"Dont be short the long end." That was the advice that Simon Ballard, senior credit strategist at RBC Capital Markets, gave his clients in an incisive research note distributed in December 2010.
Ballard clearly foresees a continuation of last years most prominent trend in liability management in the corporate sector, which was maturity extension. "If the market opens 2011 in buoyant mood, then this terming out process may well pick up momentum once again," Ballard advised. "Moreover, corporates will likely want to act ahead of any (anticipated) further rise in government bond yields, as a result of future monetary tightening being priced into the market."
Bankers say coporate sector liability management is not new. "Liability management has always been driven by cycles," says Sven Pongs, head of EMEA liability management at Barclays Capital in London. "Over the last decade we have seen cycles driven by M&A, regulatory capital and the strong new issue market, and in 2010 the cycle was driven by extending maturities as it was in 2004-05."
True enough. But as Pongs and others point out, while activity in 2009 was clearly driven by issuers from the financial services sector, the main theme in 2010 was a resurgence in corporate liability management, underpinning volumes that eclipsed previous records.
John Cavanagh, head of liability management at Bank of America Merrill Lynch, says by late November there had been 111 completed liability transactions in Europe worth Eu63bn (equivalent), with an average size of Eu640m. While that is almost double the amount in 2008 and 50% more than 2006 and 2007, it is a slight decrease on 2009s total of Eu85bn in 195 transactions.
But 2009 was exceptional in the FIG sector. This is why the most striking feature of 2010 was the rise in corporate liability management relative to volumes in FIG.
According to Cavanaghs data, in 2009 the corporate sector contributed 90 transactions worth Eu25bn, versus 105 deals valued at Eu60bn in FIG. By late November 2010 there had been 75 corporate deals worth Eu33bn, compared with 36 FIG transactions amounting to Eu30bn.
While those corporate deals have been concentrated in a handful of western European economies, Pongs is encouraged by the increasing geographical breadth of corporate liability management. "We did our first deal last year for a Turkish company, Yasar, which exchanged an existing Eurobond into a longer dated dollar bond," he says. "So this seems to be a trend that is spreading from core Europe into emerging markets."
Like RBCs Ballard, Cavanagh believes that in spite of 2010s activity in corporate liability management, there is scope for an expansion in volumes in 2011. "We anticipate a consistent upward trend," he says. "On an annual basis, the market for liability management is three to four times larger in the US than in Europe, which suggests that there is room for growth on a relative basis."
Stretching the maturity
The motives underpinning continued activity in corporate liability management, say bankers, will be similar to those that drove the rise in issuance in 2010. The most important of these, for investment grade corporates, has been an opportunistic drive to extend maturities.
That, say bankers, is an understandable and legitimate response by corporate treasurers to low interest rates and a benign new issuance climate. But there have been other drivers of corporate liability management, at least two of which are legacies of the financial crisis and the subdued macroeconomic climate of the last two years.
"A lot of companies in Europe came out of the financial crisis long of cash, having built up war chests to protect them at the bottom of the cycle," says Paul Hawker, head of liability management at Credit Suisse. "They dont need cash because demand for expansion capex is low, but they are attracted by new issue pricing.
"So rather than issue a new bond and sit on the cash until maturity in three or four years time, a number of them have been going to their bondholders and proposing that they exchange existing bonds that are nearing maturity into longer dated issues. Borrowers such as Air Liquide, Rhodia, Rio Tinto and many others all used this strategy very successfully in 2010."
Another legacy of the crisis that has steered borrowers towards the potential of more proactive liability management, both in the corporate and the FIG sectors, has been a heightened awareness of refinancing risk. Cavanagh describes the liability management exercises over the last 12 months as "sleep-easy at night trades".
"Treasurers are very mindful of the events of late 2008 and 2009, and how quickly liquidity dried up at the height of the crisis," he says. "Maturity extensions are a sleep-easy trade because treasurers know that they wont be beholden to volatile markets if there is another big bump in the road."
The lessons drawn from 2008 and 2009 may also have prompted an important shift in corporates attitudes towards pricing of liability management exercises. "The first big wave of European corporate liability management took place between 2003-06 in similar market conditions to 2010 in the sense that new issue yields were low," says Andrew Montgomery, head of liability management at HSBC in London. "But spreads on shorter dated debt were wider at the start of 2010 than they were between 2003-06.
"In previous liability management cycles, the bonds that corporates were targeting were trading around mid-swaps flat and therefore there wasnt much of an opportunity to offer a premium. Because spreads were wider coming out of the credit crisis, issuers were able to offer more of a premium, while ensuring that liability management trades remained economic."
