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Bonds replace loans as company finance favourite

24 Jun 2009

Investors are turning to the European corporate bond market in droves and there is little on the horizon — neither rising defaults nor worsening economic fundamentals — that will make them turn back. This boom is here to stay, says Nina Flitman.

The shift in the corporate funding model from loans to bonds takes the European market closer to its US cousin, where corporates have always been more reliant on bond financing.

The credit markets in the US have traditionally been more developed, with many more corporates, both high yield and investment grade, having obtained ratings.

Analysts at Citi estimate that roughly 80% of the eurozone non-financial credit instruments are loans, while in the US the split between bonds and loans is closer to 50:50.

The move to a US style funding system for corporates has been hailed as a healthier model by loans bankers.

"European high grade issuers have generally been over-reliant on bank funding," says Kristian Orssten, head of European loan and high yield capital markets at JPMorgan in London. "Loan financing has historically been cheap, flexible and in plentiful supply.  This has been driven by a highly fragmented banking landscape and the desire by European banks to build their client franchise beyond their national borders and consequently has fuelled significant competitive price tension.

"Most banks are re-evaluating their client strategies which we believe will lead to more focused client targeting and capital management. It is this uncertainty that is driving many CFOs towards securing financing from the public securities markets."

As well as seeing decreasing volumes, the nature of European loans is likely to change to become more in line with the US system. In the US, the majority of bank paper for high grade corporates has been for standby facilities, commercial paper backstops and liquidity facilities that were not routinely drawn down. However, European corporates have generally taken advantage of their bank lines, and this may be one of the reasons why European loan portfolios have significantly lower returns than their US counterparts. 

But the new loan market will provide a different style of funding as banks develop a more disciplined approach to lending, especially as corporate loan losses increase as more borrowers fail.

Tenors have decreased sharply as banks limit the amount of time they are exposed to corporate borrowers. While previously many borrowers were able to obtain five year revolving credit facilities easily, now 364 day loans have become more typical.

Bond takeout activity is also set to increase especially for M&A finance, with corporates accessing the debt market to pay back loans soon after they have been finalised.

In March, Roche took this logic a step further by tapping the bond market before the loan market to fund its $47bn takeover of US rival Genentech. The Swiss pharmaceutical firm had been expected to try to secure bank debt of around $20bn, but following the high uptake for its bonds, through which it raised about $39bn, the loan deal fell away.

For credits looking for large amounts of funding, the bond market offers greater choice and flexibility. While in the past, borrowers have been able to set out bespoke loan terms and repayment schedules, now that lending facilities in banks are becoming centralised (in some cases, the decision for the loan goes up to chief executive level) the generous benefits offered to corporate borrowers are being reduced.

Although it is reasonable to assume that the maturity profile of new loan transactions will be extended as the economic environment improves, it is unlikely that there will be a return to the tenors widely offered pre-financial crisis.

Similarly, although banks’ credit squeeze will probably abate, prices will not bounce back to previous levels where loans were run as loss-leaders to attract corporate clients to the more lucrative wholesale businesses.

New levels
"Previous post-crisis trends would indicate that we will return to a low margin environment again," says Orssten. "However, this time it’ll be different. We’ve got Basel II in effect, which will be very sensitive to credit profiles and financial institutions will be more focused on improving the profitability of their loan portfolios.  Do we think the markets will return to a more competitive level after this crisis? Yes, but we don’t think that they’ll go back to the levels we saw in 2006 and the first half of 2007."

Corporates to bonds
The model for corporate funding has changed fundamentally as the perceived function of banks has changed.

"Over the last few months, the banking sector has been criticised for poor regulation, and now a clear backlash is coming with the intent of squeezing the leverage out of the system," says Christopher Marks, head of debt capital markets Europe at BNP Paribas in London.

"The more exuberant parts of the business, like synthetic exposure, have been cut back, but lending and fixed income balance sheet deployment are the babies that may well go out with the bathwater. Balance sheets are more expensive now and we no longer cross-subsidise certain businesses, so there will be less debt and debt equivalents available from the traditional banking system."

After 18 months of abundant credit for corporate financing, as banks come under pressure and find their capital levels squeezed, they have had to re-evaluate what resources are to be made available to their loan portfolios. Research analysts at Barclays say that in both the euro and sterling loan markets, banks’ loans to non-financial corporates were negative in March, as repayments exceeded the amount of new credit extended to borrowers.

