The corporate bond market has recovered its poise after the downgrading of General Motors and Ford, with June looking set to be the busiest month of issuance since early 2004. But while the turmoil of this year has passed, the lessons investors have learned could have a lasting impact on the market. Neil Day reports.
"Did we dream March and April?"
SG CIB credit analyst Suki Mann's question, posed in mid-June, was a timely one.
Just over a month earlier, on Thursday May 5, the credit markets had suffered the double-whammy downgrades of General Motors and Ford by Standard & Poor's (S&P) — the former from BBB- to BB and the latter from BBB- to BB+.
While the junking of the auto giants had been well flagged by the rating agency, particularly since General Motors' profit warning in mid-March, the ejection of two companies with debts of some $450bn from investment grade indices was expected to spark panic.
In the immediate aftermath, the rating actions did prolong the volatility that had engulfed the corporate bond markets in March and almost paralyse the primary market.
But some five weeks on, the picture was quite different. Some Eu13bn of corporate supply had hit the new issue market by mid-June, which was set to make the month the busiest since the beginning of 2004.
And investors have welcomed the market's return to health. "We are amazed at the amount of supply that we have been seeing," says one credit analyst at an asset manager in Paris. "We are quite positive on credit and several of the deals are quite attractively priced."
One of the simplest explanations for the rude health of the market has been its supply dynamics over the year. As analysts at Dresdner Kleinwort Wasserstein pointed out in research examining the surge in issuance, this has kept investors hungry for paper.
"Actual year to date issuance is below expectations in all non-financial sectors outside of industrials, despite the recent acceleration we have seen," they said in mid-June, "and in contrast to the significant volume of issuance we have seen in subordinated financials so far this year. Furthermore, issuance also remains below the levels achieved in the first five months of 2004 for most sectors."
While corporate issuance in the same period last year reached Eu43bn, according to DrKW, year to date issuance in 2005 has been some Eu40bn. This is around Eu12bn lower than DrKW's full year forecasts had suggested the market might reach by this point in the year.
Downgrades? What downgrades?
Any level of supply would not result in a buoyant corporate market without a commensurate or greater level of demand, and the key factor, in the words of one fund manager in London, is that investors have got their confidence back.
This is largely because the doomsaying that followed the GM and Ford downgrades did not become a reality.
In the wake of the downgrades, speculation abounded that certain hedge funds had been wrong-footed by the timing of the rating actions and that, as they unwound their positions, volatility would only increase and spreads move wider still. A Citigroup research report said that March had been the worst month for hedge funds in at least 2-1/2 years and that April could be worse still.
Even reasonable voices in the market were being cautious. "Two of the three biggest borrowers in the corporate bond market were downgraded to junk and it is difficult to believe everyone was on the right side of that trade," Gary Jenkins, head of European credit research and fundamental strategy at Deutsche Bank in London, told EuroWeek. "It is hard to know who is hurting as aftershocks take a while to show themselves. Russia defaulted in August 1998, but the collapse of LTCM did not appear until October."
There were also fears about forced selling by investment grade portfolios, but these too appear to have been overblown. Indeed, analysts at JP Morgan had, in surveys of European credit investors preceding the downgrades, found evidence suggesting the investor base was well positioned to cope with the auto companies' fall — even if it had prepared itself to cope with it somewhat unintentionally.
"If you step back in time to the beginning of 2004, people felt that spreads were tight, but not too tight, and that it would be a difficult year to generate alpha," says Stephen Dulake, a credit strategist at JP Morgan in London. "Asset managers therefore pushed for more flexibility within high grade mandates."
This was because they had seen occasions when credits had fallen from the investment grade indices only to return not long afterwards. "Looking back to the dark days of 2001 and 2002 and the large cap credits that moved from high grade to high yield," says Dulake, "in most cases they overshot on the downside in their ratings trajectory — at least with respect to most analysts' initial recovery values — and some people wanted to give themselves the flexibility not to be a forced seller."
"So when we have surveyed investor opinion we have always been underwhelmed by investors' requirement to sell Ford and GM paper within three or six months of any downgrade, and that is entirely consistent with money managers having given themselves a lot more flexibility."
This contributed to what, with hindsight, was an orderly reshaping of the credit market. "Our sense was that, generally speaking, some time before the ejection of Ford and GM from the high grade indices, those investors that had to reduce their exposure had already done so," says Dulake, "and those that were required to seek an additional mandate to own Ford and GM as effectively off-benchmark risk had done so.
