DCM 2007: Where do we go from here?
The primary corporate bond market in Europe has re-opened for business following a hiatus of around seven weeks, albeit at a cost to borrowers that have been forced to accept a notable spread concession to access funding. While there is definitely an increase in risk appetite, the question is how market professionals view the current environment and how they see the corporate market shaping up in the medium term. Andrew Perrin reports.
AstraZeneca re-opened the primary market in mid-September by successfully placing €750m of January 2015 bonds at a spread of mid-swaps plus 70bp. This was at the tighter end of original guidance, offered a premium of some 20bp versus the issuer’s CDS level and came on the back of an order book just shy of €2.5bn. The issue went on to perform very encouragingly in the secondary market, opening a small window of opportunity for other issuers to follow suit, a window that opened significantly wider the following week when the Federal Reserve moved more aggressively than many had anticipated. The 50bp cut in rates was compounded by some encouraging central bank rhetoric and intervention, helping to improve the fragile state of confidence further. The bellwether iTraxx credit indices rallied sharply as participants looked to cover short positions, and in the primary market some €15bn of investment-grade corporate supply was absorbed by investors in the space of a couple of weeks.
While this is clearly an encouraging development, as far as the credit market getting back on its feet is concerned, the level of new issue premium that these borrowers have had to pay clearly reflects the fact that, while the worst of the crisis may now be behind us, the market is by no means out of the woods just yet and risks still remain. E.ON for example, the A2/A rated utility, launched a €3.5bn dual-tranche five and 10-year transaction on the heels of AstraZeneca. These transactions priced at a chunky negative basis of 30bp and 35bp, respectively, despite having commanded a combined order book in excess of €12bn, certainly one of the largest books for an investment grade euro corporate benchmark so far this year and probably ever.
Joe Biernat, director of research at European Credit Management is one individual that shares this guarded view. He notes that the ABCP (asset-backed commercial paper) market remains a concern, as does the leveraged finance overhang of approximately €350bn in the US and Europe that still has to be completed. “Until that happens, that market will continue to move like a glacier,” says Biernat.
He also outlines an ongoing problem with liquidity. “While banks have improved and are now well off their extreme stresses, the cost of funds is still high and there is not a great deal of cash around to buy paper right now.” This cautious sentiment was echoed by Peter Bentley, senior vice president, portfolio manager sterling & euro credit at PIMCO in London, who reiterates that the problems in the short-dated markets are not fully resolved and feels that the volatility will probably remain a feature in the market for some time.
Both Bentley and Biernat agree that the new issue premium currently being paid, while likely to depress gradually, is unlikely to change too significantly for the foreseeable future. “The probability is that the differential between cash and CDS will eventually be arbitraged away as people look to take on basis trades. However, while we still have a steady flow of fresh supply and hedge funds in particular remain short of cash, the differential will most likely remain negative for some time,” says Bentley.
Biernat also points out that the deteriorating economic backdrop should also limit any tightening bias going forward. “Corporate fundamentals are still relatively sound but the US economy is beginning to look pretty grim, and while Europe is in better shape, it is not totally decoupled from events across the pond. Most economists still believe that the US will avoid a recession, but the likelihood of very slow economic growth, a weak dollar and high oil prices would undoubtedly have a knock-on effect into Europe,” he says.
More positively, this means that spreads are now at levels that offer attractive investment opportunities in many areas, a scenario that has been reflected in the generally large book sizes that the recent crop of transactions have achieved. BASF, another one of the handful of borrowers that have taken the plunge since the market re-opened is another good example of this. The €1bn seven-year deal attracted an order book of around €4bn at initial guidance in the mid-swaps plus 55bp area. This level of interest paved the way for pricing at mid-swaps plus 52bp, equivalent to a premium of around 20bp versus CDS.
“We were selective going into the sell-off, as we believed that there was not enough emphasis on credit quality and very little differentiation of risk. This followed a period in the first half of the year when spreads were extremely tight and risk/reward was subsequently compressed. We are now in a phase where we will remain discerning and individual credit analysis is key. Generally, cyclical sectors are expected to underperform in line with our view on the global economy, whereas non-cyclicals offer some value and have scope to outperform,” Bentley says. Biernat is a little more specific, suggesting that automakers and retailers could find it particularly challenging against this economic backdrop.
Both see value in a senior banking sector that has understandably felt the full force of the liquidity crunch, as illustrated by the recent developments that have befallen Northern Rock. “Corporates are generally trading at tighter levels than financials but in some cases this has been overdone and there are opportunities [in the banking sector] to be had” says Bentley. Biernat adds that “the run on Northern Rock has now ended and central banks have shown that they will not let these institutions fail.”
Meanwhile, the message from the sell side prior to the re-opening of the primary market suggested that investors had struggled to persuade potential European issuers to bite the bullet and pay the new issue premium required. This scenario is still prevalent in many cases, despite the fact that European investors have shown a willingness to get involved. This is in contrast to the US market, which has seen a strong flow of corporate dollar issuance throughout the summer.
Eirik Winter, managing director co-head of fixed income at Citi attributes this in part to the fact that US corporates traditionally look at the absolute coupon to assess their funding costs while European borrowers typically think more in Libor terms. While the recent spate of US issuers has also been forced to pay a sizeable new issue premium versus CDS, the significant rally in Treasuries over the summer has ensured that, for many, absolute coupons have actually been lower than they would have been earlier this year. Moreover, many European borrowers that are not in urgent need to cash and still have a reasonably upbeat outlook on the economy prefer to monitor developments from the sidelines rather than bow to investor demands. Many already have fairly healthy balance sheets and do not need to run the risk of a failed deal damaging their reputations.
This is reflected in SG CIB’s revised expectations for investment-grade corporate issuance in 2007. “When you consider the overall pipeline, including those issues that were postponed in June coupled with what is expected into year-end, we envisage around €20bn-€30bn of issuance. Prior to the volatility this would have been closer to €40bn,” notes Jean-Francois Mazaud, global head of origination at SG CIB. However, he is also keen to note that this is probably a conservative guesstimate in light of the fact that almost €15bn of supply had already emerged by the end of September, while the pipeline is looking quite healthy: “€20bn-€30bn of fresh paper would still put 2007 volumes roughly in line with last year’s total of €120bn-€130bn despite what has been a major market crisis,” he says.
Not all banks feel it is appropriate to make predictions at this juncture, however, among them BNP Paribas. “A lot of issuers are still undecided whether to draw on their bank lines, wait until the last minute to fund or bow to current conditions. Of the crop of issues that have emerged so far, E.ON and Enel decided to come to the market as they have large financing plans moving forward and did not want to leave it until the last minute, which was a wise move, while recent transactions from Schering-Plough and Schneider Electric were acquisition driven. However, opportunistic issuers are yet to emerge,” notes Frederic Zorzi, co-head of syndicate at the bank.
He also outlines various factors that make forecasting issuance volumes extremely difficult. “There are a number of things to consider, such as the type of credit, whether cyclical or non-cyclical, their longer-term view of the economy and, of course, how long the negative basis can return to more ‘normal’ levels. Banks that attempt to make predictions in the current environment are taking a shot in the dark,” he says.