open to them — including an increasingly confident private debt market?