Coming out of the worst of the credit crunch, British American Tobacco spotted an opportunity. The firm saw it could take advantage of low funding rates, and minimise its refinancing risk.
"We liked the long term underlying rates and the issuance conditions in terms of spreads we could achieve in the long term market, but we didnt need to add any new debt to our portfolio," explains Neil Wadey, deputy treasurer at BAT. "Traditionally the cost of carry would have been low, with flat yield curves, but over the last two to three years, the cost of carry has been extreme. So pre-financing and holding the cash to the next maturity point didnt make a lot of economic sense."
The company saw it could retire some short term bonds and issue in much longer tenors, to stretch its maturity profile and lock in the historically low rates on offer at the time.
BAT extended its curve, buying back paper due in 2013 in exchange for new long 11 year and 25 year notes. The borrower secured around a 50% take-up on the 2009 offering, which involved sterling and euro denominated issues.
The following year, it conducted a straight buyback of just over half of its sterling denominated bonds due to mature in one and two years time.
BAT is not alone in looking at debt buybacks and exchanges. Liability management exercises (LMEs) for corporates have boomed since the financial crisis as issuers take advantage of low borrowing costs.
"Corporates have built up strong cash resources over the last two years," says Andy Burton, head of liability management at Royal Bank of Scotland. "Coming out of the financial crisis, many companies are not willing to contemplate share buybacks or large capex expenditures, so instead they are spending money buying back near and mid-term maturities."
LMEs are still on the rise. In the year to the end of May 2011, there had been 13 corporate LMEs to refinance Eu4.3bn of existing debt. That was up from nine LMEs on Eu3.2bn of debt in the same period in 2010 while corporate debt new issuance has been flat or slightly down on last year, says John Cavanagh, head of EMEA DCM product solutions and liability management at Bank of America Merrill Lynch in London.
"Before the credit crisis, typical corporate benchmarks could range between Eu2bn and Eu4bn in size, compared to between Eu500m and Eu1bn today," says Cavanagh. "Now, as corporate issuers look towards refinancing some of those jumbo-sized maturities, they recognise that it is not necessarily feasible to refinance these bonds in a single operation. Therefore, corporate treasurers are employing liability management strategies such as exchanges and concurrent tenders and new issues to proactively manage those upcoming maturity towers."
As well as taking the pressure off as maturities loom, addressing redemption spikes is a strategy welcomed by ratings agencies, says Cavanagh. Similarly, pre-crisis worries that short dated debt would be difficult to buy back have eased. For example Belgacom secured a 51% take-up in March this year when it offered to buy back November 2011 paper.
Rates, or rather the expectation that they will be going up, have become a big driver of LMEs.
"If borrowers think its going to be more expensive to borrow in two years time, then they will try to tap the market now," says Stephanie Sfakianos, who works in liability management at BNP Paribas. "If we are faced with any more uncertainty surrounding sovereign debt or financial sector debt, we might see issuers pre-financing big spikes in their maturity profiles a little bit sooner. There is a lot of refinancing to do in 2013, and the combination of interest rate uncertainty and current tight spreads means this is a good time to do it."
Tools of the trade
Each liability management exercise is different: they are carefully tailored to fit a borrowers requirements and vary depending on the volume, maturity and trading levels of debt outstanding. But there are two main categories of structure the exercises can be based around: buybacks and exchanges.
Bond buybacks, or cash tender offers, are the simplest form of liability management exercise. A borrower may wish to buy back outstanding issues to slim down its overall debt burden or to smooth out a redemption spike.
They can be run at the same time as a new issue creating the simplest equivalent to an exchange offer. A recent example of this strategy comes from Schiphol Nederland, which issued a Eu348m 2021 bond in April after buying back Eu403m of outstanding 2013s and 2014s.
Borrowers can offer to buy back their bonds at a fixed price typically at a premium to secondary trading levels to encourage participation or through a modified Dutch auction process. In such a process, the issuer specifies a minimum repurchase price but considers more expensive offers.
