ECP maturing, but hurdles remain

  • 07 Jun 2001
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Although overshadowed by its US counterpart, the Euro commercial paper market is offering corporates an increasingly deep and flexible pool of liquidity. Problems with settlement procedures, regional variations and regulatory hurdles have yet to be overcome, but bankers are optimistic that as investors grow in sophistication, the European market - including a healthy asset backed sector - can reach maturity. Philip Moore reports.

First, the good news. The euro commercial paper (ECP) market is booming. Issuance levels are at all-time highs and most bankers predict more growth around the corner. According to an update published in January by JP Morgan, ECP outstandings at the end of last year were $226bn, up 29% on 1999's total, and a rise of 77% since the launch of the euro at the beginning of 1999.

The ECP market is also gaining in terms of liquidity and critical mass. The number of issuers with outstandings between $2bn and $3bn more than doubled last year, according to the JP Morgan report. The report also found that "the outstandings of the top 100 ECP issuers make up about 8% of the market, with the top 10 and 40 representing about 25% and 50%, respectively".

"The growth we are seeing in the ECP market is good by any stretch of the imagination," says John Ford, who doubles as ECP product manager at Deutsche Bank in London and chairman of the ECP Association. "The biggest influence on the growth in the market was probably the launch of the euro, which led to a lot more centralisation of cash management in Europe and meant that the new European whole was larger than the sum of its parts. But there has also been an increase on the demand side, with a number of new money market funds being established in Europe, mainly in the form of US based funds setting up new operations focusing on the ECP market."

Others are also encouraged by the growth of the ECP market. "The excitement at the moment is that we are seeing so many new names coming to the market, and there are plenty more in the pipeline," says Sally Vernon-Evans, director of ECP sales at Barclays Capital in London.

Now, for the less good news. Relative to the US CP market, the ECP sector is positively immature. At the end of last year, outstandings in the US market amounted to about $1.6tr, and bankers say that this figure has now topped the $2tr mark, driven by powerful inflows into money market funds. In terms of trading volumes, meanwhile, John Delaney, executive director at Goldman Sachs in London, says that in the US about $120bn is traded on a daily basis.

Size apart, there are other key differences between the US CP and ECP markets, one of which is competition among dealers and the distortions that sometimes result from this. One banker says that he was depressed to have been told by an issuer at a recent conference that his preference is to go to the US rather than the ECP market because of the superior price discipline in the US. "This particular issuer pointed out to me that in the US there are six serious dealers operating in a market worth $1.6tr, whereas in Europe there are at least 10 of us killing each other over a $240bn market," he says. "The problem here is that struggling dealers will be tempted to forgo their commissions altogether. I am not sure how much the banks worry about that because the CP market is such an important door opener, and provides essential contacts with corporates that can lead to all sorts of other business."

The relative failure of the ECP market to grow to a more meaningful size - compared with the benchmark of the US market - is frustrating, say bankers, because of its phenomenal value as a financing tool supporting, for example, acquisitions. The idea that CP is there simply as a tweak on traditional bank overdrafts, they say, could hardly be further from the truth.

As perhaps the best example of the role that CP can play as a critical source of acquisition funding, and one that opens up access to the very different source of liquidity than is provided in the term market, several bankers point to the example of Unilever and its use of the market in part funding its jumbo acquisition last year of Bestfoods. "Unilever used a combination of CP and very big 13 month floaters," explains Delaney at Goldman Sachs. The offering consisted of a $6bn tranche documented under a new short term notes programme and a Eu1.5bn tranche issued under Unilever's EMTN programme. "That gives an indication of the buying power that is on offer in the US market," says Delaney. "But the interesting point is not that Unilever was able to raise $6bn in a couple of days, but that the transaction attracted total orders of $15bn."