"We’ve certainly experienced a seismic shift in the financial markets," says Luke Spajic, the head of European credit and ABS portfolio management at Pimco in London. "Banks won’t be the same again; they’re de-leveraging and becoming a lot more utility-like, with higher capital ratios and a less gung-ho attitude. Industrials have realised that banks won’t be the ultimate provider of capital at every level and they have to adjust their vision of funding."

For corporate borrowers, the bond market has proved to be a pragmatic alternative to loans, especially for longer dated funding. Although bond spreads have widened to the highest levels seen in years, as absolute interest rates have fallen, issuance is still cheap compared to historical levels. And with investor cash flooding into the sector, the bond market offers a huge amount of depth for borrowers.

"Investors have just realised that there is an asset class out there with good returns and hopefully limited risks and this is the main reason why the shift has happened," says Verena Volpert, the senior vice president in finance at E.ON in Dusseldorf. "And spreads are still quite high and attractive for these investors."

Some investors have flocked to the market, escaping the volatility of the equity sector, while government bond investors have been attracted by a pick-up of up to 200bp-300bp in corporate bonds.

Tighter, better, deeper, stronger
With more issuers relying on corporate bonds for funding and more investors active in the sector, the market has strengthened dramatically in 2009. Credit analyst Suki Mann from Société Générale in London says supply in the first 4-1/2 months has outstripped the total redemptions for the year (Eu120bn). The amount of non-financial issuance in the first quarter was more than double the amount raised in the same period in 2008.

Analysts at Citi expect corporate net bond issuance in euros to rise from Eu45bn in 2008 to Eu150bn in 2009. They predict the largest ever annual amount of gross issuance at around Eu280bn, up 125% year on year.

"It’s a marriage of convenience between issuers and investors," says Spajic from Pimco. "Issuers are happy to come to the bond market and there’s a huge demand for credit from investors. Credit is the new equity. You get the equity-risk like returns but only a third or a fifth of the volatility."

The corporate bond sector has remained robust over the last few months, and even cyclical names have been able to tap the market.

"We have had a complete shift in investor focus," says Volpert. "2008 was a difficult year in the euro market, even for utility companies such as E.On. The market was closed for most of the year and in total was only open for about two to three months. You had to be careful and jump in when there was a window. This year, the market has been wide open. From January, it’s always been there and it’s getting better: weaker corporates are getting access, spreads are coming down, and the books are massively oversubscribed."

Even with this amount of volume, spreads have materially tightened so that on a total return basis, corporate credit has beaten government bonds and equities to date.

For example, at the beginning of May, oil firm Total (Aa1/AA) printed Eu550m of six year paper with a coupon of 3.625% and a spread of 75bp over mid-swaps. In the same week, financial institution Nordea (Aa1/AA-/AA-) priced a shorter 2014 transaction at 185bp over mid-swaps and with a coupon of 4.5%.

High yield in play
But despite the ever-growing appetite for corporate paper, there are many borrowers who will not be able to tap the bond market, either because they are unrated and unknown to the market, or because the high costs are prohibitive. These are the smaller borrowers that would have previously relied on the loan market and that will struggle the most to raise the bulk of their financing through bonds.

"Large firms are the ones that already have access to the bond markets, but it’s these middle-sized firms, with revenues of Eu3bn-Eu5bn, that need to change their funding behaviour away from bank facilities," says E.On’s Volpert. "These resources aren’t available in the same size as in the past, and so they’ll have to adapt and look to prepare, for example, getting a rating. But how can mid-sized corporates access the capital markets if bond investors don’t know them?"

On getting a rating, many of these firms would find that they fall into the high yield sector. Although this market has been flourishing in the US, in Europe the sector is not as highly regarded by issuers, and high yield has been perceived as a dirty word. But the distress in the banking arena could force these issuers to look for funding diversification, driving the high-yield bond market forward.

"High yield bond issuance in Europe has historically been very disappointing," says Orssten. "Companies have had access to attractive and flexible loan financing from numerous banks, and therefore have had little pressure or incentive to seek a rating and tap the public bond markets." 

However, despite the potential of the high yield sector some investors are cautious of the riskier market, at least until the effects of ratings migration and defaults become clear.

"There is some appetite for high yield, and the market’s been buzzing recently," says Emma du Haney, European fixed income product specialist at Insight Investment. "But with historical default rates of 35% in recessionary times you have to be very selective."

Although high yield may be a step too far for some, investors’ appetite continues to move down the investment grade credit spectrum, with more cyclical borrowers raising funding at attractive levels through bonds. As with many corporate credits, these names may be realising that the future of their funding lies in bonds, not banks.

24 Jun 2009