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Thursday, 23 November 2017

Top 250 2005 - Credit rollercoaster

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Credit markets suffered a period of extreme volatility in April and May following the downgrade of GM and Ford to sub investment-grade status. But primary market confidence was restored in early June, with sentiment stronger than ever, suggesting that the auto sector has had less impact on the market than some had originally thought. Helen Bartholomew and Andrew Stein report.

GM and Ford were finally confined to the junkyard at the beginning of May when S&P downgraded the issuers to BB and BB+, respectively, after a long and drawn-out decline. Although some sceptics were predicting apocalyptic fallout, credit markets appear to have taken the events in their stride, and apart from some initial nervousness, spreads have snapped back to late March levels. The euro corporate market now looks as buoyant as it was at the height of the bull run.

Although on the cards for a number of months, the downgrades did come as a shock to many in terms of timing and the severity of GM's double-notch downgrade. And there was further bad news when Fitch later downgraded GM to sub investment-grade status in late May, sealing the issuer's fate to high-yield status, at least until an upgrade occurs – something that analysts believe will be a long way off.

"The fallout in the autos seems to have been surprisingly isolated, leaving the broader market largely unscathed," said Steve Kaseta, fixed-income portfolio manager at Loomis Sayles. "Our sense a year ago was 'watch out', but the market has been taking the downgrades in stride."

Euro credit markets took a battering in early March when spreads ballooned more than 30bp in just over two months. The iBoxx euro corporate index hit an all-time tight on March 3 of Bunds plus 42.24bp and by mid-May had traded as wide as Bunds plus 74.26bp. The US market has been on a similar path as the Lehman Brothers US credit index (excluding autos) backed up to 80bp on an option-adjusted basis in late March, from 67bp at the start of the year.

"We believe that the iBoxx corporate index is pretty fair value at the current levels and many others are thinking the same, but it could quickly turn around – and this might be the last opportunity of the year to buy credit at these levels," emphasised Joe Biernat, director of research at investment management company European Credit Management.

While the whole Ford/GM debacle had been seen by many as the trigger for a shift in sentiment, most believe that it was simply one small part of an array of negative newsflow that emerged over a short period of time. The combination of historically tight spreads, a back-up in rates, and poor deal execution in the case of some new issues at the height of the bull run, all served to create fear within the investor community. The auto downgrades certainly added to investor fears and might have had some bearing on the magnitude and speed of the widening.

Perhaps the most important spanner in the works came in mid-March when rates ballooned by as much as 14bp. At the same time, Telecom Italia priced a 50-year issue at ultra-tight levels of 98bp over mid-swaps. The deal might not have caused the meltdown that followed, but it was certainly a significant factor in making investors take stock and finally acknowledge that any value left in the credit markets had been completely eroded if a Triple B telco could price such long-dated paper at that kind of level.

Through April and May, investors staged a long-awaited rebellion, forcing issuers to widen pricing, and many were forced to pull transactions as investors took their long overdue place in the driving seat. Another force also added to the volatility as event risk returned with a vengeance after ISS spreads ballooned on takeover fears.

The resurgence of LBO risk has had allowed investors to win the battle for improved takeover protection in small and mid-cap issues – something that many have long been asking for to no avail while issuers had such a dominant position through the bull run. Since the beginning of April, bonds from Wienerberger, Syngenta, Sixt, Manpower and Rheinmetall included change of control covenants in their new issue documentation. But ultimately, investors accept that the phenomenon could be short-lived and are making the most of their new-found position of power and are asking for covenants to be included for any company with an enterprise value of up to €15bn, whereas previously the limit was significantly lower at just €5bn.

"For the first time in a long time it is investors who are calling the shots rather than the issuers. We've seen it many times in sterling, but it is relatively new in the younger euro market and it won't last forever," said Ian Robinson, find manager and credit strategist at F&C Asset Management.

