Credit risk: the migration to Europe

  • 01 Jul 2000
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If asset classes were a compendium of games, the credit market would be its Snakes and Ladders. The opportunities it offers to investors in the form of enhanced yields are self-evident enough; but so too are the pitfalls which are lined along the way for investors in the credit market in the form of event risk.

Europe is only now beginning to fathom event risk implications, more than 10 years after it first appeared and was accepted in the US.

Event risk was succinctly defined in a recent Chase Manhattan report as: "The risk that an unpredictable or unanticipated event could radically and rapidly alter credit quality."

Fixed income investors in the US credit market have accepted event risk as an occupational hazard for several decades, and one whose impact was dramatically felt in the mid-1980s. "In the US market, the clearest lesson we learnt in terms of the impact investment grade credit risk can have on performance was in the LBO excitement of the 1980s," says Bart McDade, managing director and co-head of global fixed income at Lehman Brothers in New York. "The most obvious example was with the RJ Reynolds buy-out, when a double-A rated company all of a sudden became a double-B rated issuer and investors literally lost something like 1,000bp overnight."

Buy-out risk has never entirely disappeared from the US market and there are isolated instances of the peril in the European credit sector. It was among the many risks to have bedevilled one of the market's worst recent performers in terms of its spread - a Eu400m five year bond launched in November 1999 for the diversified UK transport company, Stagecoach.

When the bond was launched by Dresdner Kleinwort Benson and JP Morgan at 153bp over the BTAN or 120bp over Euribor, one of its leads was quoted as saying that it had caused a "frenzy" among investors. Six months later, the bond had indeed caused a frenzy, but not quite for the reasons the borrower or its leads had hoped. By April 2000 the spread had widened by up to 400bp, following the company's announcement of its intention to dispose of Porterbrook, its rolling stock lease company, which has contributed significantly to group profits.

But as Chase Manhattan explained in an update published at the end of April: "The ratings downgrade that followed this announcement accounted for only a fraction of the subsequent spread widening. Far more important were the markets' concerns that the management was preparing to take the company private. Stagecoach has suffered a decline in its share price of about 75% since June last year and is considered by the market to be an LBO candidate."

While other companies with consistently poorly performing share prices will inevitably emerge as candidates for LBOs - with one analyst picking out Marks & Spencer as a prime candidate - bankers seem to agree that a repeat of the buy-out mania of the 1980s is unlikely on either side of the Atlantic.

Speaking at Chase Manhattan's 2000 State of the Markets Symposium, Chase Securities' director of corporate bond strategy, Bill Cunningham, pointed out that the level of activity in LBOs over the next few years will "not come close to the frenzied pace of the late 1980s and early 1990s".

His view was that with valuations less depressed than 10 or 15 years ago, with corporate cost structures less bloated than in the late 1980s and with the "executive greed" factor less pervasive, LBOs have become less alluring. "The failures of the LBO craze a decade ago have left an indelible impression on management and investors that has resulted in an increased valuing of financial flexibility by management and the market overall," he said.

Nevertheless, event risk is likely to remain the principal challenge for investors in the credit market - especially in Europe, where the pursuit of shareholder value (often at the expense of bondholders) is becoming a boardroom obsession.

"Shareholders have enjoyed two to three years of good returns based largely on the pick up in European growth," says Andrew Crawford, co-head of credit research at Chase Manhattan in London. "But we are unlikely to see strong growth in the underlying economies in the years ahead, and at the same time much of the cost cutting that companies aimed to achieve has already been implemented. So the question that arises is: where does management look in order to keep this gravy train rolling for its shareholders? One obvious answer for them is to use more leverage in the corporate restructuring process."

Mark Howard, managing director of fixed income research at Lehman Brothers in New York, agrees with this appraisal, saying that in some respects corporate behaviour in Europe is now starting to resemble US trends 15 years ago. "In the late 1980s in the US market we had a shift away from a management focus on the long term and towards generating short term shareholder returns," he says.

"That happened very quickly and at the expense of bondholder value, and I would argue that the same process is now unfolding in Europe, with the focus on short term returns coming through increased leverage, increased financial engineering and reduced credit quality. It means that Europe is in a transitional period that can be especially painful for bondholders without experience of how to deal with event risk."

