The Evolving Bond Market

Floating a new bond issue is easy now, but changes taking place in the debt capital markets could make it much harder for some issuers in the years ahead.
Randy Myers

For the last few years, raising capital in the corporate debt market has been about as hard as raising the push-button top on a luxury convertible. With Treasury bond yields at extraordinary lows, corporations sold nearly $4 trillion of new debt globally to yield-hungry investors last year, according to data compiled by Bloomberg, smashing the previous record of $3.89 trillion set in 2009.

Still, CFOs shouldn’t be complacent. It isn’t just that the appetite for corporate bonds will surely dwindle once the economy improves and the Federal Reserve decides it’s okay for Treasuries to return more than the value of a jelly-of-the-month-club subscription. The corporate debt market itself is evolving in ways that could challenge issuers when economic conditions normalize.

Some of the changes are readily discernible: a retrenchment from the business by some banks, including UBS, and the push by some broker-dealers and big investors to launch electronic bond-trading platforms. But other changes are less obvious, masked by the huge demand for corporate debt that has made it easy for companies of almost any size or credit quality to come to market. It may not be long before the market for debt looks very different — and much less friendly — than it does today.

A Market’s Evolution
To understand how the corporate debt market has evolved over just the past 5 or 10 years, it helps to go all the way back to what it looked like prior to the 1980s. Then, banks routinely premarketed new bond issues to investors over periods of days or weeks, setting pricing based on the order book they assembled from investors. That changed after shelf registrations debuted in 1982, allowing issuers to access the market on short notice and shrinking the opportunity for premarketing. For the next two decades, banks took on much of the pricing risk in new bond issues, essentially buying the bonds themselves and then selling them to investors.

All that changed again after 1999, when Congress repealed the Glass-Steagall Act barring commercial banks from underwriting. Soon, corporations began funneling an increasing share of their debt deals to the banks participating in their credit facilities. With the business spread out among so many competitors, banks soon stopped buying deals themselves and returned to premarketing.

Reuben Daniels, a former investment banker and co-founder of capital-markets consultancy EA Markets, says this latest business model has reduced banks’ incentive to work on smaller, more complex deals, by prompting them to focus on larger, more “regular way” transactions. “Today we have syndicates of 10 book-running managers all sharing the fees on a single transaction,” he explains. “The allocation is not driven by the quality of the bank’s intellectual capital or its distribution capacity, but by how much it lends to the company. So what used to be an opportunity to win business because one firm was better than another has turned into a marketplace where everyone wins — or everyone loses.”

Adelphi University finance professor Robert Goldberg sees another problem with the current setup, arguing that it has inflated the yields corporate issuers are having to pay on new bond offerings. (See “Are You Paying Too Much?” at the end of this article.)

Even if Daniels and Goldberg are right — and bankers, not surprisingly, contend that they continue to compete fiercely to win clients and provide them with great service — something else has changed since the 2008 credit crisis. Simply put, banks have found it increasingly difficult to make money trading bonds and, with tougher capital reserve requirements now in place, more expensive to keep bond inventory on their shelves. In a report last September, institutional investor BlackRock noted that dealer inventories of corporate bonds had fallen 79% from a high of $286 billion in late 2007. Three months later, research and advisory firm TABB Group reported that banks had collectively booked fixed-income losses of $8 billion since early 2008.

True, none of this is affecting corporate issuers much right now, as investor demand for yield has kept the new-issuance pipeline running at full spigot. But Will Rhode, director of fixed-income research at TABB Group, warns that the pre-2008 bond-underwriting model was dependent on banks’ having the appetite and capacity to warehouse enormous amounts of inventory that could be drawn on when necessary. Now, he says, “questions are being raised about how this market is going to function if we don’t have dealers operating warehouse businesses.” Those concerns are being amplified by the impending implementation of the Dodd-Frank Act's Volcker Rule against proprietary trading by banks.

“I’m a little bit concerned,” concedes David Tiberii, portfolio manager for investment-grade corporate bond portfolios at investment manager T. Rowe Price & Associates. “Broker-dealers used to be the cushion that absorbed the flows; they would short bonds to investors who wanted a particular issue or issuer, take bonds into inventory when you wanted to sell, and then try to equalize their positions with other clients. Now broker-dealers are a very small part of the market and can’t be the cushion they were prior to the financial crisis.”