"This pricing method gives issuers a bit of clarity as to where the price versus size dividing line is for investors, to see how many investors are prepared to sell at the minimum level," says Andrew Montgomery, head of liability management for EMEA at HSBC.
Once all the bids are in, the borrower can decide the price they want to buy the bonds back at, depending on the interest received. The technique is particularly appealing to issuers who are sensitive to the cost of buying back their debt. And it is a strategy that investors are getting more comfortable with.
"There is limited liquidity in a lot of these securities, so someone with a large holding could look at the minimum price and say, its a premium to the market, its not fantastic, but given I have Eu250m Im going to offer my bonds, because it is my only option for selling in the size I have," says BNPPs Sfakianos. "At the other end of the spectrum, somebody might say I dont particularly want to sell, but if I can get a silly price then Id be silly not to."
National Grid and Centrica are two borrowers to have used the modified Dutch auction process recently.
In July 2010 National Grid bought back Eu398m across three euro and sterling denominated issues maturing between 2011 and 2014. The borrower paid a slim premium to the secondary market, of around 10bp-13bp, to repurchase the bonds. A few months later, Centrica bought back around £450m equivalent of sterling and euro denominated paper maturing between 2012 and 2014, paying a premium of 15bp-25bp to secondary levels.
The modified Dutch auction strategy resulted in tight buyback premia for the borrowers, says HSBCs Montgomery, who worked on the transactions.
"Both had, and achieved, their size targets, but they were prepared to be aggressive and take a bit of a gamble on the pricing," says Montgomery. "As it was, investors agreed to sell at levels that werent generous, but which were sufficient."
Avoiding P&L hits
While straight buy back exercises are effective for cutting overall debt levels, the situation is more complicated if the bonds are trading above par. This is where exchange offers come in.
"If you buy back a bond at a premium above par, you as an issuer incur a loss if the liability is at 100 in the balance sheet," says Mirko Gerhold, DCM official for hybrid capital and liability management at Commerzbank. "If you just buy back the bonds, this premium translates into a loss in your P&L. But if you exchange into a new bond, under certain conditions, which are defined in IAS39, you may get exchange accounting treatment which means you can distribute this loss over the lifetime of the new bonds, rather than taking immediately and in full through P&L."
Under an exchange, a borrower offers to swap investors into a new bond typically with a longer maturity rather than giving them cash for the outstanding issue. The technique has grown in popularity in Europe since 2003, when the exchange accounting was introduced under IFRS, says HSBCs Montgomery.
And for investors, an exchange offer gives them certainty about their exposures.
"In rare credits, investors would only want to give their bonds back if they know they will also be allocated into new issues," says Gerhold. "In such a situation you could either offer investors who have participated in buyback preferential treatment in a new issue provided this is fully disclosed to all investors, or you could offer an exchange into a new issue."
Rather than a direct bond exchange, issuers can simply offer cash tenders at the same time as a new issue. While they are two separate transactions, running them consequentially allows a borrower to tailor the size of the new issue according to the amount of bonds tendered.
This method allows investors to choose between taking cash or a new bond. The dealer managers can use allocation codes to give preferential treatment to those investors that will only tender their existing holdings if they know they will receive similar allocations in the new issue.
"Most investors hold bonds through clearing systems, and no one knows the identity of the holders," explains RBSs Burton. "So if a major investor calls up and says, I want to tender, but only if I get more bonds, were able to give them a code to put in their tender instructions, so we know to allocate them a certain number of bonds. We used allocation codes in the Next transaction, for example, so that investors tendering their bonds would get a guaranteed allocation."
By their nature, liability management exercises are not snappy trades that can be put on the screens in the morning and wrapped up by the end of the day. Generally they take at least a week, allowing dealer managers time to contact investors and for the holders to fully consider the offer.
This adds a fair degree of execution risk to the process. A borrower may indicate a spread or price range for the new issue, alongside buyback or exchange prices at the launch of a tender offer. That is needed to give certainty around what the new paper will yield to investors considering the offer. But the market can move a long way in a week, and by the time the offer closes the new issue price may look either wildly cheap, or aggressively tight.