That, says Montgomery, suggests that many of the corporate liability management exercises in 2010 were strategic, rather than purely opportunistic, as they may have been in previous waves.Duane Hebert, head of liability management at Deutsche Bank in London, says the exercise navigated by Frances EDF was 2010s most striking example of the maturity extensions that combined opportunistic and strategic motives. The most notable component of EDFs buyback of part of Eu4bn of bonds due in 2013 and 2015 was the issuance of a new Eu750m 2040 transaction, which was the first 30 year euro corporate bond in 2010 representing maturity extension par excellence. Issued alongside a new 15 year bond, the 2040 issue was led by BNP Paribas, Crédit Agricole, Deutsche Bank, Goldman Sachs, HSBC and Natixis. EDFs 30 year bond was priced at the tight end of guidance (160bp over swaps), and generated orders of more than Eu1.5bn, demonstrating the demand for long dated corporate exposure in Europe.
Maturity extensions were the principal theme for corporates in 2010 but other liability management exercises were conspicuous. The first, chiefly a characteristic of the high yield market, involved consent solicitations from corporate issuers looking to amend terms and conditions of existing notes. To Deutsches Hebert, the standout exercise of the year in this segment was the Wind transaction, calling for consent for indenture modifications across six bond tranches worth the equivalent of Eu5bn. "There is no doubt that its size, complexity and importance makes Wind the deal of the year in the indenture modification and high yield space," says Hebert.
Consent solicitations are an important feature of another type of liability management exercise that appeared sporadically in 2010, which was a by-product of merger and acquisition activity. "In situations like the acquisition of Cadbury by Kraft, weve seen liability management exercises conducted on a newly bought subsidiarys bonds to harmonise the covenants with those of the parent group," says one banker.
Bankers believe there will be plenty of scope for more liability management driven by M&A in 2011, given the mountains of cash sitting on some companies balance sheets. In Germany, for example, one banker says that some companies have built up cash positions of as much as Eu8bn, suggesting that there is a vast amount of firepower available to underpin big-ticket M&A activity.
For banks liability management teams, the beauty of balance sheets oozing with cash is that they ought to deliver opportunities in any market environment. This is because companies with large cash positions will come under increasing pressure to use it to support inorganic growth, or to refinance or buy back existing debt. Either way, liability management skills will be in demand.
Electrifying cash tender
Opportunistic buybacks were already a feature of the European liability management landscape in 2010, especially in the UK. At HSBC, Montgomery picks out the Eu400m cash tender for National Grid in July as a highlight in a crowded market featuring deals for UK companies such as Centrica, Land Securities, Tesco and Welsh Water.
"The National Grid deal was a relatively straightforward cash tender, but it was executed via a Dutch auction across two euro denominated issues and one in sterling," says Montgomery. "That allowed us to buy back significant volumes at much reduced premiums of about 12bp-13bp on the euro debt, which compares with levels of 25bp-30bp paid by other issuers for similar exercises."
While the UK was the main driver of buybacks in 2010, the dominant source of corporate liability management activity last year was France, which by late November had accounted for 17 of 33 announced maturity extension exercises. By vivid contrast, German corporate borrowers were conspicuous by their almost complete absence from the liability management space.
Some bankers confess to being stumped for an explanation as to why French corporates were so much more active in 2010 than counterparts elsewhere in Europe. The most persuasive explanation is the structure of the domestic investor base in France, which is heavily populated by insurance companies and other institutions with a voracious appetite for long-dated exposure.
In spite of this, by the end of the year, there were indications that corporate liability management exercises in France were encountering resistance, perhaps due to investor fatigue. Liability management exercises from a number of French corporate borrowers towards the end of 2010 attracted acceptance levels that appeared to be disappointing by the standards set earlier in the year. In the case of an Auchan exchange in November, for example, take-up reached just 17%.
Bankers concede that alongside execution risk, investor fatigue may be one of the principal risks facing corporates looking to exchange existing debt. They caution, however, that it is a mistake to measure the success of liability management exercises purely on the basis of acceptance ratios. "Take-up ratios in exchange offers always need to be looked at in the context of pricing and of the success of the new issue," says Pongs at Barclays Capital. "Participation levels alone are not always an accurate measure of success."
Bankers say investors like the opportunities from maturity extension trades. "Investors welcome corporate liability management exercises because of the liquidity they create," says Hawker at Credit Suisse. "As long as the pricing dynamics are right, they are usually being offered new and more liquid bonds at a new issue premium."
In some respects, the market for FIG liability management in 2010 remained different from the corporate market. As in 2009, many of the larger liability management exercises in the FIG sector in 2010 were driven by banks continued need to strengthen their capital bases, or to respond to EU regulations restricting the room for manoeuvre at banks in receipt of state aid.