That reduction in credit quality has already been reflected in the evolution of credit ratings in recent years, even though superficially credit quality among rated issuers outside the US appears to be improving. In its analysis of first quarter activity in 2000, Moody's Investor Services reported that global credit quality appeared to be on the mend, with 112 upgrades outside the US market compared with 38 downgrades. This, noted the agency, was the "widest margin since the start of the Asian crisis" and compared with an average of 107 downgrades per quarter between 1997 and 1999.

Much of this improvement in credit quality, however, was accounted for either by companies in Asia or by issuers in the financial services sector, with European industrials faring much less well. Of Moody's 54 western European upgrades in the first quarter of 2000, 46 were for banks, and 24 of these were upgrades of junior subordinated debt to one notch below the senior ranking. In the non-financial sector in western Europe, by contrast, Moody's assigned nine downgrades and eight upgrades.

In the European market today, the headline-grabbing downgrades have tended to be of acquisitive telecoms operators in the single to double-A bracket. But acquisition risk is also affecting the very highest-rated corporate borrowers. When AAA rated Unilever, for instance, announced its planned acquisition of Bestfoods in June 2000, Standard & Poor's (S&P) was quick to put Unilever on CreditWatch with a negative outlook. "Although the proposed transaction would add a portfolio of strong brands to Unilever's already superior business positions," S&P noted, "this is unlikely to compensate for the expected decline in the group's financial profile and, therefore, the ratings may be lowered."

Bond investors appeared to agree with this gloomy prognosis. In a single day - June 6 - the spread on one of Unilever's more liquid outstanding bonds, a 6.5% 2004 Dutch guilder issue, widened by more than 20bp, from around 20bp over the benchmark German government bond to a 42bp spread.

While analysts appeared to agree that the Unilever acquisition of Bestfoods represented a negative credit risk for the Anglo-Dutch food giant, opinions have diverged on other recent deals. A good example of this came in June 2000 when Invensys, the product of the merger in February 1999 of BTR and Siebe in the UK, announced the proposed acquisition of the troubled Dutch software company, Baan. Moody's immediately put its A2/P-1 rating of Invensys under review for a possible downgrade, noting that "the review will concentrate on the planned integration and restructuring of the acquired company. It will also analyse the company's acquisition strategy and financing policy going forward as well as the management's balance between creating shareholder value and focus on debtholder protection."

S&P, by contrast, was far more relaxed about the acquisition of Baan and its potential impact on the financial strength of Invensys. Reaffirming its A+ rating with a stable outlook, S&P advised shortly after the acquisition that "the Invensys group's EBIT net interest coverage is expected to decline temporarily to less than management's comfort threshold of six times. Other credit measures, however, are expected to remain in line with the rating category, thanks to solid market positions and a focused business strategy."

But the Baan acquisition came at a sensitive time for investors in the primary credit market, given that only weeks before the announcement, in the middle of March, Invensys had launched a debut euro denominated transaction via Deutsche Bank and Warburg Dillon Read. This Eu500m A2/A+ five year offering was priced at a re-offer level of 35bp over Euribor, and its spread widened sharply immediately after the announcement of its plans for Baan.

Salomon Smith Barney advised its clients that the knee-jerk spread widening that followed the Invensys announcement represented a good buying opportunity. "Investors are very nervous about acquisition risk, and I think rightly so," says Bob Buhr, industrials analyst at Salomon Smith Barney in London. "We have seen spreads blowing out in some instances even on the rumour of an acquisition, although in the particular case of Invensys I think the bonds probably widened out unjustifiably far.

"Our house view is that strategically it was a sensible acquisition for Invensys to make. It clearly moves them higher up the technology chain, which is the way in which the industry is evolving. Although one has to throw in the caveat that Baan is in a mess, I have been following the management of Invensys since before the Siebe/BTR merger and I have been impressed with the way in which they have managed their mergers and acquisitions."