"So, in a way, the rally that we have seen in Ford and GM, particularly through the second part of May that has continued into June, has perhaps been the result of dealers short covering. We didn't see the expected index-related selling that some had thought they might see, and therefore short positions had to be covered."
The pendulum swings...
Some investors have welcomed if not the volatility of recent months, at least the widening of spreads that resulted. "Spreads are currently sitting nearer fair value," says one portfolio manager in London. "The valuations were very stretched at the end of February this year."
Issuers have also been less pushy than they were in the past. "A lot of companies issuing bonds now are trying to issue in size and are less specific about the pricing of their deals," he says. "They are quite happy to leave a little bit of spread on the table for investors just as long as they can get the size of issue away.
The coming into effect of the EU prospectus directive on July 1 has added momentum to the corporate supply — as well as other sectors of the fixed income markets — as issuers have sought to raise funds before the reporting and documentation regime changes.
As well as being more flexible on pricing, companies are also facing investors who are more demanding in terms of the protections that they are seeking.
"Throughout the credit rally of 2003, 2004 and early 2005 issuers were on top and they could get away with anything," says one London-based fund manager. "Now some balance has returned. You have seen specific examples of event risk that have hurt European bondholders, such as LBO risk, and that has highlighted the issue for investors."
S&P highlighted this in a report published in mid-June entitled 'Buyer beware: investors seek greater LBO protection from European investment grade bonds'. "With the increased possibility of leveraged transactions in the investment grade arena," said the rating agency, "investors are starting to pay more attention to the potential loss of value from a change-of-control event. A repercussion of this could see more change-of-control protection in new investment grade bond documentation.
"A number of European investment grade issuers have recently found market conditions strongly favour inclusion of change-of-control protection. These factors have seen several recent investment grade bonds issued with change-of-control language included."
Investors learn their lesson
This has largely been the result of lessons learned when Danish cleaning firm ISS Global was the subject of an LBO in April that resulted in investors seeing the value of the Eu1.35bn nominal of bonds outstanding fall by 25%-30%.
An example of the new environment came when French car parts maker Valeo was marketing a Eu500m eight year bond issue in early June, and was summed up by one investor.
"The pressures on auto manufacturers make you predisposed to think that auto parts suppliers will suffer, but there are still stronger credits among the auto parts companies," said Ashton Parker, senior credit analyst at Insight Investment in London. "I don't really view it as an A3 rated company but at BBB plus it is a strong credit and the level of mid-swaps plus 80bp-85bp is reasonable value.
"But I wouldn't be a buyer without [the change-of-control] protection. The market has become much more aware of LBO risk and Valeo is one of the companies that is mentioned as a candidate. It was an issue we brought up at the roadshow a couple of weeks ago."
Volker Marnet-Islinger, head of credit at Cominvest in Frankfurt, echoes this view and says that corporates should be happy to oblige.
"Covenants are a major issue for bondholders after what happened with ISS Global and TDC and it does not just benefit investors," he says. "It is also a good clause for a company as potential buyers know they will have to pay back the bonds — companies are beginning to accept that we are in the same boat."
Bearish on credit, not spreads
Although the renaissance of the corporate primary market is widely viewed positively as the causes of the recent volatility have receded, investors say that the outlook is not without potential problems.
"One of the factors that drove the spike in the credit markets earlier this year was the expectation that interest rates would have to rise faster than had previously been thought," he says. "This caused the volatility that we saw and then we had GM and Ford, and the problems that this was causing hedge funds.
"But since then, expectations as to the speed of rate rises have declined and now people are moving to the opposite point of view. Europe has seen weaker economic growth, the UK has seen weak growth and the US is showing some signs of weakness, although that is not conclusive yet."
Dulake at JP Morgan says that he, too, has heard bearish forecasts. "Some market participants have been talking about dramatically wider spreads," he says, "saying that we are at some form of turning point for the credit markets."
However, he is confident that any lower risk appetite on the part of investors will have a limited impact on spreads given their current levels of exposure to credit.
"Our sense is that while investors themselves may have become negative, it is not clear that they have any risk for sale," he says. "Our surveys have shown for the past 12 months or so that most investors consider themselves to be positioned fairly neutral.
"We would be concerned about a market where investors are negative and there is evidence that they are really long, as it means that they will have bonds for sale. But what the absorption of recent new issues has shown is that, if anything, investors are a little bit underinvested in credit, so I think that the credit market is not in as bad a shape as some people would have you believe."