A new structure the intermediated exchange has evolved since the crisis to tackle this issue. A dealer manager acts as intermediary on the offer, buying back the outstanding paper and distributing the new bonds. The intermediary bank exchanges the paper with the issuer for new cash, allowing the borrower to use exchange accounting to amortise any losses as if the transaction were a straight exchange offering. Investors, meanwhile, retain the flexibility of participating, or not, in the new bond. It minimises the risk for both investors and issuers that a new issue price which looks attractive today will appear much less so when the trade closes.
"For the issuer it gives them superior execution on the new issue versus a traditional exchange, because theyre not waiting around for a week with a price in the market, and running the risk of a mispriced trade if the market moves," says BNP Paribas Sfakianos. "The buyback leg is done very cleanly as a cash offer and the new issue follows a normal timetable, but the issuer gets exchange accounting treatment. We did the first one of these with BAT in 2009, and we did around 12 of them last year. Its the smart way of doing exchanges."
Initially it was a technical anomaly that drove BAT to look at the intermediated exchange option for a debt exchange in 2009. But even once the technical factor had disappeared, the strategy still made sense.
"We were attempting to achieve the accounting treatment of a normal exchange," says Wadey. "We can price the two parts of the transaction a little more flexibly, but certainly with more flexibility than in a normal exchange. From the economic and execution point of view, the transaction looked like a tender and new issue, but we got the accounting benefits of an exchange."
When BAT did its LMEs, the post-crunch drop in funding rates made the offers clearly efficient from an economic perspective. But that has since changed.
"When we did our 2009 and 2010 transactions, we didnt have to assume rates would rise, they were positive for us on an economic basis," says Wadey. "Now, given our debt profile, we would have to assume credit rates would rise by for example around 20bp between any liability management exercise and the refinancing point for a deal to be NPV positive. That would be a reasonable judgement: spreads are tight, and we have quantitative easing. But from our perspective, its less compelling today than it was."
Nevertheless, it is prudent for borrowers to look at reshaping their maturity profiles through LMEs now, say bankers."Certainly you could argue theres no reason why rates should compress meaningfully from where we are here," says Anthony Bryson, head of European corporate DCM at BNP Paribas. "Its probably a good time to take money out of the market, especially since corporate markets have been resilient to volatile newsflow."
Ones to watch
EuroWeek asked the experts about the top areas to watch.
Buying back debt due to mature in the coming year used to be an uphill battle, in part because money market funds sought out these shorter dated tenors. Since the crisis, that has changed, and borrowers are finding that even bonds due to roll off in the short term can be successfully targeted in LMEs.
"Issuers used to be averse to tendering for debt shorter than 12 months, because there was a view that they wouldnt meet a strong investor take-up," says John Cavanagh, head of liability management at Bank of America Merrill Lynch. "However, recent high take-ups on short dated debt tenders have allayed these and have encouraged issuers to pursue these operations."
In November 2010 Coca Cola HBC, for example, showed it is possible to buy back short dated issues. The borrower bought back close to Eu200m of a Eu500m issue due to mature in July 2011, in a move to cut its interest costs and improve its debt profile.
Geographies: Italy, Germany
French borrowers have stood out as being particularly active in the liability management market. Now those issuers may be reaching saturation point and it is time for other jurisdictions to shine, bankers say.
Germany is top of the list for Duane Hebert, head of liability management for EMEA and Asia at Deutsche Bank. "Last year there were an awful lot of liability management exercises out of France, and there is less capacity in that market for more trades," says Hebert. "Now we may see some more out of Germany. Those borrowers havent been as active as others."
Meanwhile, offering liability management trades to professional Italian investors became a lot easier after the national regulator, Consob, lifted a ban on borrowers targeting institutional investors. And while not all bankers say the move will herald large changes in take-up levels on LMEs, they agree it will smooth the way."Italian holders were used to finding ways of participating, either selling their bonds on the secondary market prior to the transactions close, or participating through offshore funds," says Andrew Montgomery, head of liability management for EMEA, at HSBC. "This will increase the efficiency and it will be helpful for Italian issuers who have a sizeable Italian investor base."