Published: June 01, 2008
One of the most significant outcomes of the credit crisis is, without doubt, the change in investors’ influence, and in particular, the type of investors which now hold most sway over the bond markets. So-called ‘real money’ investors, such as pension funds, which generally seek to buy and hold, are dominating order books and are driving pricing. In fact, these investors now represent an average of 85% to 90% of orders in corporate bond issues in 2008. What’s more, they hold individual orders larger than they would have done a year ago. This is in contrast to hedge funds and bank proprietary desk whose order sizes are significantly smaller than in 2007.
Many corporate borrowers have traditionally turned to the Eurobond market for their long term funding, but with market conditions substantially different to those of last year, is it still realistic to look to Eurobonds as a source of funding? In RBS’s view, although the current market may be a more challenging one, there have been, and remain, windows of opportunity for many potential corporate issuers.
According to Dealogic Bondware, corporate issuance of bonds denominated in euro and sterling has reduced by 10% from a year ago in the UK, with a 15% drop in Continental European issuance. However, April and May were record issuance months with strong demand from investors driving a significant number of transactions. It is often said that ‘change is the only constant’, and nowhere is this more true than the bond markets at the present time. Volatility remains the key driver, with every new piece of news sparking a new period of flux, leading to opening and closing of issuance windows. To date, financial institutions have experienced more volatility than corporates as concerns about liquidity in the financial industry have been in the forefront of investors’ minds. The majority of investor demand for corporate paper has been in highly regarded, non-cyclical credits, whereas in financial institutions, demand has pre-dominantly been for ‘too big to fail’ type names.
Timing is, of course, essential to delivering a successful transaction with some price tension. At certain times, investors are still receptive to new issues, while at others, generally for a period of a few days after a gloomy news release, they are stepping back from committing to new deals. This is resulting in intense periods of issuance as illustrated during the month of May, followed by periods of very little activity.
Although many market participants look back over a year of ‘doom and gloom’, there have been particular events which have marked a watershed. Firstly, prior to the sale of Bear Stearns to JP Morgan Chase in March 2008, investors were concerned about systemic risk which affected the whole credit market. With the Federal Reserve’s effective backstop to protect Bear Stearns’ debt holders, investors gained confidence in the market overall, which led to a rally in credit spreads and a two month surge in corporate new issue volumes. [[[PAGE]]]
With the impact of the credit crisis still potentially to affect corporations and continuing uncertainty surrounding energy and food prices, this volatility looks set to continue. Again, this will lead to markets being open and closed for certain periods of time. We see the risk of credit deterioration continuing until the end of the year before conditions start to improve. However, although the market appears volatile, we expect to see some issuers seeking to issue in the Eurobond market, before the traditional summer break sets in during August. This is likely to create higher volumes of issuance now, with other issuers without an immediate need for financing focusing on post summer opportunities.
Whilst the credit investor community still has cash to put to work, understanding the needs and concerns of investors is essential to successful issuance, and as these institutions have the ability to be selective, issuers need to understand these clearly.
When looking at a new issue, investors will consider outstanding cash bonds and credit default swaps of the issuer as well as relevant comparables. In today’s market investors are prepared to purchase new corporate paper at a premium to outstanding secondary cash bonds. Depending on market conditions, this new issue premium may be higher or lower.
In order to achieve the best pricing for a transaction, the requirement is to offer benchmark type characteristics thereby enhancing perceived liquidity of the issue. This is important for investors who seek to exit or adjust positions in the future, which has been an issue in the recent past. Also, it is crucial to select the right maturity for any given credit profile, cyclical names for instance have received far better investor reception in the intermediate tenors, whilst the longer maturities have worked well for utilities. Furthermore, covenants such as change control or coupon step up need to be added to bond documentation where required.
Highly rated corporates remain an attractive investment proposition for today’s investors, many of whom are ‘buy and hold’ investors. For lower rated corporates, the timing of issuance is of significance to catch the periods of upswing in the market, but the increased challenge in issuing bonds does not mean that bonds are an unrealistic way of raising finance, as illustrated by a number of cyclical BBB rated corporate borrowers having successfully issued in the market this year.
A year ago, the Eurobond market was really an issuers’ market, with corporates negotiating attractive pricing without compromising a bond transaction. Today, whilst still being able to push pricing, the ability to do so has been reduced as orders have become more fragile and can more easily drop out of an order book if pricing is pushed too aggressively. At RBS, we find it beneficial to sound out potential investors on a confidential basis prior to launch, ensuring that we will have a successful deal. Prior knowledge that a transaction has significant lead orders allows us better pricing leverage. Selecting accounts carefully for this kind of pre-sounding exercise is absolutely critical. Positive feedback ensures successful transactions prior to launch, whereas negative feedback allows us to halt the deal from entering the public markets, thus avoiding an undesirable impact on firms’ reputation.
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