The success of Metsä-Serla's euro-denominated Eurobond issue reveals a healthy appetite for credit products and a willingness to look to the emerging euro market. 

On the face of it, there was nothing particularly eye-catching about Metsä-Serla's Eurobond issue last December. Like many corporates, the Finnish paper and forest products group, the fourth-largest in Europe, was seeking to diversify its funding sources away from the bank loan market and public domestic bond market by accessing the international capital markets.

Hence it decided to enter the euro sector in preparation to the upcoming single currency corporate Eurobond market. On December 14 1998, the company priced its inaugural benchmark Eurobond issue off its newly established global medium-term note programme. Metsä-Serla issued e200m seven-year bonds at a reoffer spread of 120 basis points over the January 2006 Bund, with Salomon Smith Barney acting as lead manager.

Far from being just another corporate bond issue, Metsä-Serla's offering was in many ways a ground-breaking transaction in the Eurobond market. It was the first ever bona fide euro-denominated Eurobond issue, as all outstanding euro deals had previously been settled in Ecus (European currency units).

Metsä-Serla's offering settled on January 11 1999. More importantly, prior to its bond offering, the company had obtained public credit ratings with Moody's and Standard & Poor's and was assigned senior ratings of Baa2/BBB, respectively.

Peter Charles, director (fixed-income syndicate) at Salomon Smith Barney, says: "Triple B rated credits in the past had very little market access in Europe, while this year we have seen very active issuance at this rating level, be it from lesser known European or US corporates. "Thus Metsä-Serla not only made its debut in the euro market, but it also became the first BBB rated credit to issue bonds in the new currency, revealing a healthy appetite on the part of investors for credit products.

The offering achieved a more than 25 per cent hit ratio on its road show and a significant level of investor diversification, with two-thirds of the issue placed outside Finland and 85 per cent non-bank investor participation. The bonds tightened by two basis points after breaking syndicate and the spread continued to hold in the secondary market.

"Previously these corporates may not have readily found a welcoming in the traditional Eurobond markets, where name recognition was important." Mr Charles adds: "With the creation of a single currency, there is a demand for a broader range of names to provide the sort of yields the investor base is seeking. This is partly because of greater liquidity. But, more importantly, the investor base has had to shift its focus away from currency plays and more towards credit products. Most of the large funds around Europe have been boosting their credit resources rather significantly and can now look at these credit stories that previously would not have accessed the market."

An enormous amount of capital markets activity has been generated by the introduction of the euro this year and it is coming from a number of different areas. First of all, those corporates that were actively using capital markets before were mostly accessing the euro, dollar or localised currency markets, such as the Deutschmark, French franc and so on. Also, if they used any bulk financing or 10-year or longer-dated financing, they would probably look to the Yankee market in the US.

So there has been a substitution of activity by corporates, generally out of dollars and into more active involvement in issuing directly in euros. A single currency seems to have crystallised and clarified the investor base to the point where it has become apparent that there is strong demand for corporate credit stories in general. US corporates as well as euro-zone issuers are becoming more active in the euro market.

This is likely to continue apace given the probable impact of FAS133, the controversial proposal that may require US corporations to mark-to-market through the quarterly profit-and-loss account the value of foreign currency swaps used to hedge borrowings to fund foreign subsidiaries. A number of US multinationals have cited this uncertainty as a reason for funding their EU activities with euro-denominated bonds.

Many of these companies appear to be using the funds to support their large-scale European operations, rather than as a route into dollars. Since the launch of the single currency in January this year, Euroland has become the world's second-largest bond market after the US, with a total market value of $6600bn.

The creation of a single currency means that investors within the euro-zone can no longer aim to increase their returns or hedge their risks through currency shifts. They now have more of their eggs in one euro basket, whether in bonds or equities. The first half of 1999 has been a bonanza for the investment banks in that they are increasing their issuance and, of course, they are raking in significant fee earnings on the back of this high volume of issuance. The volume of new Eurobonds coming into the market continues to rocket, with growth of 43 per cent year-on-year in the second quarter, after rising 32 per cent in the first three months since the launch of EMU (economic and monetary union).

Within this general euphoria, corporate bond issuance was up 2.5 times in the second quarter. Bond issuance by European companies in the first half of the year was estimated to be as big as in the US. In the first quarter alone, euro-denominated corporate bond issuance topped $25bn, compared with close to $30bn for the whole of 1998. The second quarter saw e30bn of issuance in euro-denominated corporate bonds, making up 14.5 per cent of total public and private issuance for the period, compared with e12bn, or 8.3 per cent, for the same period last year.

Roberto Fumagalli, European credit strategist at JP Morgan, says: "There has been an enormous amount of issuance, especially in the corporate sector. We have also seen an increase in the size of deals. The nature of the market has been changing in that it is able to absorb bonds in excess of e1bn in longer maturities of 10 years or so."

