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Sunday, 20 April 2014

A very different scenario

Mid-2007 marked the high-water mark in the international credit markets, since which time well-documented crises have undermined confidence and stymied borrowers. Yet supply has not dried up completely and for the strongest credits, demand remains. For those lower down the scale, acknowledgment of the new reality has been paramount and no return to the past looks likely. Philip Wright reports.

Those with a penchant for market history need backtrack only a year to discover that the past is indeed a foreign country, where things are done differently. Mid-2007 saw the credit markets at the zenith of their longest bull-run on record. Investment bankers, investors and issuers were united in either their inability – or unwillingness – to call an end to proceedings. Spreads were at all-time tights, fund managers awash with cash and order books many times covered.

Fast-forward twelve months and, while elements of that scenario remain intact – in that investors still have plenty of resources at their disposal and a number of recent transactions have attracted an extremely strong following – much has changed. It has been one of – if not the – most tumultuous years in market history. Some observers deem it the biggest banking crisis since the Great Depression.

The great – if unsurprising – change has been in the margins required for borrowers to secure funding. What has become noticeable is a greater degree of credit consciousness on behalf of the buyside and a corresponding unraveling of spreads that had become so compressed so as to make nuances of quality all but meaningless in the greater scheme of things. That was certainly not the case in the early part of 2008: supply from high-grade sovereigns, supranationals and agencies continued apace, while that from the purer credit plays in the corporate and beleaguered financials markets diminished markedly.

Despite the second quarter producing record-breaking months for both corporates and financials in the European market and, more notably, producing eye-watering amounts of supply in the US (US$114bn in April and US$133bn in May – plus a further US$18bn in the retail sector), overall global volumes for the first five months of 2008 were significantly down. According to data from Thomson Reuters Markets, the amount of international paper issued across all unsecured asset classes came in at just US$771bn equivalent – compared with US$1.907trn in the corresponding period of 2007, which, in turn, was up from US$1.546trn in 2006 and US$1.253trn in 2005.

A great deal of the early-year supply was from the SSA sector, although this is not necessarily a phenomenon peculiar to 2008, as the sovereigns in particular have a history of frontloading their issuance. The Libor levels available have been compelling, however, with an undeniable flight to quality evident on behalf of investors. Add to this a basis swap that meant European issuers could access the US dollar market at already attractive yields and swap back to euros at previously unimaginable levels, and all looks well.

And this is a situation that Morgan Stanley’s head of syndicate, Giles Hutson, does not expect to change in the second half of the year with supply finite and investors still cash rich.

“Perhaps the only cloud in the sky has been that demand was generally at the front end, in the two, three, five-year maturities,” he said. “The long end has been a bit more difficult, but they have enjoyed a reasonably happy first half of the year.”

In contrast, the corporate market in the US has not been as constrained, with no shortage of 10 or 30-year paper absorbed throughout the year. The backdrop is rather different from that in Europe, however: there was never a seizing up of supply to the same degree, as the volumes that were produced on a continual basis demonstrated.

As Jim Esposito, global head of investment grade financing and syndication at Goldman Sachs, pointed out, volumes in the US market have remained robust in 2008 and continue much on a par with 2007. “What has changed is the lack of activity in the 18-month to three-year sector, which used to account for about 50% of the market. In 2008, it’s only 15%,” he said.

He highlighted what he called a “barbell of liquidity” available to borrowers, where the CP market and longer tenors remain open while the shorter end of the term market – so critical for balance-sheet maintenance, particularly the FRN sector – continues to be resolutely closed.

The result of this long-end strength, as Esposito said, is that “on a duration-adjusted basis, US volumes are up: in fact, by more than 40%.”

What has become clear throughout the year, which fits in with the relative ease with which the Triple A rated borrowers have accessed the market, is that investors are newly cognisant of creditworthiness. “Investors are getting specific,” said Hutson, who stressed that buyer confidence is key. This accounts for the fact that issuers are relying far more on their home markets for strategic funding, where their credentials are better recognised, the cross-border transactions of yore now being a rarer animal.

In Europe, this can be illustrated by the fact that the SSA sector had produced US€125bn of supply up until the end of May, close to 2007’s €129bn, a downturn in agency supply compensated for by increased volumes from sovereigns and supranationals. And elsewhere in the higher rating echelons, jumbo covered bonds are running at 90% of their 2007 levels at €72bn. The most noticeable fact is that Spain, which last year produced 22% of supply, has seen that percentage halved. The UK has contributed nothing at all so far, compared with 11% in 2007.

This reinforces the view that “there is still some risk aversion around the investor base”, as Jean-Francois Mazaud, deputy global head of the capital raising and financing division at SG CIB said.

This is illustrated by the fact that parts of the market remain closed – most notably in Europe at the long end and in high-yield, where nothing has priced since last July. “We need further evidence of stability, and I think that will come in quarters. We need another one or two, minimum, and from there you will gradually see the rest of the segments reappear – assuming there is no major problem, that is,” said Mazaud.

For its part, supply in the financials sector is well down on the corresponding period of 2007. In Europe, senior unsecured volume is not much over 50% of last year at €131bn, while capital issuance is well under a half at just €7.3bn. But as David Soanes, head of global capital markets in the EMEA region at UBS, pointed out, this is not purely a function of the market being bereft of appetite. “It is quite simple,” he said. “If banks are not buying, they are not issuing.”

