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On the way out?

30 Jun 1999

The arrival of the euro has hit the US Yankee bond sector hard, with Europe's fast developing credit market providing an alternative and highly competitive source of funding for non-US corporate issuers.

In addition, US investors have been slow to recover their appetite for foreign issuers after last year's shocks and are more reluctant to take on complex credits than in the past.

As a result, Yankee bond issuance has tumbled - although many would-be Yankee deals are being dressed up as global bonds to save on fees for the issuer and access the widest possible investor base.

Is the Yankee bond destined to be sidelined by the globalisation of capital markets? Or does it still have something to offer as a stand-alone funding source? By Danielle Robinson.

If evidence is needed of the impact that the introduction of the euro is having on the US capital markets, look no further than the Yankee bond sector.

Issuance by non-US high grade corporates into the US market has plunged more than 44% in the first six months of this year, to $14.7bn and 45 deals from $26.4bn in 104 transactions in the same period last year.

Choosing between the European and US capital markets has been an easy decision for top European corporates like BAT, Repsol and Mannesmann: either to tap a new euro market clamouring for top corporate credits, or to approach a half-hearted US investor base whipped by last year's emerging market collapse and this year's interest rate-induced bond market volatility.

"At the margin you will see less European issuance in the Yankee market," says Phil Bennett, managing director and head of international debt capital markets at Salomon Smith Barney.

"The US market still offers longer maturities than the Euromarket. But in general, with the existence of a European credit market, entities like BAT and Repsol that used to issue Yankees now have a home market to go to where they are well known and sought after."

The euro is not the sole factor. Its onset has coincided with huge spread movements in the US corporate bond market this year due to US interest rate uncertainties.

Spread widening of as much as 20bp has been experienced in top corporate credits at various times this year in a high grade sector that normally considers a 5bp to 10bp widening to be dramatic.

Even many US corporate bond issuers were shut out of the market in the weeks leading up to the US Federal Reserve's June 30 Federal Open Market Committee meeting, where it made its first rate hike in over a year.

A new issue premium of anywhere from 5bp to 25bp has re-emerged for US and Yankee bond issuers - while for 144a deals another 10bp is usually required to compensate for perceived illiquidity. This time last year there was no such thing as a 144a

High quality issuers like BAT have attempted to come to the Yankee market and failed. The company had planned a $500m intermediate 144a offering in May with Morgan Stanley Dean Witter, but was forced to pull the deal because the US market froze over in anticipation of a Fed rate tightening.

"The market was telling us it was not the right time," says Julia Leung, principal and head of Yankee bond origination at Morgan Stanley.

"It was at the time when the Fed took a tightening bias towards raising interest rates and investors were putting up their hands and saying 'enough, there is too much volatility in this market'. It was a period when the market went into semi-paralysis."

Although slow in the first two months following Brazil's devaluation in January, Yankee bonds started to come back in favour in the latter part of the first quarter as investors started moving out of their safe haven in Treasuries and into higher yielding corporate debt.

But investors have been and remain selective. With all of the hits taken since October 1997, US allocations to Yankees are still down. The average portfolio allocated about 20% to Yankees before October 1997.

That steadily dropped to around 14% by the end of 1998. It has crept back up to around the 20% level, but investors will take only the best credit stories, or those issues which are priced to sell.

There have been some notable newcomers. The Republic of Chile made its international capital market debut with a $500m Yankee bond led by Merrill Lynch.

The deal, however, was an act of mercy on the part of the sovereign to help reopen the market for Chilean corporates, whose bonds had suffered significant - and, in the eyes of the Chileans, unwarranted - spread widening as a result of emerging market crisis.

Although four times oversubscribed, the deal paid 175bp over Treasuries, a premium to current comparables. That compared with spreads in the 80s for A- rated Chilean
electricity companies in mid-1997.

But buying into Chile has not rewarded US investors hoping for a spread tightening. The deal was trading at around 200bp in early July.

US investors have been particularly keen on Asian issuers which are coming to market for the first time since late 1997 and who are willing to pay up for market access.

MTRC issued a 10 year deal in February at what was considered a very generous spread of 265bp over Treasuries, which has since tightened in to 145bp.

"It was a situation where it was too hard to ignore certain issues tightening," says Morgan Stanley's Leung. "China, for example, has gone from 277bp at the beginning of the year on its 2008 bond to a current level of 185bp. Hutchison Whampoa's 30 year bond maturing in 2027 has tightened in from 370bp earlier in the year to 280bp."

Yet the costs to the issuer were high and the Yankee market lost even some
non-European borrowers to the more cost competitive euro-denominated market.

Hong Kong conglomerate Hutchison Whampoa, for one, shifted away from the US market and into euros in the first quarter - launching non-Japan Asia's first euro-denominated bond, a Eu500m deal led by Deutsche Bank and HSBC Markets.

Defying sceptics, Hutchison was able to break through its current dollar trading levels to launch the seven year deal at 5.5% to yield 170bp over Bunds - at a time when its existing 2007 dollar paper was trading in the 260bp/250bp region. After swaps the savings to the company was in the order of 10bp.

US underwriters have tried to meet the euro challenge by structuring more Yankee bonds as globals - to capture whatever non-US demand there might be for a dollar deal, but also to make a US dollar bond deal more competitive on an all-in cost basis.

"We've seen a lot of what I would call fake globals," says the head of Yankee origination at one Wall Street firm. "They are deals which are clearly targeted at the US investor but for fee efficiency they are structured as globals."

