Some investors have long argued that issuers should price deals as close as possible to guidance, and if initial price thoughts (IPTs) can be dispensed with altogether, so much the better. This, they argue, gives them the confidence that even if the deal prices at the tightest possible spread, their relative value judgement will remain valid, which is not the case when final pricing comes much tighter than where IPTs started off.
Ditching IPTs has happened only in covered bonds when last October Hypo Noe issued a seven year deal. It almost happened last week when Credit Suisse priced a €1.25bn seven year covered bond at mid-swaps plus 13bp from 14bp area guidance.
But since Credit Suisse didn’t actually dispense with initial price thoughts that were also set at 14bp area, the market viewed the deal in a negative light blaming weak demand.
But it was only slightly less subscribed and the book much more granular than a €1bn five year transaction that Commonwealth Bank of Australia issued on the same day.
IPTs for CBA’s €1bn five year were set at low 20bp over mid-swaps, which gave the impression that a spread of 23bp was within reach, a level which many said was too generous. This was followed by guidance of 20bp area and a final print of 18bp.
The fact CBA managed to tighten the spread by 5bp from IPTs to final pricing gave the illusion of book momentum. But in reality it was only 1.3 times covered compared to 1.2 times for Credit Suisse’s deal.
Even though Credit Suisse was only able to move its spread by 1bp from IPTs to final pricing, it attracted 110 orders compared to 73 in CBA’s deal.
Form that perspective it is hard to see why Credit Suisse's deal was reviewed so poorly and it is obvious the part IPTs can play in allowing lead managers to spin the success of a deal.
Lots of liquidity
The covered bond market prides itself on being liquid. Covered bond liquidity is, according to the European Banking Authority’s analysis, on a par with the sovereign bond market. Because the sovereign market offers enhanced liquidity it confers a greater degree of price transparency. That means the initial price thoughts can sometimes be dispensed with.
The IPT process does have considerable value because price discovery is rarely straightforward. And it has become more complicated thanks to market guidelines that prevent issuers from divulging potentially market sensitive deal information to select investors and not the whole market.
But since most core issuers have liquid curves and comparable peers, it should be possible to estimate the clearing level of a putative deal provided investors work closely with issuers to identify the spread level that they really care about.
Pricing conversations occur regularly without investors assuming that every deal idea they are called up about will come to fruition. And if there are enough such conversations with the relevant people it should be possible to gauge accurate market clearing levels for core covered bonds where bid/offer spreads are tight.
For peripheral issuers, where bid/offer spreads are wide and liquidity is less assured, the IPT process is justified because the pattern of demand is different. And if investors don’t like the final price they can always drop out of a deal if they think it has become too expensive compared to IPTs.
But, where core covered bonds are concerned, it is worth considering whether or not IPTs are at all necessary.