Although generalisations are hazardous, it would seem that over the last year or so acquisition risk has become much more of a negative influence among European issuers than among those in the US. To investors in the Eurocredit market, acquisition has become something of a dirty word over the last 12 months, chiefly because M&A activity has been dominated by debt financed transactions in the telecoms sector that have mostly been credit negative for aggressors.

But even in the telecoms sector, investors have not viewed all acquisitions with suspicion. Unusually, both debt and equity investors welcomed Telefónica's purchase earlier this year of the minority stakes it did not own in Telefónica de Argentina, Telesp and TeleSudeste Celular in Brazil and Telefónica del Peru. "It was one of those very rare events which looked like good news for share and bondholders," says one London based telecoms analyst. "Because the entire deal was equity financed with no new debt involved, it left Telefónica's debt protection ratios more or less the same.

"Clearly on the negative side we will see an increase in Telefónica's cashflows emanating from Latin America, which is seen as a higher risk area than, say, Europe. But I think there is also a perception that because Telefónica now has 100% ownership of so many of its Latin American subsidiaries it will be in a much stronger position to control that cashflow, so on balance it was seen as a positive deal, which will benefit all Telefónica's investors." The ratings agencies agreed, with Moody's, S&P and Fitch IBCA all affirming their ratings on the Spanish company, and Moody's revising its outlook from stable to positive.

Beyond the telecoms sector, bondholders were not dismayed by tobacco giant Philip Morris's $14.9bn purchase of food manufacturer Nabisco, announced in June. Equity investors were rapturous, pushing the Philip Morris share price up by some 15% in the days after the announcement. But bondholders were also pleased, with spreads on Philip Morris's outstanding bonds scarcely responding to the news.

"From an investor's point of view, a lot of bondholders interpreted the deal as showing how confident Philip Morris is of winning forthcoming litigation lawsuits," says Pilar Gomez-Bravo, director of European corporate bond research at Lehman Brothers in London. "They drew comfort from the fact that the company does not see the need to hoard its cash for future lawsuits but is confident that it can weather the storm ahead."

In some sectors, analysts say that acquisitions can even be event positive. In the UK banking sector, Lloyds TSB was upgraded by Moody's to AAA when it acquired Scottish Widows. At Lehman Brothers in New York, Howard points out that merger activity in the oil industry has probably enhanced credit quality by creating a small group of powerhouses such as BP Amoco, Elf Total and Exxon Mobil.

None of this is to say that bondholders in the US credit market are having an easier ride than their counterparts in Europe. Spread widening in the US credit market this year has been brutal, as Rick Rieder, co-head of the global credit business at Lehman Brothers in New York points out. He says US credits have deteriorated in the first half of this year at a pace not seen in the previous five years.

"Thirty of the 54 worst credit deteriorations the US corporate market has seen during the last five years have happened since January 1, 2000," he says, adding that the performance of some credits has been "shocking". "In the first half of this year we have seen credits move down in some cases from par to 50 cents in the dollar, whereas in the past downward moves would have been closer to 25bp or 30bp."

A number of technical factors have driven credit deterioration in the US dollar sector, including the withdrawal from the market of scores of hedge funds and a massive oversupply of new issuance which saw gross supply rise from $80bn in 1994 to $313bn in 1999, and $118.7bn in the first five months of 2000. This has contributed to the average spread on 10 year corporate bonds in the US ballooning from 60bp in 1997 to 107bp in 1999, according to Lehman Brothers.

Rather than being unduly influenced by acquisition risk, credit spreads in the US have been hit hard this year by a combination of operating risk and oversupply, as well as the macroeconomic risk from possible future Federal Reserve tightening.

"In the US when companies announce that they are not going to meet their earnings targets for the quarter, share prices tend to fall very sharply and spreads widen in a much more pronounced way than they do in the European market," says Chris Wait, managing director of the fixed income syndicate at Lehman Brothers in London.

John Raymond, Lehman's London based executive director of credit research, agrees that the relationship between secondary market pricing of equities and bonds is less conspicuous in Europe than in the US. "Event risk is clearly the main driving force for big spread changes in Europe," he says.

