Low rates to end, but fresh challenges await MTNs
The market for corporate MTNs has come under pressure from monetary policy, regulation and a proliferation of alternative products. Dealers have been forced to adapt to new conditions to find ways to demonstrate value, but fresh challenges are approaching. Lewis McLellan reports.
In the corporate world, a slew of new private debt options has drawn issuers and investors’ focus away from MTNs. With private debt, and the Schuldschein in particular, in the ascendancy, the corporate MTN world is increasingly the preserve of blue chip frequent issuers — such as utilities and car companies.
The costs of establishing a programme are high (though issuing from it thereafter is cheap), so the format makes sense only for issuers with large enough needs to issue on a regular basis.
“Bespoke private placements, not from MTN programmes, have really drawn the bulk of the attention at the lower end of the credit spectrum,” says the head of MTNs at a bank in London.
But even for borrowers for whom the MTN programme remains a staple of their private debt issuance, competition with public markets has made the market challenging.
The European Central Bank’s asset purchase programme has pushed down yields across asset classes and throughout the curve. As a result of the ECB’s presence, corporate issuers have had superb access to the public bond market, enjoying smooth executions during which they have been able to capture low coupons.
“Historically, if you’re getting cheap funding, you have no need for MTNs,” says Richard Proudlove, head of MTNs at ING in London. “With spreads so tight and rates so low, the appetite for illiquid privately placed products has dried up.”
The rationale for an investor is simple. If it is forced to put money into a 10 year asset yielding 1%, then putting it in a public benchmark with some liquidity and the possibility of switching out into a higher yielding asset is a more attractive option than an illiquid MTN.
However, even if private placement demand surges as public markets become less accommodative when the ECB eventually retires its quantitative easing programme, corporate MTNs may not be the sole beneficiary. The suite of private placement options for corporate issuers has become increasingly crowded.
“There’s been a lot of attention on bespoke private placements and EU private placements for lower grade credits,” says Proudlove. “Schuldschein is also expanding its remit and taking some business at the upper end of the credit spectrum.”
However, in spite of the excellent prevailing conditions in primary public markets, MTN volumes have held up remarkably well. Dealogic data indicate that corporate MTN issuance in the first quarter of 2018 is only a little below last year at €7.6bn, and higher than every year since 2013.
However, although volumes have remained steady, competition for deals has never been fiercer and margins have been squeezed accordingly.
Dozens of top investment banks have MTN desks staffed with experienced and knowledgeable veterans. As one head of MTNs in London puts it: “Everybody knows what they’re doing.”
As a result, fees have fallen and profit margins have been compressed. But arrangers remain keen to do well in the MTN business because of its utility in winning other, more lucrative business. Dennis Bachmaier, head of MTNs at BayernLB, says: “Successful tailor-made MTNs show a bank’s distribution power. That, along with league table position, enhances a dealer’s reputation in front of an issuer and helps secure follow-up, fee-paying trades like benchmarks.”
Because the competition is so strong, banks hoping to charge fees are swiftly undercut by banks willing to forgo them. Even the buy-and-sell margin has been squeezed, to the extent that “some arrangers even subsidise trades just to get something done,” according to Bachmaier.
While subsidising trades is nothing new, thanks to the increasingly intense competition, it may be on the increase. However, no data is available on the proportion of trades that make a loss for the bank.
The value of the MTN for issuers and investors has historically been its flexibility. Unusual tenors at the very long or short ends of the curve have been one of the product’s main points of attraction.
But QE has opened the public market up for longer tenors than ever, stunting the extra value added by MTNs. Rudolf Bayer, head of EMTNs at UniCredit, says: “As we see spreads widen and curves steepen, I expect to see new opportunities in the long end of the curve.”
But not everyone agrees. Some believe the long end of the corporate MTN market may not recover when extraordinary monetary policy support is removed.
The introduction of the Solvency 2 capital regulation for insurance companies has made the long end the almost exclusive domain of high quality public sector issuers and the very top end of corporate credits.
ING’s Proudlove says: “There’s such a high charge for holding long dated assets with credit ratings below triple-A, it’s just not cost-efficient for insurance fund investors.”
While government bonds pay a low return, the cost of capital means they are still a preferable investment.
The Market Abuse Regulation, which came into force in 2016, has also put a dent in the ease with which corporate MTNs can be put together, particularly for infrequent borrowers. Without large, liquid curves, information on a potential MTN could be market moving, meaning the investor would have to be brought across the wall on the deal. “It adds a layer of complexity to the process,” says Proudlove. “And if it gets harder to do a deal, investors look for alternatives.”
Moreover, issuers have taken advantage of low interest rates to issue large volumes of long maturity debt over the past year or so. With treasuries stuffed with long dated cash, Proudlove suggests corporates will simply not have much need for long end paper in the foreseeable future.
Another key product for the MTN market is the structured note. While the 2008 financial crisis hit demand for exotic structures, there is still appetite for paper offering a pick-up in yield, such as callable bonds or those with coupons linked to stock baskets or indices.
“With the changing monetary policy environment, floaters in the mid-curve are more popular,” says UniCredit’s Bayer.
Size appetites are changing too, Bayer adds. “We’re seeing trades in bigger sizes — around €300m often. There are investors who are happy to go for private placements in order to get higher allocation in deals they would not be able to find in the public market.”
But while demand is returning for structured notes, issuers are less willing to serve it. “They are typically too small to be relevant,” says an MTN dealer in London. “Issuers have limited time and resources. Structured notes take up a lot of both but provide only small amounts of funding.”
Just like vanilla MTN products, when public markets are in good health, structured products fall by the wayside. Volatility is the MTN desk’s friend. “Volatility makes access to public markets less straightforward,” the MTN dealer adds. “That prompts issuers to look at other types of deal like structured notes.”
With the end of eurozone QE looming, perhaps as soon as September 2018, volatility, long banished from public markets by the ECB’s comforting presence, could make a comeback.
The adoption of new technologies always heralds a period of turbulence. Capital markets are, like many other industries, being driven by management to find technological solutions for long-standing difficulties, including high costs.
Those with their eyes on the bottom line at investment banks are seeking efficiency savings through digitalisation, automation and disintermediation.
Many banks have their own tech departments, building platforms and solutions in house. All of them are monitoring promising fintech start-ups, eager to spot the next development that will change the way capital markets business operates.
However, some companies are trying to cut investment banks out of the business entirely. Marex Solutions, a specialist derivatives division of Marex Spectron, has issued a pair of structured notes direct to an investor. The pair were identical except that one transaction was settled via traditional means while the other was printed through blockchain.
By issuing a security via blockchain, Marex was able to cut out expensive depository and custody services, lowering the cost to the investor and speeding up the settlement process.
Since investors often only require structured notes of small size, issuance costs are a significant barrier to issuance, so reducing these could be a big factor in improving demand.
Banks are always likely to have a role in originating such transactions. Spotting opportunities and bringing the right issuers and investors together remains the investment banker’s primary value.
Origin Markets, an MTN dealers’ platform, originally set out to bring issuers and investors together. However, it swiftly discovered that the MTN market depends on the input of dealers in generating trades, so it pivoted to become a service communicating issuers’ levels directly to dealers.
Nevertheless, if investment banks are unable to innovate to provide competitive pricing on structured products, then one of the cornerstones of the MTN market may slip out of their grasp.
While MTN dealers have successfully ridden out a difficult period of low interest rates and volatility, the arrival of new technological systems brings new challenges. The MTN market must continue to adapt if it is to remain a useful part of a corporate issuer’s funding strategy.