Unilever's financing is by no means an isolated example of what can be achieved in the CP market by borrowers in search of acquisition funding at a much cheaper level than they could hope to find in the bank market. Delaney says that there have been many instances that could be used as case studies, with one very striking example being the way in which the Royal Bank of Scotland Group (RBS) used the shorter dated market as a funding vehicle to support its acquisition of National Westminster in the UK.

"RBS was an especially interesting example because it was a case of a new borrower coming to the market," says Delaney. "In the past, its use of the capital markets had primarily been to raise bank capital funding in the US, and to a lesser extent in Europe, through preference shares."

The extra twist with the NatWest acquisition, says Delaney, was that part of the consideration was due in the form of cash to shareholders, although at the time the acquisition financing was being raised there was no way of knowing the precise size of this portion of the financing. "So RBS needed to have a flexible funding facility that it could draw down on in order to pay the NatWest shareholders," says Delaney. "There was no point in issuing a bond because it might have issued too much, and as it only needed the funding for a relatively short time, as the adviser to RBS we suggested that it set up a global CP programme."

An important strategic element to this option was that RBS was naturally reluctant to cannibalise its existing base of investors in its sterling certificates of deposit (CDs). Hence the ultimate decision to raise some $3.5bn in global CP, of which about 70% was accounted for by the US market in dollars and the balance denominated in a combination of euros and dollars in the ECP market.

Two factors about the execution of the RBS global CP programme stood out: its flexibility and user-friendliness on the one hand, and the size of funding it was able to raise on the other. Delaney says that the timing was critical, given that RBS needed to have the funds in its bank account by a specific date, and that the entire CP funding exercise met the objective of delivering the funds in a speedy and efficient manner, with the process completed within four days. "We started issuing for RBS on the Monday and we had to be finished, and to have swapped the proceeds back into sterling, by the Thursday," says Delaney.

With respect to its size or the demand it elicited, the RBS programme was not, perhaps, as spectacular as the Unilever blitz on the short dated market. Nevertheless, Delaney says that Goldman Sachs attracted very substantial orders for the programme.

To Delaney, the use by both Unilever and RBS of the shorter dated market bears witness to the successful globalisation of CP and to its value as a means of allowing the corporate sector to access capital in the broadest possible way. "As with the term market, if you are an issuer in CP you want to establish visibility among the broadest number of investors," he says. "That means finding the investor who is prepared to pay the most for your notes, whether he lives in Milan, Milwaukee or Manila."

On balance, that message is probably best understood by companies in the US, where the likes of Kellogg's and Abbott Laboratories have also made shrewd use of the CP market to raise large amounts of acquisition finance. But the message is also filtering through to treasurers outside the US.

At the beginning of May, Peter Eisenhardt, vice president at JP Morgan in London, addressed an audience of UK corporate treasurers at a conference in Birmingham, and impressed upon them the other attractions and uses of the CP market. "It is a highly flexible market," he explained. "You can choose the size you want to issue, the exact maturities you are interested in, and the currencies you want. And if the market is unable to give you exactly what you want on a day-to-day basis, it is still very easy to fall back on your existing financing arrangements."

Eisenhardt also offered examples of how the ECP market could even have advantages over its US counterpart for European issuers. Name recognition is obviously stronger for European borrowers in the ECP market, while the benefits of trading and settlement within the same time zone should not be underestimated, he said. The multi-currency element of the ECP market is also attractive, relative to the US market, which is entirely dollar denominated.

He added that the ECP market was now becoming much more diverse in terms of the credits it accommodated, with corporate issuance growing rapidly, as well as being more friendly to smaller issuers than the US market. "The huge money market funds in the US very often do not show any interest in issuers that do not have at least $1bn or even $2bn outstanding on a regular basis," he explained. "In the ECP market it is much easier for an issuer to raise as little as $100m or $200m."