"There are very few credits in Europe which will widen or tighten significantly on the basis of everyday operating performance. In the retailing industry, for example, credit investors are not going to worry very much about whether an individual company has a market share of 20% or 21%, as equity investors might. They will be much more watchful, however, of whether or not a retailer plans to make an acquisition in central Europe or Asia."

In addition to acquisition risk, a growing hazard for bondholders is buyback risk. Many European companies are recognising that in the absence of high growth to drive the expansion of profits, or with reduced scope to bolster earnings per share (EPS) levels through aggressive cost cutting, an efficient method of delivering value to shareholders is to reduce the size of its outstanding equity.

US investors are no strangers to buyback risk, which plagued the secondary credit market sporadically during the 1980s. "Equity buybacks diminish corporate debt protection, even more so when they are funded with debt, as opposed to cash," notes a special report published by Moody's in April.

"When the net stock buybacks of non-financial corporates climbed up from 1983's 12.4% of pretax profits (meaning gross equity issuance topped gross equity retirements) to 1986's 57.8%, the average yield spread over Treasuries for long term, investment grade company bonds widened from the 79bp of 1983's final quarter to the 205bp of 1986's final quarter. Because 1986 was the first time investors had to contend with the loss of credit worth to stock buybacks on such a grand scale, the broadening of yield spreads may have been exaggerated."

More recently, in the US market one of the clearest examples of the relationship between share buybacks and credit ratings came when Ford announced its extensive buyback scheme, to which ratings agencies immediately responded with a downgrade.

Although the process has been slower to take hold among European companies, a recent example of the potential impact that share buybacks can have on credit quality arose when the British Airports Authority (BAA) announced plans to buy back part of its stock.

Moody's was unduly concerned with the announcement, maintaining a stable rating on BAA and saying that "while the stock repurchase programme will reduce cash reserves, it does not significantly impact the company's financial position at this time". S&P, however, was less relaxed about the BAA initiative, downgrading its outlook on the company from stable to negative and warning that "further share buybacks would stretch the company's financial flexibility to the limit".

Another element of risk to bondholders in the European credit market, which has scarcely impacted its equivalent in the US, has been privatisation risk, which has already been played out in sectors such as the UK electricity utilities industry. Loss of government ownership and the promotion of competition and deregulation in this sector clearly exposed investors to rising levels of event risk, and analysts warn that investors need to remain vigilant in their assessment of government owned borrowers which, sooner or later, are expected to be privatised. Good examples of this, in Europe, include issuers such as the Aa1/AA rated Deutsche Bahn, which is grooming itself for privatisation in 2004, and the AAA rated Electricité de France (EdF), a prolific issuer in the Euromarket which few analysts believe can remain state-owned indefinitely.

A key issue for borrowers such as these is whether or not existing bond issues will be grandfathered by their present owners. In the case of EdF, this is far from certain. As Merrill Lynch warns in a recent report on the European utilities sector, "existing EdF debt does not contain any grandfathering clauses, offering no protection to bondholders should a change in the legal status occur. Whilst it is possible that the State might choose to grandfather existing debt, bondholders should be aware that this is not guaranteed. Should grandfathering not occur, we would expect significant ratings downgrades to result."

In isolated instances, investors in the euro denominated market have been offered important and innovative safeguards protecting them against privatisation risk well in advance of the event. A good example of this came when the state-owned Public Power Corp of Greece (PPC) launched a Eu500m 10 year deal in February 1999 via Credit Suisse First Boston and Paribas. Pricing for this BBB issue was set at 87bp over Bunds, which represented a pick up over Greece itself of about 30bp. A key feature of this deal was that it becomes puttable if the Greek government reduces its holding below 51% or if PPC loses its monopoly - which means it will remain quasi-government risk.

Management credibility: guilty until proven innocent?

While events such as acquisitions, buybacks and privatisations all represent readily identifiable (although not necessarily quantifiable) hazards for investors in the credit market, in the minefield of corporate bonds there are a number of other risks that are much less straightforward to identify or quantify. One of these can loosely be categorised as the risk which investors are increasingly associating with management credibility, especially in Europe. Bluntly expressed, investors' concern is that recent events suggest it is increasingly perilous to rely on what management tells them during roadshows or other presentations.