Several of the most successful FIG transactions also represented the later stages of balance sheet management exercises begun the previous year. On the basis of its sheer size, the most prominent was the £1.25bn retirement of tier one dollar bonds launched in May by RBS.
"The RBS transaction was notable for being the largest FIG liability management exercise of the year, but also because it demonstrated how many markets you can operate in simultaneously," says Cavanagh. "That transaction involved the sterling, euro, US dollar and Canadian dollar institutional markets, and we were tendering for dollar retail-held preference shares, so there were five separate markets involved in a single transaction."
Another FIG highlight was the debt to equity exchange exercise by Lloyds Banking Group in June. Arranged by BofA Merrill and UBS, this offered holders of $1.85bn of upper tier two debt the opportunity to exchange holdings into equity. The bankers involved in the deal say that investors response surpassed expectations. "We got 41% of investors to convert dollar denominated debt into sterling denominated equity, which dispelled the myth that you need the currencies on either side of an exchange to match," says Cavanagh.
Rob Ellison, managing director of DCM at UBS, also highlights the Lloyds liability management exercise, which followed on from the groups jumbo contingent capital exchange the previous year. "The emergence of debt to equity exchanges by groups such as Lloyds and Bank of Ireland has been very eye-opening," he says. "They have changed the nature of liability management in Europe by offering investors an even broader choice of positions to occupy in the capital structure."
Although techniques such as these are applicable only in the FIG sector, there are themes common to corporate and financial borrowers in liability management. Ellison says what links borrowers is the inefficiencies that have become features of the term bond market.
"There has always been inefficiency in the term bond market for investors and issuers," he says. "For investors inefficiencies may arise when the remaining maturity on their holdings falls to a level at which it is no longer index-eligible. For issuers inefficiency can be a function of bank treasurers changing views of the regulatory credit theyre given for their levels of capital. Or it could be something like the costs of carry for corporate issuers that have pre-funded. The proceeds of this pre-funding used to be invested in low yielding government bonds or highly rated CP at deeply sub-Libor levels. As risk asset spreads have widened, investing in their own short dated debt becomes a highly efficient alternative, and the smoothest way to achieve that is often via liability management."
Motives for liability management in the banking sector are mirroring those entrenched in the corporate market. "Borrowers in the FIG as well as the corporate space have grasped the message that refinancing risk is here to stay," says Montgomery at HSBC. "An increasingly prominent theme in FIG will be maturity extensions."
Two transactions stand out from 2010. In September, Dexia Municipal Agency offered to exchange Eu14.5bn of existing bonds into three longer dated obligations foncières the first liability management exercise in covered bonds. Led by Credit Suisse, Deutsche and HSBC, it helped Dexia to raise new funding while steering clear of a potentially overcrowded new issue market.
Bankers say the Dexia exercise was significant because of the precedent it established. "It allowed the borrower to issue Eu2bn of new bonds at a difficult time in the new issue market," says one banker, adding that the transaction heralded the start of a mini-trend that has seen other issuers such as Banco Popular use liability management in the covered bond market.
Then came Caja Madrids offer in November to buy back almost Eu17bn of outstanding securities across 12 notes. As well as encompassing cédulas and senior notes, it offered investors the opportunity to exchange existing government guaranteed bonds into new, longer dated GGBs. "To achieve such a level of participation across such a wide range of securities was a great success, given how uncertain market conditions were at the time," says Marie France Guay, director in the financing solutions team at Barclays Capital.
Looking to 2011, bankers expect to see more maturity extension trades in the FIG space. They expect a resurgence in FIG activity as clarity emerges over Basel III. "There is still uncertainty about grandfathering," says Hawker at Credit Suisse. "But there will be a big wave of refinancing of capital securities to comply with Basel III."
Deutsches Hebert agrees. "I would expect to see a substantial increase in volume in 2011," he says.
One area of liability management yet to materialise in Europe is at the sovereign level. Although there were some modest transactions in 2010 for sovereigns such as Iceland and Italy, bankers say that sovereign liability management remains an emerging market story. Certainly, there has been nothing in Europe to rival the ambition of the debt swap programme launched by the Philippines via Citi, HSBC and UBS, which offered investors the opportunity to exchange 14 bonds worth a total of $17.7bn.But as bankers point out, eventual fall-out from the sovereign debt crisis in Europe may be liability management exercises. "European sovereigns have been reluctant to put themselves in the same boat as emerging market issuers," says one banker. "But who knows if some of the stressed issuers talking to the EU and the IMF wont be forced down the liability management route?"