Global bond fees are less than half the standard 6.5% fee on a 10 year US bond. The Merrill Lynch-led $600m issue by British Sky Broadcasting (BSkyB) in mid-February, for instance, was a global but only 25% of its bonds went to international investors.

"We have definitely seen a blurring of the distinctions between markets that historically were more segmented. The Yankee bond is much less distinguishable now from a Eurobond or a global bond than was the case a few years ago," says John Cooley, managing director and head of debt syndicate at HSBC Markets in New York.

Other than to those with a vested interest in pure Yankee business, the global bond is a much welcomed development. The global structure enabled BSkyB to get a Yankee deal done and at the same time test European appetite for a BBB- rated credit on negative outlook.

The structure also provided enough extra demand to create some price tension and to increase the deal from $500m. Although its 198bp launch level was wider than trading levels for lesser-rated television-based companies in the US market, it was nevertheless better than the initial low 200bp guidance on the deal. The orderbook was strong enough to bid the deal in another 10bp on the break.

"The BSkyB deal was a Yankee from an origination standpoint so it makes no difference now as to how we cut the deal," says Chris Schade, managing director in charge of Yankee origination at Merrill Lynch.

"We want to structure Yankee deals so marketing and selling them is much easier. We want to give the issuer the best terms possible and, even if a deal is considered a pure Yankee, most of these bonds will have Euroclear and Cedel language in them to facilitate sales into Europe."

Marketing of Yankees has been tough and the deals which have fared best in the primary market tend to be those which are easy stories for an investor to grasp.

That was no better demonstrated than by the stark contrast between the reception to UK food and drinks conglomerate Diageo's $1bn Yankee offering in June and UK publishing company United News & Media's $500m offering the following week.

Although both companies launched their transactions in difficult market conditions before the Fed's June 30 FOMC meeting, investors lapped up the Diageo deal, but balked at United News & Media.

With worldwide brand names like Johnny Walker, Burger King and Haagen-Dazs, it was not difficult for lead managers Morgan Stanley and Goldman Sachs to get investors interested in Diageo's five year Yankee bond.

Diageo was also sensible enough to price the deal attractively at 90bp over Treasuries when other top brand name companies like Heinz were trading in the 70bp region for 10 year paper.

"They could have been cunning and tried the high 80bp region to begin with, but having the psychologically important 90bp area guidance enabled them to tighten in to 88bp on the break anyway," said a banker. The deal is now trading between 90bp and 93bp over.

The story was very different for United News & Media, however. The company was forced to halve the size of its Yankee bond debut and widen the price talk by as much as 25bp the next week.

The deal, led by Morgan Stanley Dean Witter, was originally expected to be about $1bn in size and price split into a five and 10 year tranche with 145bp to be talk on the five year and 175bp on the 10 year.

It ended up coming at $500m, split evenly between a five year priced at 165bp and a 10 year at 200bp.

"One of the differences between the two deals is that United News & Media is more of a complex credit," says Leung. "It is more of an intensive credit story whereas Diageo has a large range of well known international brand names which speak for themselves.

"To some extent investors do not feel they really need to go through the story of Diageo as much as they would with a credit like United News & Media."

The two deals also highlight how much difference a week can make in terms of timing.

Diageo benefited from a brief respite from market nervousness when it issued its bonds, brought on by lower than expected US CPI figures and positively viewed comments by Fed chairman Alan Greenspan in the week it issued.

One week later and the market was littered with pulled and restructured deals as interest rate panic once again gripped buyers and intermediaries.

In the week that United News & Media decided to go ahead with its deal even Ford Motor Credit had abandoned its planned $6bn to $10bn offering.

By waiting until the FOMC meeting was out of the way, Ford was able to come to market in early July with its record breaking $8.6bn deal.

Bad timing was also the downfall of Australian telecom company C&W Optus. The Cable & Wireless subsidiary came to market just days before the FOMC meeting with a $350m 10 year deal priced at 220bp - a huge premium over C&W's own 10 year paper which was trading at levels of 160bp, even though it is rated only a notch lower than the parent.

Optus had decided to go ahead with the deal, led by Merrill, because it was convinced that the market was not necessarily going to improve after the FOMC meeting.

In contrast, Canadian telecom company Teleglobe decided to wait for better markets and delayed a $500m deal scheduled for June. It finally came to market in mid-July with a successful $1bn offering, also led by Merrill Lynch.

The outlook is for continued volatility until the end of the year, with concern also focusing on the huge calendar of US bond supply from issuers trying to squeeze into the market before the fourth quarter.

"Investors are likely to start winding down as early as September or October this year because people are too jittery about Y2K," says Leung.

"Also if they have had a good year then they won't want to take on any additional risks. Remember that, for the last two years, October has been a very traumatic month for them."

Further out there is also the threat of regulatory changes.

The US accounting body, FASB, is due to table a controversial swaps rule in the new year which would require all issuers that comply with GAAP accounting rules to mark their swaps to market.

That could well deter a sizeable number of would-be Yankee bond issuers who planned to swap their dollars into another currency.

On the plus side, the high level of cross border merger and acquisition activity will continue to help drive Yankee issuance, with non-US corporates looking to match their US assets with liabilities.

A case can also be made in favour of the Yankee market for diversification purposes. BAT still wants to issue a Yankee bond, simply because it makes sense to keep up a US investor following.

"Any major company has to look at all of the funding sources available," says Richard Desmond, group treasurer at BAT. "We will keep an eye on the Yankee market because we have to."

30 Jun 1999