UK Bond Market 2010: Part II

IFR: Before we move on from Gilts, I just wanted to talk a bit about the syndicated Gilts programme, specifically the transferability of that issuing format to other borrowers. We have seen significant demand for syndicated Gilts. Might that offer an opportunity for SSA borrowers to issue in size under this format?

Robin Stoole, Lloyds Banking Group:I think the shift in the DMO’s issuance tactics to the large syndicated issues has been extremely well received by the markets. I think it’s perceived to be more transparent and I think it’s added a degree of order to the process, which potentially I think SSAs could look to take advantage of.

Via the process, I think it will be clear if there is at any particular time excess demand that hasn’t been mopped up, and the SSAs could potentially look to take advantage of in a relatively short order in much the same way as they did with the traditional auction processes, prior to these syndicated deals being done.

Myles Clarke: What the syndication mechanism allowed them to do was engage the investor base, which doesn’t happen when you do auctions, particularly in the linker market where they rely heavily on the GEMMS to step up on the day, take down the transaction, and then the investors have the option within the next few days of whether they want to buy or not.

That is easier to do at the shorter end, but with such a dramatic increase in their programme, the execution risk of relying on your GEMMS to always step up and take down the risk is not realistic, particularly at a time where balance sheets are constrained. So what it does is it engages investors from the outset, and allows them to have that direct dialogue.

And investors like it because they have a lot more notification on when these transactions are going to take place, and for them to get size done, it’s an easier way to get access to liquidity in a primary new-issue transaction, as opposed to always relying on the secondary desks. So it’s the engagement factor for me that works, which hasn’t always worked for the other issuers, because they’re looking at the arbitrage. And while the DMO always wants to get the best rates, that’s not the same thing as arbitrage. So you’d like to think that that engagement process works for everyone, but it’s just not necessarily transferable if people don’t want to be involved.

Thomas Schroder: Most of our sterling issuance is done on a reverse inquiry tap basis. When we start a new line, we quite often use a book-building procedure, but there are limits to what we can accept as a price taker. When we issue we have to control pricing, so we refrain from doing auctions.

Samantha Pitt: Pretty much all of our issuance in sterling is done on a syndicated basis apart from when we’ve done some taps of the inflation-linked bonds that have been done on reverse inquiry. But we wouldn’t do the large volumes that the DMO does because our funding requirements aren’t that great. And if we raised all of our funding in one bond, we get cash management issues and the cost of carry on the cash.

IFR: I’m aware the EIB does £50m and £100m taps as the most frequent sort of size, but what if the EIB and others larger issuers were able to do with £500m or £1bn trades without it being detrimental to your all-in cost effectiveness? I’m still not quite clear as to whether or not the market would be able to take that. It seems to me there’s no reason why a market-maker couldn’t take a position and hedge it, as may be the case with other deals in other currencies. Not all deals are sold at the outset are they? Often there is some residual, which can be hedged and sold at a later stage. In fact, some deals are almost marketed on the basis of that, which appeals to ongoing retail demand. But the economics just don’t stack up, I assume.

Frazer Ross: I think the supra/sovereign complex in sterling demands a very specific type of execution. As Thomas and others have mentioned, quite often, they’ll open up a line, but then it really comes down to a very good interaction with the banks in terms of the swap desk, your syndicate desk and your traders. So quite often, deals are taken down, where there’s a basis point, half a basis point in it. Thomas is very transparent in terms of levels, so we’re sitting there literally every couple of hours seeing when the secondary market lines up with the levels. And then if it works, we’re prepared to take the risk and we take it down.

Because it’s such a fine margin, because the EIB has very specific targets, I don’t think the market can continually bear larger lines because the banks do take a lot of risk. Even a £100m deal can take three or four days to settle down. If you’re making a basis point, the hedges cost the profitability. So then you’re basically doing a flat trade. We can all have business reasons for doing that, but most of us are here in the business of making money, and so we need to make sure that we manage our risk profitably, and these deals are very, very finely priced.

IFR: The other area I think is quite interesting is longer-dated issuance. We saw RFF come out with a 50-year deal in March, for example, which has already been tapped a couple of times. Is there room for non-sovereign ultra long-dated supply?

Thomas Schroder: We issued a 50-year back in 2004, which we have tapped over the years, but that was an exception. We try to get a decent maturity match between our borrowing and our lending so if our lending is, say, in the 10-year area, we try to borrow close to that. So this year for example, we’ve done an average life of seven and a half years. We don’t have a genuine need to raise 50-year funds.

Samantha Pitt: Well, we’ve only got the government guarantee to 2052. Actually, we have issued a lot of long-dated debt and sterling inflation linked debt. You could argue our assets are long life, why don’t we asset liability match? We target more of an average duration of our debt. So in fact, we’ve got a lot of long-dated debt. We keep the longer-dated for the inflation-linked and the nominal issuance is likely to be at the shorter end.

