1. The Magazine
  2. July/August 2005
  3. Features : Debt Markets / Caught In The Downdraft

Features : Debt Markets / Caught In The Downdraft

Author: Laurence Neville

European companies are finding themselves trapped in the fallout from recent downgrades of GM and Ford.


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Borrowers in the European bond markets have been on a roller-coaster ride in the past four months. Having grown accustomed over the past 18 months to almost ideal market conditions, the market took a sudden turn for the worse following the downgrades of Ford and General Motors and the leveraged buyout of Danish cleaning company ISS. But as strength has returned to the new-issue market, it seems corporates are no longer taking investors for granted.

The benign issuance conditions of the past 18 months have had a unique set of drivers. Regulatory changes have resulted in a move by insurance and pension funds out of equities and into fixed income. Meanwhile, the low interest rate environment globally has created a hunger for yield, increasing demand for credit. With supply low and redemptions high, the market was well bid.

As Stuart Bell, head of European DCM at ABN AMRO in London, notes, most corporate treasurers had become apathetic about market conditions. “They had been constantly told that issuance conditions were at the peak, but the predictions hadn’t become true, and consequently there was less urgency to issue,” he says. But in early March the technical conditions that had created that situation ground to a halt. “Everyone was fairly fully invested,” he says.

When GM’s earnings warning—the precursor of its downgrade—came on March 16, it created a change in sentiment that was more severe than most anticipated. “It began a spiral for the debt markets which it took until the end of May to recover from,” says Jean-Francois Mazaud, head of corporate origination at SG CIB in Paris. “The negative sentiment was fed by bad news for almost two months—first from GM and Ford, then by the downgrades and their removal from investment-grade indexes.”

The second event to shock the market was a complete surprise: the €3.85 billion LBO of Danish company ISS by Goldman Sachs Capital Partners and EQT, the largest European bond issuer ever to be targeted, at the end of March. Spreads widened by as much as 400 basis points (4%) on the 2014 bond, recalls Mazaud. “There was an immediate reaction among investors to consider almost anything—even DaimlerChrysler—to be at risk of an LBO, and spreads widened accordingly.”

Around the same time, the market decided that US rates would likely have to rise more quickly than expected. “It had an effect on the carry trade,” explains Bell. In a tightening spread environment, against a backdrop of low interest rates, it makes financial sense to borrow money to fund bond purchases. The trade is widespread, but hedge funds tend to leverage their trades, making them more vulnerable to rate rises.
European Issuers Hold Fire
As spreads widened—all of 2004’s spread tightening unwound in just one month—and market rates moved upward, the outlook for such investors suddenly looked pretty bleak, and certainly no one wanted to buy new issues. Inevitably some corporates were caught out by the sudden change in sentiment. Some, such as German automotive and defense company Rheinmetall, chose to delay their issues.

But others, including Austrian brickmaker Wienerberger and Swiss pharmaceuticals firm Syngenta, pressed ahead and had to pay up for their decision. They were in the market during the week of April 11, and as investors got more skittish over the prospects of LBOs, the borrowers were forced to include change-of-control covenants in their bonds, which would guarantee investors a put at par in the event of a takeover. For debut issuer Wienerberger, the change-of-control clause was a price worth paying to diversify its funding base away from banks in Austria and Germany. “Even with the change of control, the bond market is still very flexible relative to bank lending,” says Hans Tschuden, CFO of Wienerberger. Tschuden does admit that he wishes his bookrunners, ABN AMRO and Bank Austria Creditanstalt, had warned him of the potential need for a change of control on the €400 million seven-year deal.

Syngenta was less happy to offer the change-of-control covenant as it had an existing EMTN program. But as Domenico Scala, CFO of Syngenta, notes, if a company intends to target UK-based investors, in particular, plans to issue more than €100 million and is a potential LBO candidate, then a change-of-control clause is likely to be necessary to complete a deal.

Of course, market conditions can change dramatically for the better as well as for the worse. Just a month after Wienerberger and Syngenta, BASF and Sanofi-Aventis re-opened the market—albeit on investors’ terms. Double-A-rated BASF realized that real money accounts—pension and mutual funds—had built up cash while the market was closed and were seeking a high-quality home for it.

Double-A-rated Sanofi-Aventis chose to focus even more narrowly on the demands of one group of investors and used its high A1-plus/P1 short-term debt rating to its advantage. Among French corporates outside the banking sector only oil company Total has a similar rating, and consequently money market funds and banks were eager to buy Sanofi-Aventis’s two-year €1 billion FRN.

Since then the market has re-opened more widely as bonds have recovered 75% of the value lost since March. GlaxoSmithKline was able to achieve a coupon of just 4% at the beginning of June for a 20-year deal, and a slew of hybrid issues—perpetual subordinated debt that is counted as equity by rating agencies—from corporates such as the world’s biggest sugar producer Südzucker have proved that investors’ reluctance to buy lower-rated credit was an aberration. Part of the reason for this is practical: Inflows remain strong, and they have to be invested somewhere. Also, fears of a rate rise in the US have receded, meaning the carry trade is once again economical.

From an issuer’s perspective the introduction of the EU prospectus directive on July 1 has been a boon to issuance. “It is concentrating issuers’ minds on their deal timetables,” says Eirik Winter, European co-head of fixed-income capital markets at Citigroup in London. “They know that if they don’t do a deal shortly, they will have to spend some time preparing new documentation and then have to wait their turn once the market opens after the summer.”

In addition, treasurers have realized after the fright of the months after March that credit markets can easily turn bad and lock them out. “It’s been a rude awakening,” says ABN AMRO’s Bell. “Corporate treasurers are now cognizant of volatility in a way they were not in March. They’ve also realized that on a four-year horizon absolute yields are unbelievably low.” But the way in which issuers are approaching the market has changed. As Citigroup’s Winter notes, the new watchword among issuers—in relation to market conditions, timing or investors’ demands on tenor, pricing or structure—is responsiveness.

Laurence Neville