After dropping by a third this year, the bond market is gradually picking up again - but progress is slow. Jules Stewart reports.
Debt syndicate desks will be watching anxiously over the next few weeks and hoping that the recent rally in the bond market will continue into 2003. Nobody is looking for a banner year in terms of issuance, given the current level of investor resistance due to fears of credit deterioration - the main factor behind this year's 30% drop in the market compared with 2001. Many investors took a highly conservative funding position, going into sovereign bonds and cash-type instruments rather than the riskier end of the corporate sector. It is worth bearing in mind that the market is gradually recovering from one of the worst crises in recent years. Even during the calamitous days of the Tequila or Russia crises, the markets managed to rebound quickly. This time it has taken a lot longer, and the end is not yet in sight.
First signs of recovery
But signs of recovery have begun to emerge in the run up to the New Year. Given US investors' higher level of sophistication, it is unsurprising that the first indications of a turnaround have emerged in the US. "The recovery is being led by the US," says Tom Ineke, executive director fixed income syndicate at UBS Warburg. "The non-government bond market surged over the past month and the supply was easily taken up by investors. We've seen a few issuers at the long end in the sterling market as well."
Historically the US markets have proved themselves able to open very quickly after a period of sharp volatility, while in Europe confidence building tends to require more time. Hence, US issuance levels have recently outweighed those in Europe by more than three to one in the last few weeks of recovery, largely because of US investors' deeper understanding of the credit market. In Europe, however, with the advent of the single currency, the investor base has become focused far more on credit than on currency, and strategists believe it is only a matter of time until European issuance matches the US market.
Strategists are looking for slightly higher issuance volumes and only slightly lower spreads in the dollar and euro markets next year, as volatility is likely to remain around the current level, which is still above average. Willem Sels, investment grade strategist at Goldman Sachs, points out that bond market volatility is linked to volatility in the equity market.
"As the latter has come down dramatically in recent weeks it has opened a window of opportunity for debt issuance," he says. "However, in an environment of subdued economic growth, CFOs and CEOs are not tempted to invest in infrastructure or get involved in M&A activity. Lacking the need to invest in fixed assets - and in the US capacity utilisation is at a 15-year low - there is no pressure to issue in the bond market. Also, there is pressure to borrow less, with rating agencies skewed to negative outlooks and putting companies on watch." For next year, says Mr Sels, a lot will depend on how the global political situation unfolds and the level of economic uncertainty.
The potential for military conflict in Iraq and continued economic uncertainty are two major factors that will weigh heavily on the performance of the bond market in the coming months. "The big question mark about issuance next year is the effect of the potential Iraq conflict," says Martin Egan, global head of debt syndicate at BNP Paribas. "That is very much in people's minds, especially in terms of the first quarter." The market prices in certain scenarios to an extent, such as the Iraq crisis. While it is impossible to predict how a war situation would turn out, most strategists believe some level of military action has already been discounted for next year.
Constructive year predicted
Despite this dark cloud hanging over the market, Mr Egan is looking for a more constructive year in 2003. "In global markets across the board, we will see more supply from governments," he says. "Some are using the syndicated bond market but in countries like the UK you will see larger funding needs next year. Therefore we will see pretty strong numbers in the high quality end of the market. For corporates, there are big refinancings next year, as there are heavy redemptions in dollars and euros upcoming. We will see more utilities in the market and a consistent supply from telecoms, which will be predominantly refinancing. We would also expect an industrial supply from some rarer names."
On the economic outlook - the other big variable that is likely to determine levels of issuance next year - Mr Egan is optimistic that in the current low rate environment, particularly if this is favoured by some growth in the US economy and in Europe, bond issuance could reach acceptable levels. "The market wants diversification," he says. "All investors follow the indices very closely and they are heavily weighted to autos and telecoms, so any name with a solid credit story to tell is going to receive good execution from the markets. A lot of issuers are looking to obtain credit ratings for the first time and this will help the market to develop.
"Last year there was very strong growth in triple B names, although this year has been tougher because of the credit climate. In the longer term that market will continue to grow, not so much single A credits that have been downgraded, but real first-time triple B issuers. Investors want yield and diversification. The market will be very attractive for debut names and first time issuers, particularly if they are from industries that are rarer in the market, such as retail or industrials like chemicals."