There is no issue here of fraud or illegal misrepresentation. But the concern among analysts and investors about management is two-fold. First, there is the suspicion that management will inevitably paint an unrealistically rosy picture on the likely response of the ratings agencies. Second, analysts say that management in Europe simply does not have sufficient experience in terms of establishing a dialogue with bondholders in the way that their counterparts in the US do.

As the clearest example of an incident in which - in the words of one analyst - management credibility was "shot to pieces", most observers point to the developments at Mannesmann in 1999. When the German company was premarketing its groundbreaking Eu3bn issue in May 1999, it aimed to reassure investors on two key fronts. The first of these was that the proceeds generated from the offering were being earmarked for general corporate purposes (rather than for an acquisition). The second was that the company would remain determined to maintain its single-A rating, which to many investors unable to step down into BBB rated credits was an even more important reassurance.

When, some months later, Mannesmann announced its bid for the UK mobile telephone group, Orange, both these pledges were shown to be worthless. Mannesmann's bonds traded out dramatically overnight following the announcement, with inevitable and catastrophic implications for those investors obliged to mark their holdings to market.

Olivetti's recent about turn with respect to its planned merger with Technost provides another notable example of management action leading to a loss of faith among fixed income investors.

Clearly, not all management teams have established for themselves reputations as being poor at communicating their strategy to their fixed income investors. Several applaud Vodafone for having been what one banker describes as "masterful" in developing a frank dialogue with its bond as well as its equity holders. Another points to the UK utility, PowerGen, as an example of a company which in its deal related roadshows in 1999 made no secret of its ambitions of expanding via acquisition in the US.

Also in defence of the broader corporate sector, some observers point out that individuals may not be as culpable as they seem if and when borrowers follow a new issue with a credit sensitive acquisition. "I do have some degree of sympathy for companies because on occasion it may be that the managers organising the finance are not privy to what the chief executive's strategy is," says one credit analyst. "But as a general rule it is true that companies should not be making acquisitions straight after launching a new bond issue. As a bondholder you should feel entitled to at least six months or a year of performance before experiencing an event risk bombshell."

Although some companies such as Vodafone, PowerGen and others seem to score well in terms of keeping their existing and prospective bondholders fully informed about their future strategy - even if this risks inflating their borrowing costs over time - analysts complain that a clear trend in Europe since the Mannesmann episode has been a deterioration in investors' faith in what senior management tells them. "I think that post-Mannesmann a lot of companies are being automatically tarred with the same brush, however unjustifiably," says one analyst. "Increasingly it is a case of borrowers being guilty until proven innocent, rather than the other way around."

Others agree that in a much broader capital market context - spanning the equity as well as the bond market - management credibility has taken a turn for the worse over the last year. "Obviously there is going to be an increasing amount of scepticism among investors when you have highly respected companies such as Procter & Gamble and Marks & Spencer coming out with repeated profit warnings," says one analyst. "These are by no means the only example and the list is getting longer all the time."

The result of this trend, in Europe at least, appears to be that investors are increasingly factoring in worst case scenarios when evaluating bond spreads in the secondary market. As a classic example of an instance in which, today, investors plainly do not believe what management is telling them, many analysts say that they need look no further than Stagecoach, which in recent months has repeatedly promised its bondholders that it will not delist from the London Stock Exchange.

The ballooning spreads on the company's existing euro denominated bond seem to have told a different story. "Clearly investors are factoring in a 100% probability of an LBO at Stagecoach, which I think may well be excessive," says Emmanuel Weyd, head of credit research at JP Morgan.

The extent to which investors can reliably gauge management credibility - and price bonds accordingly - is open to debate. They can look for some help in this respect towards the ratings agencies, which will often endeavour to factor management's experience and trackrecord into their ratings.

Ultimately, however, bankers say that the market will be the arbiter of management credibility, and that if corporates fail to service their bondholders with due care and attention they will end up paying the price in terms of basis points. Increasingly, even in Europe, bankers say that corporates are waking up to this reality.