One of the more dramatic cases in point this year was Spanish oil and gas company Repsol's landmark eurobond issues to fund its acquisition of YPF, Argentina's largest company. Merrill Lynch, Goldman Sachs, Citicorp and UBS, along with domestic banks BBV and La Caixa, raised a e3.25bn loan for Repsol. The 18-month floating rate note operation was the largest issue of its type by a European company.

Previously Repsol had issued a e1.4bn five-year bond at 3.75 per cent per annum, and this was the largest fixed-income offer by a Spanish company and the benchmark for the corporate fixed-income market in euros for five years. But as Mr Fumagalli points out, the changes are not just a matter of higher volumes. There has also been significant growth in the structure of the market, and this is the result of a financial calculation that is more relevant and is also a phenomenon that most likely is here to stay

. "There has been a sharp increase in mergers and acquisitions in the first half of the year," he says. "This clearly means higher financing needs, especially on the corporate side." The creation of the euro has provided a stimulus to an already accelerating trend of takeovers, mergers and other corporate deals as large corporates seek economies of scale to hold their own on a global commercial stage. Mergers and acquisitions within the euro-zone had already been growing by 25 per cent a year in the five years before EMU to reach $370bn.

Nearly e123bn of corporate mergers and acquisitions are now awaiting clearance at the European Commission. The implications for bond issuance related to this M&A activity is enormous, and promises a continued jamboree for investment bank underwriters. "The bottom line of this process is really that there is less lending," says Mr Fumagalli.

"It has been replaced by other sources of funding and, clearly, bond issuance is one of the prime candidates." Euro-zone bank assets of $9600bn are the highest in the world. But in the current low interest rate environment, banks are seeking to cut corporate lending and move to debt securities. In terms of choice between the loan and bond markets, it is difficult to justify a borrower's preference for the bond market as loans tend to be cheaper than bonds and, in general, they are more flexible.

Loans offer embedded features such as to the ability to close, extend or review the facility. Bond issuance is a big and highly differentiated market in the range of products on offer. But, in general, there is greater flexibility through the loan market. Nevertheless, corporates are going to the bond market for various reasons.

"For one thing, the supply of loans is shrinking. Also, M&A funding needs have been sharply increasing and lending associated with this activity tends to be fairly expensive," says Mr Fumagalli. "Whereas for a normal loan, in general you pay less than for a bond, a lending facility associated with a merger tends to be more expensive than a bond. All the big banks are competing for the same markets, and one of the problems is that we need to guarantee our return on capital.

"What we are seeing is that the commodity part of lending is not allowing us to reach our returns target. Within our normal planning, we are happy to get into lending when it comes bundled with other higher return businesses, typically mergers and acquisitions." Most investment banks are shrinking their syndicated lending business and focusing on bond underwriting and lending in connection with other M&A activities.

UBS stated publicly when it announced its results last March that international lending to non-core clients by its investment banking division, Warburg Dillon Read, would be wound down. Between June 1998 and last December, the bank's loan book was cut from SFr268bn ($177bn) to SFr175bn. The syndicated loan market is not about to vanish from the European financial scene. For one thing, there is still a price advantage for big-ticket borrowers in that, in most cases, the bank loan syndication market has an element of relationship oriented pricing, while the bond markets are generally more expensive.

The banks recognise that by taking part in a syndicated loan they improve their chances of getting any spin-off business and therefore pricing is generally a bit tighter in the syndicated loan market. "There is still a role for relationship banking," says Mr Charles. "There is an element of disintermediation taking place in the market but, at the same time, relationship banking remains a very important facet of any corporate's activity in fundraising."

A prime attraction of the bond market for corporates is the ability to issue in reasonable size and volume beyond what they can obtain in the bank market. This reduces their reliance on relationship banking in which funding generally becomes difficult beyond five years, whereas the bond markets are readily available for most corporate names up to 10 years.

The benefit for issuers in using the capital markets as a whole is that they can get seven-year and 10-year money that is not easily obtainable from their relationship banks. They can also access a broader investor base and diversify their investment. "In previous years, it was very tough to generate strong transactions, although there were investors on a private placement basis for smaller transactions," says Mr Charles.

"However, it was difficult to put together a large liquid transaction in the legacy national currencies. This year has brought more volume in terms of corporate issuance than anybody had imagined. It is a welcome event as the Eurobond markets have been very reliant on the frequent borrower community, such as supranationals, sovereigns and the financial issuers. "The corporates represent a positive diversity for everybody.

I think we will continue to see very strong issuance and very large volumes driven by cross-border M&A activity. "Corporates are realising that Europe is a real alternative to the US capital markets in terms of the depth and presence provided by the euro."

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