But even names that have been considered relatively defensive plays, such as Ford and GM, have suffered from internal problems as well as the economic downturn. Analysts believe that these firms will be trying to do as much securitisation as they can get away with, given the expense of issuing straight vanilla bonds. The European auto industry has seen its fair share of problems, notably Fiat and DaimlerChrysler, which are also expected to look for other sources of financing, either from banks or securitisation. Ford and General Motors have already announced lower needs for unsecured debt and are looking at the asset-backed securitisation (ABS) market.
The appearance of newer names is a trend that has already become visible, taking into account the volumes of issuance from traditional borrower sectors such as autos and telecoms, which historically account for at least half of the euro market. In the year to date, these sectors were down 42% and 68% respectively.
Some industries active
On the other hand, the market has seen a surge of activity from "opportunistic" industries, such as pharmaceuticals and chemicals (+33%) and pulp and paper (+452%), as of November.
"As we continue to move away from this extraordinary period of post-bubble refinancing, supply becomes much more a function of opportunity rather than necessity, in contrast to recent years," says Alison Miller, credit strategist at Dresdner Kleinwort Wasserstein. "As a result, our 2003 forecast for euro corporate supply is E90bn-E100bn, in line or slightly lower than levels for the current year. This may sound uneventful, but in a world where supply grew by 63% year-on-year in 2001 and fell 45% in 2002, no change in 2003 actually represents an event. Issuance is also likely to be in the form of smaller size deals from less-frequent issuers across a wider diversification of sectors."
She points out that the drivers for corporate bond supply are primarily refinancing, investment and capital structure considerations. In 2001, the peak of euro-denominated corporate bond issuance, the main driver of growth, was refinancing of existing debt, particularly that of short-term debt into long-term. Now issuance will be increasingly driven more by opportunity or as a result of fresh financing needs, a trend already in place in 2002, she says.
Financing to stay low
However - as was the case this year - fresh financing needs as a result of increased corporate investment spending will remain low in 2003, given that companies are still recovering from the debt-financed investment boom of the late 1990s. The new exceptions that might help lift M&A slightly from the doldrums could include sectors such as utilities, tobacco, retail and consumer goods. As for capital structure considerations, the weighted average cost of capital has been increasing for corporates due primarily to the fall in equity valuations.
However, most European corporates are facing lower debt funding costs despite wider spreads, as a result of lower government yields and the ability to enter swap transactions.
"Higher-rated corporates could be tempted to swap equity for debt, but for the lower-rated sector the focus is likely to remain on debt reduction and further balance sheet strengthening," says Ms Miller. "The presence of very low inflation will also act as a further restraint to voluntary re-leverage. New names will continue to enter the market, as European corporates seek diversification of their funding base and reduce their reliance on bank financing."
So nobody is under any delusions about sailing smoothly through 2003 on the back of a US-led economic recovery. In an environment of subdued economic growth, it will be a struggle to persuade CFOs and CEOs to fund themselves for investment in infrastructure or to get involved in M&A activity.
In some issuer countries, notably Germany, the crisis that has hit the financial institutions sector will play nicely into the hands of the bond market. With German banks fallen on hard times, most players can no longer afford to lend. German corporates that do not tend to issue and that are highly dependent on bank loans will find this source of funding less accessible and could find themselves having to turn to the bond market.
Boost to German bonds?
On the other hand, it might also provide an opportunity to boost Germany's underdeveloped debt market. Historically the big corporate issuers in Europe have been in the UK and France, with little coming out of Germany. Next year could see Germany forced to catch up in terms of issuance volume, which would boost the overall European bond market.
In terms of fees and execution, Europe still has large numbers of players competing for deals compared with the handful of traditional bulge bracket institutions in the US market. "I think there are stronger demands than ever in Europe for investor education," says Mr Egan of BNP Paribas. "In the corporate deals we've done this year perhaps as much as 80% have been roadshowed. You rarely roadshow a domestic deal in the US. In Europe people want to become more familiar with credits, hence execution has become a lot more important this year with the highly volatile markets. The lesson going into next year is that if there is a window of opportunity one must react quickly. People will be far more focused on the execution of deals and the best way to get a deal done. A lot of deals this year were postponed or cancelled, so this puts the focus on best execution."
UBS Warburg's Mr Ineke highlights the fact that 2002 was a year in which many investors and banks learned the hard way the necessity to do more due diligence and analysis on credits to avoid a repeat of past crises. "This has been evident in the third quarter, with blue chips and some triple B credits coming back and finding good demand," he says. "We would expect to continue to see investor confidence return to the market next year. Barring unexpected events, the market looks set to remain on its recovery path."