Eisenhardt also highlighted several more general points in favour of the CP market. Documentation, he said, is fairly standard and programmes can be launched in between six and eight weeks. As for the bank intermediaries involved, his advice was that "you need enough dealers so they will give you broad distribution, but at the same time not so many that they won't be sufficiently focused on working hard to sell your name". Inevitably, there are costs involved in setting up a programme, but Eisenhardt reassured his audience by telling them "you're a bunch of people with very sharp pencils and I'm sure you will be pleasantly surprised in terms of the basis points you save in very short order".

Clearly, all these plus points are important. But bankers say that relative to the US market, there are probably three factors that, for the time being, are holding back the European shorter dated market, and preventing it from realising its full potential. These are settlement, regional variations in regulation, and demand.

The main difference between the US and the European market, in terms of settlement, is that Europe still has no mechanism for same day clearing and settlement. That means that the ECP market still has very obvious shortcomings in terms of the flexibility with which it can be used as a substitute for a bank overdraft. At Deutsche, Ford points out that as a result, the average maturity of facilities in the US is about 20 days, compared with somewhere between 60 and 75 days in Europe, although he believes that a range of initiatives afoot in the ECP market will narrow this gap.

At Barclays Capital in London, Vernon-Evans says the opportunity costs to treasurers arising from the deficiencies of the European settlement infrastructure are considerable. "If you are a large company with a lot of cash earmarked for an acquisition that you have to pay for in a few days, you have almost no option in the euro market other than to place the funds on deposit or buy European treasury bills," she says. "In effect, that means you have to go to the US market, because the European market is much less liquid and if you are talking about billions then it might be difficult to find the liquidity outside the US market. If ECP could be bought overnight, you would see a lot of corporates that are placing money on deposit going for the higher yield in the CP market."

Deutsche's Ford agrees that the opportunity costs for borrowers associated resulting from the absence of same day settlement are also high. The alternative, he says, is to borrow funds from banks, probably at anything from Libor to Libor plus 25, compared with a CP market that will usually offer sub-Libor funding. Granted, the cost differential is minimised because maturities are so short. Nevertheless, for large companies with very sizeable treasury operations, the associated costs will mount up and theoretically place companies reliant on the ECP market at a disadvantage relative to their competitors in the US CP market.

The move towards same day clearing and settlement in the ECP market passed an important milestone in December when Euroclear, Clearstream and the Depository Trust Company (DTC) announced a co-operative effort to improve ECP settlement. According to a JP Morgan update on this initiative, "the Euro Pre-Issuance Messaging System (EPIM) will be created as a single standardised messaging vehicle for allocating codes. Based on the DTC's PIM system, proven in the high volume US market, EPIM will aim to be secure and fast settlement while standardising information requirements and eliminating the need for phone communication." This is a development that delights bankers involved in the ECP market. As Vernon-Evans at Barclays Capital points out, under the present system, the issuance procedure typically involves making around eight phone calls, which she describes as ridiculous.

When, eventually, same day settlement becomes a reality in the ECP market, its impact on the size of the sector could be dramatic. Goldman Sachs' Delaney points out that if the market evolved in the same way as its counterpart in the US, its size could more or less triple. "In the US, about 65% of outstandings is for maturities of up to a week, whereas in ECP 100% of it is for two weeks or more," he says. "If you use that simple multiplier and say that two-thirds of the market could potentially be in the sub-one week maturity, the ECP market should be worth about $750bn."

A second way in which the development of the ECP market is being constrained is in the variety of regulatory frameworks across Europe that, for the time being at least, will keep the market highly fragmented. Although Spain and Italy are quirky in their CP regulation, France is usually cited as the chief European villain. This is mainly because of the awesome size of the French CP market, which, say bankers, is probably worth about half the size of the entire ECP market.

The problem with the French market is that the local regulators do not recognise ECP as a regulated investment, which in turn means that French institutions are not allowed to put more than 10% of their assets into the market. "So what do they buy instead?" asked Eisenhardt at the May conference. "They focus on domestic French CP, which can be seen as a protectionist gesture. This impedes the growth of an efficient pan-European market." True enough, although it is also a very handy status quo for the French banks.