"It is definitely the case that historically CEOs have underestimated the power and influence of bondholders," says Marco Figus, head of European debt capital markets at Lehman Brothers in London. "But I think they are increasingly coming to terms with the fact that bond markets are just as sophisticated as equity markets, and that bondholders need to be approached with the same roadshows, information and management time that is given to equity investors."

The problem with retail

Another source of risk which analysts say is virtually impossible to quantify arises from the involvement in the fixed income market of retail investors, or of the classical Belgian dentists who were traditionally heavy buyers of government and supranational paper, but who are now stepping with increasing confidence down the credit curve. Of course, high levels of buy-and-hold retail participation are welcomed by issuers, given that they can help to broaden distribution and in many cases materially bring down borrowing costs.

The drawback for institutional investors and for the analysts who cover the market is that unsophisticated retail participation - which is usually based largely on name recognition and maturity, rather than on an analysis of value - can exert a highly unpredictable influence on spreads.

At Deutsche Bank in London, head of credit research Anja King points to the relative performance late in 1999 and in the first few months of 2000 of Mannesmann and Tecnost bonds as an illustration of the process. "The Mannesmann 04s performed very differently to the Tecnost 04s because there was an amazingly strong retail bid for Mannesmann, which is a household name among European retail investors," she says.

The situation was exacerbated, King adds, when Mannesmann was downgraded from single-A to triple-B, which led to many institutions being forced sellers. "One of the reasons there was so much institutional selling of Mannesmann was its downgrade, but the other side of the equation is that there is absolutely no correlation between ratings and the retail bid," she says. "As a result, when institutions were selling the 04s and the 09s, retail investors were coming in with orders for 1m or 2m of the five year bonds every day because they were attracted by the opportunity of buying cheap Mannesmann paper. It provided a perfect balance and the result was that we even saw the Mannesmann 04 trading through its new issue level."

There was no such luck in the case of the Mannesmann 09 deal - with a 10 year maturity unpopular among retail investors - or with the Tecnost paper, which has very limited name recognition.

The extent to which institutional investors can construct strategies which allow for the strength of the retail bid is limited. "If you wanted to express the influence of the retail bid in a formula," says King, "then in an ideal world you might be able to say that this would be worth, say, a random number of 20bp. In other words if the fundamentals say that a bond is worth 90bp over a given benchmark, then retail bid might bring it in to 70bp."

But King warns that an approach such as this would be very unscientific and fraught with dangers for any institutional fund manager. "It would not be easy to justify buying paper on the basis that you think a strong retail bid is going to pull the price in, for two reasons," she says. "First because you can never be certain that the retail bid is going to materialise. And second, because if spreads then blow out it is going to be very difficult for a fund manager to turn to his trustees and say that he bought the paper because he was expecting a strong retail bid."

Another potential pitfall attempting to factor in the extent to which the strength of the retail bid will move spreads in the future is that bankers expect the influence of retail investors to be increasingly diluted as the European credit market gathers critical mass. "Going forward, increased supply in the corporate bond market ought to make it more efficient," says King at Deutsche Bank. "Although the retail component will not disappear altogether, as a percentage of the total market the influence of the retail bid will be diminished, which means we will be able to price issues much more efficiently and come up with better relative value analysis."

Unrated transactions

Irrespective of the future influence of retail investors in pricing levels in the primary and secondary market for credit, historical retail support for well known names has meant that a number of borrowers in the market have not felt under any pressure to secure credit ratings. As a result, although the unmistakable trend among issuers in the corporate credit market has been to apply for credit ratings, unrated issuance still accounted for about 14% of total primary activity among corporate borrowers in the euro denominated market in 1999.

Analysts hope and expect that this proportion will continue to decline over the coming years, with more and more issuers recognising that by refusing to secure a rating they are effectively shutting out a wide cross-section of investors unwilling and sometimes unable to buy unrated paper, irrespective of their views on the credit. "I would say that those companies that can come to the market without a rating are a dying category," says Weyd at JP Morgan in London. "We will inevitably still see some unrated transactions for companies with very strong name recognition, but fewer and fewer large scale deals will be unrated."