Although LBO and shareholder friendly activity has been isolated to a few names, companies will continue to feel pressure from investors to shift capital. "More activity will be driven by shareholder activism that will continue to play an increasing role in the redeployment of capital," said Jeff Weiss, Lehman Brothers' co-head of global finance.

The most notable casualty of shareholder pressure this year was Carl Icahn's turning of the screws at oil services firm Kerr-McGee. The company's decision to finance the repurchase of US$4bn in stock at a premium with debt sent its paper spiralling wider and prompted the rating agencies to downgrade the credit to junk status.

While bondholders are taking advantage of rattled sectors to lock in tighter covenants, sectors that have seen steady flows such as the US REIT industry are taking advantage and weakening bondholder agreements.

The changes could allow certain REITs to increase their leverage ratios at a time when many are sceptical about real estate valuations, and leave bondholders in weakened positions within credits that pay 90% of their taxable income out in dividends.

Simon Property's recent US$1bn issuance provided an example of the flows heading into the sector as the offering was doubled in size. However, once bonds with the prior covenants mature, the new stipulations will allow the company to increase its debt to 65% of total assets from 60% and decrease its secured debt to 50% of its assets from 55%.

The recent pains of the credit market seemed all but a distant memory by early June, when spreads had stabilised back to near their tights and the fear of rate rises had eased, forcing Bund yields to new lows on an almost daily basis. What followed was one of the busiest spells in the credit markets to date, with activity buoyed by the onslaught of the EU prospectus directive implementation deadline, which brought issuers out of the woodwork and saw more than €10bn shoot out of the pipeline within two weeks.

The renewed confidence brought with it a variety of innovative transactions, including a bunch of corporate subordinated bonds with deals from Suedzucker, Vattenfall and DONG and the market's first corporate inflation-linker from Veolia.

Next step for autos

For the market's two largest borrowers, the shift into the sub investment-grade universe has led to a greater emphasis on deal execution for bankers, leaving the newly downgraded autos to rely on innovation and opportune timing to regain access to the investment-grade markets. GMAC appears ready to tap the investment-grade market again through its newly created Residential Capital Corp (ResCap), which features a series of provisions aimed at maintaining separate ratings from the financing arm and General Motors.

The ResCap ring-fencing includes specific limitations on the amount of dividends the company can pay, provisions on how it can repay subordinated debt and stipulations that the company cannot extend credit to the parent companies. Those barriers allowed ResCap to achieve ratings of Baa2/BBB-/BBB and kick off a roadshow that will start a steady flow of issuance as the company has pledged to repay US$10bn of inter-company debt by the end of 2007. They may also provide GMAC with a framework on how to further separate its own ratings from General Motors (see IFR 1587).

While Ford has one foot out of the Lehman Brothers' investment-grade indices, it will likely return when Fitch Ratings' evaluations are included in July. Ford's precarious grasp on investment-grade status was thought to prevent unsecured debt issuance, but a reverse enquiry amid an ABS transaction demonstrated Ford Motor Credit's ability to access both markets simultaneously.

The credit's latest US$1.5bn three-year fixed-rate offering priced at 330bp over Treasuries, 7bp tighter than early Libor-based whispers, as a deep book grew to over 140 different investors. The issue carried a significant concession from its previous fixed-rate offering in January, which traded at 290bp over as the new supply hit the market, but not as prohibitively expensive as some had thought.

"If you're an insurer, you're looking to get your hands on anything you haven't seen in a while, even if it comes in lieu of pricing," said one trader at a money management firm.

While FMCC and GMAC have had to find specific windows to tap the market, their travails have benefited DaimlerChysler as the last of the Big Three able to tap the market on its own terms. Daimler's recent US$1bn offering of 4.875% notes due 2010 priced at 130bp over Treasuries, printing through its existing 8.00% notes due 2010 at 134bp on a book that was six times covered. The Daimler offer has tightened to 125bp over Treasuries since pricing.

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