Corporates fill the gap

And while supply in the corporate sector has been similarly subdued – certainly at the front end of the year – the spreads required have by no means ratcheted out as much as those for financials. Cash-rich asset managers are looking to them to take on the mantle of what Soanes called an “issuance makeweight”.

“Sooner or later, investors have to hold their noses and get stuck in. Corporates are seen as being less vulnerable than banks,” he said.

“Corporate leverage is still low,” said Morgan Stanley’s Hutson. “They went into the volatile times in a relatively healthy state, and supply has not been too aggressive.”

“Corporates were in a much better shape than previously going into the crisis,” added Esposito. “And they have weathered the storm so far.”

Indeed, amid the relatively slow supply, a more strategic approach has been in evidence. This is demonstrated by the fact that, in Europe, the average transaction size for the first five months of the year was €653m – a higher figure even than 2001’s €574m, when the large telecom financings were under way, and significantly more than most of the intervening years.

Buying in these credit-heavy markets has been subject to plenty of intense scrutiny. But potential buyers are no longer willing to rely purely on the views of rating agencies, whose judgment has been called into question on a number of occasions over the past year.

“A basic tenet that people lost sight of is that it’s an opinion, not a fact,” said one market observer. There is little or no accountability at the agencies, which are also not exposed to any bond’s performance.

“It’s back to the future,” said Esposito. “In terms of credit analysis, we have witnessed a robust and healthy credit discipline returning to the global credit markets.”

“For too long a period, people were relying on rating agencies and they have to take a share of the blame,” said one syndicate official, “especially those that took them at face value, who are now realising the value of doing their homework. Credit research went quiet for a while but it is now coming back into fashion.”

But the very fact that investors are willing to – indeed, feel compelled to – embark on credit work underlines the fact that any persisting woes are not born of a lack of liquidity, but of conservatism that is only too easy understand in the current environment. “It’s a valuation question, not a liquidity question,” said Esposito. “Liquidity has not exited: there are large pools of capital available.”

“There is an interesting parallel to another market in turmoil,” said Soanes. “Namely, oil: liquidity hasn’t disappeared, it is just not going around as quickly and it is being hoarded. People who have it are keeping it, and even taking up more of it. It’s the same with oil, where there is no shortage of production. There is no scarcity but there is hoarding: it’s a slowdown of the system.”

A year of two halves

And as far as credit was concerned, the first five months of the year were divisible into two quite distinct parts, virtually equal in length. The watershed occurred on March 17, when the Federal Reserve took dramatic action to stave off a deepening of the crisis by giving investment banks access to liquidity in the wake of the collapse and subsequent sale to JPMorgan of Bear Stearns. While the view held in some circles that Bear Stearns was in some way a sacrificial lamb – allowed to go to the wall “pour encourager les autres”, as Volatire would have it – may or may not be valid, it is clear that it marked a sea-change, certainly in terms of supply.

“We were treading a perilous path,” said Soanes. “We looked over the edge in March and stepped back.”

“There was clearly a correction that started around the beginning of April,” said Mazaud. This was triggered by three main factors: the collapse and rescue of Bear Stearns; the course of action undertaken by financial institutions to bolster their equity bases; and the evening out of hitherto discrepancies between the cash and synthetic markets.

But while confidence undoubtedly experienced a boost at that time, there are still major concerns that what was previously viewed as a market-specific crisis could impact the real economy as a whole.

“Confidence was growing,” said Esposito. “But now people are getting anxious once again. The biggest concern is whether Wall Street’s issues will spill over into Main Street.” The longer the situation continues, the more the danger of this having a profound and long-lasting effect.

“There are definitely more shoes to drop,” predicted Hutson. “We may be most of the way through, but there is more to come, and this will be over a much longer timeframe – months or years.”

As events unfold further, there remains the possibility that previous palliative measures will prove insufficient. The institutions and authorities involved could prove unable to take the necessary action, having already utilised many of the options available to them.

“We may be better off than we were,” said Soanes. “But we are also less able to endure another bump on the road. To a large degree, central banks have already played their hands, so it is difficult to know what the next lever will be.”

All of this makes for a backdrop for international credit that looks to be as uncertain as ever. The only redemption for putative borrowers is that there remains no shortage of cash available to be put to work. “Issuers have a backlog, but then again, so do investors,” said Soanes.

One thing is sure: borrowers will have to be flexible in their approach to the market. “Issuers used to strive to neatly match assets and liabilities, but now they have less degrees of freedom and need to take the liquidity where and when available,” said Esposito. “Windows of opportunity open and close much more rapidly nowadays.”

In former times, originators and syndicators would look for a couple of stable days before looking to launch a bond. Recently, that turned to a day and even just one session.

While the situation is far from ideal, the very fact that people are discussing the best way in which to access the market – and not always from a self-serving perspective – demonstrates that it is still possible to do business. Further hiccups are almost inevitable and return to how things were is not an outcome that anyone is anticipating. That was not normal, just as the current environment is not normal, but as to when the new normal can be deemed to have been arrived at or, indeed, what shape it will take remain open to some interpretation.

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