Although conventional wisdom now has it that ratings are a prerequisite for any issuer serious about tapping the capital markets, bankers point out that in some instances unrated transactions can be highly attractive for issuers and investors alike. Car maker Porsche has long stood out as an obvious example of a company that is so well respected by continental European retail investors that a rating would probably be counterproductive, as it would alert investors to the fact that the credit is considerably weaker than has traditionally been assumed.

But Porsche is by no means an isolated example. Over the last year or so household names such as France's LVMH (with a Eu500m seven year deal marketed by ABN Amro, Crédit Lyonnais and Credit Suisse First Boston as a single-A credit), and Italy's high quality paper manufacturer, Cartiere Burgo (with a Eu200m five year offering via Mediobanca) have been examples of unrated companies raising competitive funding through the bond market.

Among other issuers, Deutsche Bank's King picks out a borrower such as Pirelli as a good example of a company that has historically been able to rely on its name recognition among retail investors to compensate for the fact that it has no credit rating. She points out that when the Italian tyre company became one of the first corporates to tap the euro denominated market as early as October 1998, with an unrated Eu500m deal via JP Morgan, Mediobanca and Paribas, it was able to raise funding at levels comparable with better credits driven by the same sectoral fundamentals, such as GMAC and Ford. The Pirelli transaction was placed predominantly among local investors at 85bp over the French government curve, but later in the year had tightened in to a spread of below 60bp.

At Lehman Brothers in London, executive director of fixed income syndicate Lorenzo Frontini suggests that secondary market performance of this kind has not been lost on institutional investors, which are not nearly as reluctant to buy unrated bonds as the ratings agencies may have people believe. "The southern European market has been very important in helping to develop a sector in Europe for lower rated and unrated companies but which nevertheless have very strong credit fundamentals," he insists. "The best example of this was the five year deal we led for Olivetti back in 1998, which opened up the market for a series of other unrated Italian issuers."

Although Frontini accepts that deals such as the Olivetti 03 owed much of their success to the strength of the retail bid, he dismissed the notion that institutional investors will shun unrated deals of this kind. "Unrated issues can be placed very successfully with institutional investors for two specific reasons," he argues.

"First, because institutions are capable of recognising very strong credit stories even if they are not rated. And second, because institutions know that deals of this kind are going to enjoy massive sponsorship from retail investors. As a result, they know that there will be an aggressive bid for the issue in the secondary market combined with good liquidity, which can have a very positive impact on spread performance."

Fair enough. But there have also been instances in the European credit market over the last year or so in which issuers have come to regret their reluctance to solicit credit ratings - especially when they have hoped to stoke up international interest in their issues.

In the German market in particular, one or two borrowers have set themselves unrealistic targets of avoiding the scrutiny of ratings agencies in the often misguided belief that an unofficial rating from their lead bank would be unquestioningly accepted by institutional investors. One of the most celebrated examples of this was FAG Kugelfischer, which launched an Eu150m five year deal via Dresdner Kleinwort Benson in October 1999. Although this was marketed as being the equivalent of a BBB- issue, investors saw the company as being closer to BB+ in terms of quality.

Also in the German market, bankers say that a good example of the power of ratings to help promote international institutional support for new issues has been provided in the last year by a borrower such as Heidelberger Zement, which has visited the euro denominated market twice - the first time as an unrated borrower, and on the second occasion as a Baa/BBB+ issuer. Close to 90% of the first deal was placed in Germany, while more than 60% of the second - which was the first occasion on which a German BBB+ borrower had raised Eu1bn in the market - was distributed internationally.

The growing importance of credit ratings in recent years has meant that for investment banks in the market an increasingly essential component of arranging transactions for borrowers has been to provide a ratings advisory service.

"Whenever our debt capital markets team approaches an unrated issuer we will offer to give the company a preratings analysis," says Edward Bace, senior vice president at Lehman Brothers' credit ratings advisory team in London.

"And because the members of this team worked previously in ratings agencies, we know the methodology and the personnel involved, which can be a very useful service for issuers."

Bace also points out that the ratings advisory service is every bit as important for issuers that are already rated, but which are perhaps contemplating an acquisition which would jeopardise its existing rating.

  • 01 Jul 2000

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