Living it up

IFR Debt Capital Markets 2009
9 min read

While the European corporate bond market was widely expected to bounce back somewhat this year compared to the depressed issuance and volatility seen in 2008, it was still a surprise package in terms of the sheer volume that came to market. It also saw the most blistering tightening of spreads and massive levels of demand that the market had ever seen. But how much longer can it maintain the momentum? Andrew Perrin reports.

Hardly a week has past this year without another record of some sort being broken in the corporate bond markets. Risk appetite moved from the more recession-proof sectors to more cyclical credits as investors chased yield, but there has consistently been activity.

At the end of September there had been 213 benchmark corporate bonds denominated in euros, totaling €223bn. The year had already comfortably smashed the previous annual record of €200.2bn set in 2001, with a quarter of the year remaining, according to data from SG CIB. Moreover, all but three of these transactions were trading in positive territory, reflected by the iBoxx Euro Corporate index that was quoted at 192bp over the benchmark at the end of the third quarter this year, having tightened in by 59% since the start of this year and 24% since before the collapse of Lehman Brothers in September 2008.

The pace of issuance was bouyant from the word go, with €48.5bn of investment grade supply emerging in January alone. Investors were scrambling for opportunities to deposit cash with the mainly lower beta defensive corporate names that dominated issuance in the first quarter of the year.

"This was needed to initially attract cautious investors back to the market at levels that could effectively ensure a sufficient return for many that had been burnt on a number of occasions since the onset of the crisis," said Russell Schofield-Bezer, head of European corporate debt capital markets at HSBC. Asset allocations were also boosted by shrinking deposit rates, low government bond yields and volatile equity markets, he added.

The depth of the market earlier in the year was highlighted by Roche Holdings (Aa1/AA–/AA), blowing the primary corporate market out of the water in February with the largest corporate Eurobond ever at around €12.66bn equivalent. The dual-currency multi-tranche exercise commanded over €24bn of combined interest, and followed on the heels of the healthcare company's record-breaking US$16.5bn six-tranche Yankee issue the previous week.

This deal actually emerged during a temporary bout of spread widening that indicated some nervousness after such a bullish start to the year. Since then, however, the corporate market has gone from strength to strength: spreads have tightened sharply, having overcome another minor wobble in early August that also proved short-lived.

Everyone is in on it

The increasing demand for yield has seen the composition of corporate issuers consistently evolve throughout the year, as funding costs have become considerably more attractive. This initially started with the emergence of more cyclical names in the Triple B space earlier in the year, before gravitating towards rarer and unrated issuers. The explosive performance of the corporate bond market this year has elevated it to a position where it can often offer a competitive advantage versus the loan market.

For example, German automaker Daimler (A3/BBB+) recently launched a €3bn two-year refinancing that pays 160bp over Libor, not including fees. This is probably about 50bp cheaper than the company could have secured two-year funding for prior to the summer. But it compares unfavourably with Daimler's €2bn five-year bond, which was priced at the end of August at mid-swaps plus 185bp, and had tightened to the swaps plus 150bp area on the bid side as of last week. The automaker was forced to pay mid-swaps plus 600bp to take €1bn out of the three-year bond market in December 2008, underlining how far the market has rallied this year.

Schofield-Bezer expects the improved funding conditions to continue to tempt more unrated and higher beta names to the market going forward. "The frequent issuers will always be around but should start to favour more niche markets now with more reverse enquiry and privately placed deals, supported by the fact that many are now well funded for the year and well into 2010 in many cases,” he said. “If you are a non-frequent and/or unrated high yield name looking at the market, the all-in coupons that are being paid are attractive compared to the historical average.”

Basle 2 is also important. “The regulatory capital regime continues to become more stringent, so companies' access to bank capital is clearly not going to increase. This should sustain the bond market's appeal and help accommodate ongoing investor demand for yield in the process,” said Schofield-Bezer.

Even though banks are starting to come through some of the capital constraints they had post Lehman Brothers, this issue has not gone away. The market is a long way from providing the highly aggressive leverage and covenant-light structures seen in the past. "The bond market offers diversity for issuers, very appealing coupons and Triple B type cyclical names can fund on attractive terms. The credit curve remains steep and investors continue to look for good brand names and credit stories," Schofield-Bezer added.

The investor view

Laurent Crosnier, head of euro fixed income and credits at Credit Agricole Asset Management, said the market is still pricing in a default rate well above the historical average, against a back drop of improving economic fundamentals. "Three-months ago investment grade corporates were pricing in a very high cumulative five-year default rate of 20-25%. While this has dropped sharply following the blistering rally since the end of Q2, the indicated default rate is still at 8-10% (at the time of writing) which is well above the historical average of 0.9%.”

While there are still opportunities available, the potential for performance is significantly more limited that it was earlier in the year. The pace of the rally in the past six-months should slow sharply, Crosnier predicted.

Herve Boiral, head of credit at CAAM, believes that the top end of the market has returned to a level of normality for the lower beta sectors such as the utilities and telecoms. "This is reflected in the secondary market where some of these issues have become expensive in comparison to the higher beta names, and have consequently been the worst performers lately,” he said. “We now see more value in the financial and higher beta corporate names."

He emphasised the importance of having a well diversified portfolio and undertaking extensive credit work in this environment. "A large number of new investors have entered the corporate bond market this year in order to buy the coupon but not the issuer. This has been a rewarding strategy but we are now at a juncture where internal credit analysis is key with regards issuer selection. This is particularly important with the recent emergence of more first time and rarer more cyclical type issuers amid an environment of compressed new issue premiums.”

Nigel Sillis, head of fixed-income and currency research at Baring Asset Management, stressed Barings uses a more quantative technique and less fundamental analyses to assess which bonds are selected. "We look at the overall value of the market and put less emphasis on each individual component, seeking to add value to customer portfolios by getting the right weightings of asset allocation rather than augmenting that [asset allocation] decision with stock selection type returns," he said.

While he acknowledged that there are still opportunities to be had in the corporate euro market, he felt that the euro market is the least convincing of the three major bond markets, having already rallied so much throughout the year. "In general we see more value in non-financial corporates in US dollars and sterling, and also prefer the European government bond market compared its US and UK peers from a fundamental perspective.”

Thus the value of euro corporate bonds, compared to benchmark government bonds, is also less appealing as it is in the US and UK. Like the others, he also prefers higher beta names and would "expect a further rally of around 100bp in the sterling Triple B bucket for example, a level of performance that the euro corporate market would struggle to produce."