There are clearly influences at work elsewhere within the French market that have a vested interest in maintaining this status quo. "The fact of the matter," says one banker, "is that if we had a genuine pan-European market, a lot of the French companies that are now very dependent on the domestic market would have a really tough time accessing investors in the ECP market."

Eisenhardt at JP Morgan and Ford at Deutsche Bank both say that via the ECP Association, numerous representations have been made to the French authorities aimed at speeding up change in the system. In this lobbying, says Einsenhardt, the association has been supported by fund managers in France who have a clear incentive to push for change, given the inevitably lower yields on French CP relative to other markets in Europe. Nevertheless, Ford says that he is not hopeful of a resolution to the French problem for at least two years. "New guidelines are now starting to limp through," he says, "but we have been told that it will probably take two years to implement any new laws, so we are probably looking at towards the tail end of 2003 before there are any changes."

A third critical requirement that will be needed if the ECP market is to catch up with its dollar-based counterpart, is increased impetus from investors. "If you look at the history of CP in the US, it was very much an investor driven market," says Deutsche's Ford. "We have never really had an investor-led market in Europe, but one that has been borrower driven. That can take the market so far, but not nearly as far as the US has gone."

Bankers say that the investor base in the US CP market is a broad one, but that it has been driven chiefly by the sharp growth over the last five years in the market for prime money funds. According to figures published by Moody's, as of March 2001 these funds were worth almost $1.4tr, and they are as firmly entrenched in US culture as apple pie and baseball. As one US banker says, having a money market account in the US is popularly viewed as a key component of growing up. "When you leave university in the US, you want to get hold of two things as quickly as you can," he says. "A car and a money market account."

Although some of the US money market funds are now starting to target Europe, and promoting the view that cash can be a valuable, profitable and above all secure asset class, bankers say that, to date, Europe has barely scratched the surface in terms of the potential for money market funds.

Another way in which the US and ECP markets differ markedly is in the role played on either side of the Atlantic by the asset backed CP market (ABCP). In Europe, ABCP is estimated to account for no more than about 10% or 11% of total outstandings, which would equate to a little over $20bn. In the US, by contrast, according to the report published in April by Moody's, the ABCP market is now worth just over $650bn, or some 42% of the total CP market. It is also a sector, says Moody's, that has been growing by an average annual rate of 44% over the last five years. That is well ahead of the average 9% expansion rate of the unsecured CP market over the same period, and comfortably ahead of the 25% growth in the prime money funds that have been such an important impetus for the growth of the broader CP market in the US.

"ABCP's comparative yields, short term structures, and abundant supply make these products very attractive to money market funds in today's market," notes the Moody's analysis of developments in the US. "An estimated 22% of US money market fund assets are now invested in ABCP conduits, most of which are rated P-1. Credit losses among these P-1 rated programs have been non-existent, making them particularly appealing during this period of corporate credit decline."

The expansion of the ABCP market in Europe would be especially welcome for lesser rated credits, for whom securing access to the CP market is generally much tougher than it is in the term sector, which is a far broader church, accommodating borrowers from across the entire credit spectrum.

"Conduits are a very useful way of accessing the capital markets for companies falling into two categories," explains Perry Inglis, director of structured finance ratings at Standard & Poor's in London. "The first of these are unrated companies that would alternatively only be able to access the market via high yielding private placements. The second are companies that have portfolios of assets that are too small to merit a standalone issue. Receivables pools of $100m, for example, can very effectively be included in conduits.

Inglis also highlights the cost effectiveness of ABCP. "For smaller companies, the headline numbers in the ABCP market look very attractive," he says. "CP is usually traded at sub-Libor or Libor flat levels, and when you add in all the other costs of running a conduit, ABCP funding probably works out at about Libor plus 30bp or so. That is still very attractive for a smaller unrated company for which a corporate bond would cost much more. More and more corporate treasurers are becoming aware of the ABCP market as a funding mechanism, and I doubt that there are many companies in Europe that have not been pitched to by their bankers in this market."