Liquidity Concerns
Institutional investors are particularly worried about the liquidity risks they’ll face when interest rates start rising again — the risk, in other words, that they will be stuck with huge inventories of discounted bonds they can’t unload. One way to mitigate that risk is to favor the purchase of bigger, more-liquid bond issues. “On the buy side, the bigger players are getting bigger and becoming more dominant, and they want big blocks, generally, if they can get them,” says Ken Volpert, head of the taxable bond group at mutual fund company Vanguard, which manages more than $100 billion in corporate bonds. “If they are going to be allocated only $5 million or $10 million of a deal, they don’t want to participate. The heftier a deal is, the more attractive it becomes.”

Liquidity concerns also are helping to drive renewed interest in electronic trading platforms that offer greater, faster access to other institutional investors. One of the best known is MarketAxess, which debuted in 2000 to provide investors with multidealer pricing but has since expanded its trading network substantially, allowing investor-to-investor trades. It handled $56.8 billion in transactions in the month of January 2013. More recently, BlackRock has been testing its new Aladdin Trading Network, designed to allow other investors to buy and sell bonds directly with each other and with BlackRock. In the banking sector, Goldman Sachs and Credit Suisse have been developing their own electronic trading platforms.

Some industry experts, like former investment banker Jonathan Cunningham, now a principal with Aequitas Advisors, are skeptical that exchanges run by broker-dealers will gain traction. “Almost every brokerage firm has tried to start one, and most have been failures because they can’t get enough volume,” he observes. “As big as some bond issues are, they’re not like equities; they just don’t trade enough to warrant an exchange, and most investors worry they could just get picked off. Besides, the guys who would benefit from an exchange already have access to all the information they need, because the brokerage firms bend over backward to give it to them.”

Independent trading platforms seem to have a brighter future, though, as evidenced by MarketAxess’s staying power. “We probably use MarketAxess the most, and it’s been good for us,” says Tiberii of T. Rowe Price. “It has a large number of broker-dealers on the other side with a large number of clients with information about what they’re putting out on the system, either bids or offers.”

Vanguard, too, has been dipping its toes into the electronic trading market, although Volpert says he isn’t sure that will be a great source of liquidity when market conditions are bad. “If we’re selling [bonds] because [our] shareholders are redeeming, probably Fidelity and T. Rowe Price and PIMCO and everybody else will be selling, too,” he says. “At the extremes, it probably doesn’t help a lot.”

big five bondsWhat It Means for the Future
While the Fed’s current monetary policy has made it easy for corporations to raise debt capital, the longer-term ramifications of the changes taking place in the debt markets could be significant for Corporate America, especially in the small- and midcap arena, says Aequitas’s Cunningham. “CFOs who try to extrapolate today’s market into the future are going to find their expectations misplaced,” he cautions. “It will be far harder to access capital, and require a much greater level of sophistication on their part to make sure their offerings are priced as competitively as they should be.”

Cunningham and others offer these tips for issuers when conditions start to change:

• Try to float bigger, rather than smaller, offerings. “Big investors don’t want to deal in illiquid issues,” says Phillip Widman, senior vice president and CFO of Terex, a global manufacturer based in Westport, Connecticut. Anything under $250 million in today’s market, bankers and investors seem to agree, can be a hard sell. That said, don’t give up if you can’t afford to take on that much new debt. Despite investors’ aversion to small deals, “it’s always nice to add new names and get more diversification in your portfolio,” Volpert notes. “From that standpoint, the new or smaller issuer has a little advantage.” Still, he suggests, companies considering several smaller deals might try to do one big one instead.

• Line up multiple potential sources of capital, including banks, institutional investors, and insurance companies, using as many financing vehicles as possible, including private placements, securitized financings, and asset-based borrowing. Daniels notes that many investors are indifferent to whether they’re buying a private placement of debt or a public offering. And Peter Burger, head of debt syndicate for the Americas at UK-based bank HSBC, observes that smaller issuers should have more opportunities to sell floating-rate debt once interest rates finally start rising.