The downside in the European ABCP market at the moment, says Inglis, is the lack of critical mass and therefore liquidity. "Over 80% of ABCP issuance is into the US market," he says, "leaving the European market at only around $20bn. Of that total, around $8bn is in structured investment vehicles, so the conduit business amounts to around $12bn, which is not a liquid market. If you talk to dealers, they will tell you that there are some days on which you can't even get a bid. And the market can also be a little more expensive than the US market, even when you take into account the cost of swapping back from dollars. So while everybody has an interest in the European ABCP market developing, there is still some way to go."

That much was evident when JP Morgan made its presentation to UK treasurers in May. At the end of this, one borrower raised his hand and complained that it was all very well saying that the CP market was deep and liquid, but as a triple-B rated issuer his company had been unable to access the shorter dated market. This does not surprise bankers, who say an obvious solution would be to cast an eye over opportunities in the ABCP market.

Bankers explain that ratings are probably more important in the CP market than in the longer dated sector for a number of reasons. Above all, in an investor driven market, the so-called 2A7 funds in the US remain regulated by the Investment Companies Act of 1940, which stipulates that all money market funds need to have at least 95% of their assets invested in tier one securities - which means CP that has an A1 or equivalent rating from at least two of the ratings agencies.

This explains why, for the higher rated credits in the US market, maintaining the A1/P1 rating in the CP market is often absolutely essential. If the capital market were a game of Monopoly, losing the optimum rating in the CP market would be the equivalent of being sent to jail without passing Go and collecting £200.

It also explains why A1/P1 borrowers exposing investors to event risk through an acquisitive strategy, for example, will generally have to pay something of a premium to protect investors from the potential impact of a downgrade. "If as an issuer you are prepared to price in the potential for some movement in your rating, you can still raise a very considerable amount in the CP market," says Deutsche's Ford. "But if you are an A1/P1 borrower and on credit watch you are not going to find much liquidity in the market if you go for the very tightest pricing. The whole issue with mergers is that investors want to have a clear view on what the downside is likely to be if your debt rises and your capital structure changes, so if companies are transparent about this there is no need for the CP market to be closed to them."

None of this is to suggest that a A2/P2 rating is necessarily a death sentence as far as a company's aspirations in the CP market are concerned. As an example, Ford says that there has been some demand for Tier II CP this year from Asia. "We have seen a bit of resistance to some of the lesser rated credits this year," he says, "largely because of what has happened in the US economy and the impact that has had on credit quality. The general view is that there is probably more resistance to weaker credits in the CP market than in the bond market, and that might be because of liquidity constraints. Demand for CP is shaped like an inverse pyramid. The higher your rating, the greater the liquidity, and the further you go from being a strong A1+/P1 issuer, the more difficult things become in terms of liquidity."

Be that as it may, other bankers say that they have seen evidence recently to suggest that a new investor base seems to be emerging for impaired credit in the CP market. One points to the example of the Californian utility, PG&E, which has filed for bankruptcy proceedings under the burden of its $9bn of debt. He says that as its CP was traded, many of the short term notes were being bought from mainstream CP investors and were soon being sold on to non-standard money market funds. "As one door closes for an issuer, you are often finding that another opens elsewhere," he says.

Therein, believe some market participants, might lie a very important lesson for the broader capital markets. This is that the investor base is now so broad and diverse that - at a price - it can accommodate nearly any credit somehow or another. At corporate advisory firm Stern Stewart in New York, Dennis Soter has plenty of empirical evidence supporting this notion. "Companies need to recognise that cutting off one part of the universe of potential investors does not mean they are going to be unable to sell their securities at a market price," he insists. "I find it absolutely absurd that companies go to such great lengths to try to identify what the needs of their investors - be they bondholders or shareholders - are. From my experience, one group of investors is just as good as another." *

  • 07 Jun 2001

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