• Vet your bankers. “Make sure they are people you have relationships with and trust, and who have distribution capabilities and execution capabilities in the sectors of the market that might be able to provide you with capital,” says one New York–based investment banker. Widman agrees. “There are folks out there who will try to get your business but don’t know your company and haven’t lived through tough times with it,” he says. “We have found that dealing with people who know us and have credible relationships with us has helped.”

• Talk to the investor community. T. Rowe Price’s Tiberii advocates more dialogue between C-suite executives and large investors, including equity investors. “We use our equity analysts quite a bit to understand smaller, relatively unknown companies coming to the corporate bond market,” he says.

Mark Wilten, vice president of finance and treasurer at utility company PPL, says his company is already focused on doing more outreach to fixed-income investors. “I know it resonates with them, and that they are keen to see us do this,” he says. “It’s the responsibility of the issuer to make sure the fixed-income universe understands what their business is all about, and to understand the opportunities and risks residing in the business that may impact the credit judgments of those investors. That will give the issuer the best opportunity to have a lower-cost transaction.”

• Disclose your funding plans as soon as practically possible. Announcing as far in advance as possible, Volpert says, gives investors a chance to research your company.

• Don’t be afraid to stand your ground. If you’re convinced your paper is worth it, don’t be afraid to hold out for the price you want. “You’ve got to have confidence in your company and in the ability of the market to work through your value,” says Terex’s Widman. “We had several large investors who had held our paper in the past and were clamoring for a higher yield in one of our recent debt offerings. We gave them the courtesy, before closing, of saying we were going at this rate, do you want in or not? And they came in. But we are frequent issuers, and we go to a lot of conferences to keep our story in front of investors.”

Good advice now, and even better advice, it’s safe to say, when the demand for corporate debt starts to slacken.

Randy Myers is a contributing editor of CFO.

Are You Paying Too Much?
A study of yield premiums suggests issuers are paying too much interest.

Bond yields may be near record lows, but Robert Goldberg, a longtime investment banker and now a visiting associate professor of accounting, finance, and economics at Adelphi University, thinks your company may still be paying too much interest on its new issues.

A modest yield premium over comparable debt trading in the secondary market is common; it helps attract investor interest. But what’s modest? Goldberg and Ehud Ronn, a finance professor at the University of Texas at Austin, recently studied new-issue premiums for nearly 1,500 bonds issued by nonfinance companies from 2008 through January 2012. They calculated that the risks associated with buying that debt merited a kicker of 12.9 basis points, on average. But in a paper soon to be published by The Journal of Fixed Income, they report that the actual premium averaged 22.5 basis points.

Goldberg proffers two possible explanations for the discrepancy. One, he says, is the oligopolistic nature of the investment-banking business, in which a handful of banks control the majority of underwriting activity (see “The Big Five in Bonds,” above). “The banks have significant clout with the issuers in terms of getting these transactions, and the issuers in turn rely on the banks for pricing advice,” Goldberg says. “There’s no easy way companies can assess whether the new-issue premium is fair or justified.”

The other possible factor is the relationships that banks have with institutional investors, on which they depend for trading commissions and can theoretically reward by directing new-issue premiums to them.

Bankers like to counter that new-issue pricing is simply a matter of supply and demand, and that some of the very large issues coming to market today can sometimes require higher-than-normal premiums just to find enough investors.

“All true, if we were operating in a truly competitive, open system,” Goldberg counters. “But that would not explain why bonds rally in price immediately after their pricing.”

In a typical offering, Goldberg adds, it’s not uncommon for banks to book orders two to three times larger than the offering. “Is it the case that all those orders would be good at a yield of, say, 5.2%, but all melt away at 5.15% or 5.1%? Probably not,” he says. “Banks spend hours determining the allocation of the bonds before finally releasing the pricing and the final sale list. If you had a truly open, competitive situation, you would have competition for those bonds and you would find the appropriate clearing level. But there is not an open, competitive situation, because there doesn’t have to be one; the underwriting banks can just determine what the final price will be and present that to the issuer.”

Goldberg has long advocated pricing debt through an auction process. He concedes that bankers sometimes tighten premiums in response to strong buyer demand, but says their process simply can’t duplicate an auction’s ability to find the optimal level. — R.M.