Robin Stoole: For corporates or for non-SSA type borrowers, the ultra-long market is not particularly consistent. The universe of buyers is somewhat limited, but when it has been tried, the response has typically surprised to the upside. Clearly it’s a relatively narrower universe of buyers, certainly narrower than sub-30 years. But nevertheless, you can get good things done. Rabobank sold a £300m 50-year in early August, while GE’s £450m 37-year of 2003 and Tesco’s 50-year in 2007 both saw good demand, particularly the latter. Tesco could have printed larger than the £500m they did. But it is a specialist product. There is demand out there, it’s chunky and blocky, but as an ALM tool for some investors, it’s quite important.

Frazer Ross: Following up on Robin’s point, you’re literally talking about a handful of investors who drive these transactions and we all know who they are. Without those investors coming in, there’s no broad base. So you’re going to get the usual three to five guys, and then hopefully you get some follow-on. The Tesco transaction is one of very few corporates that’s been out there that long; there’s UPS as well. But frankly on the corporate side, you just don’t have people who need debt of that maturity. Tesco and Telecom Italia (which sold a €850m 50-year in 2005) basically look at this as equity. It’s somebody else’s problem to repay it in 50 years time, but it’s equity. Not many corporates look at it that way, so there’s a very small investor universe for 50-year debt.

Myles Clarke: I agree. It’s not a demand problem; it’s more of a supply problem, getting people to do the trades. At a reasonable price, the execution is very good. Blue chip names from the US would execute incredibly well, but they can issue very successfully in the domestic market. So, the reason you don’t see more trades, it’s not a demand problem it’s a supply problem.

Robin Stoole: Given where we are right now with massively depressed yields, it will be an interesting one to keep an eye on. There is definitely a bid for yield. Typically, people look down the credit spectrum rather than longer out the curve, but it was interesting to see on the one hand, IBM printing three-year money at 1% in the US and Norfolk Southern seeing US$400m of demand for the US$100m tap to its 100-year bond at a yield of 5.95%. So demand exceeds expectations for 100-year paper.

IFR: Along similar lines, Scottish and Southern Energy came out with a dual-tranche £750m/€500m corporate hybrid and a lot of issuers have entered the hybrid pipeline. I guess a lot of the things that have been said about long-dated issuance apply to hybrids. What do the panel think about prospects for corporate hybrid issuance in sterling?

Frazer Ross: If you look at the hybrid market in Europe, there have been 15-17 corporate hybrids since the market kicked off in 2005, plus a couple in sterling. I think you’re probably going to see up to 10 deals come at the back-end of this year, so put it into context: 15 or so deals in roughly five years and 10 in just three months. And there’s huge demand. What we were just talking about on the Tesco long-dated bond, that they view 50-year fixed-income as equity, well Scottish and Southern is getting equity credit at an all-in cost of 5.6% per annum pre-tax against a rights issue at something like 8%, 9%, 10%. It’s a fantastic product for all corporates. That’s why you’re going to see a huge amount of supply in the next few months.

On the demand side, what do you want to buy? Scottish and Southern five-year fixed rate at 2.5% or do you want to take a view that I’ll go further down the capital structure and I’ll get 5.6% when I’m struggling for any yield in my portfolio. To me, it’s a complete no-brainer. So both from a supply perspective and a demand perspective, I think it’s going to prove to be a very viable product.

Georg Grodzki: I think it’s worth remembering that the corporate hybrid product was declared dead in the water not too long ago. It suffered more volatility than other corporate product in the very dark days of 2008, early 2009, and at that time it was condemned as one of those flawed innovations of the heyday of credit in the earlier part of the last decade.

Hybrids have seen a remarkable turnaround. We always felt that investment-grade corporates with a decent business profile – and we’re talking about utilities here – should be eligible for non-senior debt product, and we’ve not been disappointed by the recovery that hybrids have experienced. It is well deserved and justified for new products to come to the market, but I just feel a little bit wary that the search for yield, which is becoming painful for many investors, is potentially luring them into corners of the market that they don’t really rain-check.

Long-dated corporate credit product of a non-senior nature is potentially a poison chalice because if there is a little bit of spread widening even if it is a utility which is issuing it, you can suffer a hell of a mark-to-market loss. You should look at the price charts going back three or four years for some of the euro-denominated hybrids. So let’s sort of go into this with a very open mind and a well preserved medium-term memory.

And the other point I can’t help making is we’re seeing the return of corporate hybrids at a time when it’s becoming clearer by the day that bank hybrids don’t have any future whatsoever because the features now being imposed by the regulators should make them completely unappealing. But the search for yield can do wonders, which will probably help the non-bank hybrid market fall back on its feet. So right now, we’re happy to play but be mindful of the mark-to-market downside at some point in the future.

Frazer Ross: I agree with the back half of the comment; as for the front half, I guess that comes down to the fact that the buy side and sell-side approach these things from a different angle. But if you look at 2005-2006, when we came up with this product, the question was how do you price it? It’s notable how the world has changed in those five years. We said there’s a Tier One product out there for banks; banks are great, they’re Double A, they’re regulated, they’re safe – so better than a Dong, a Vattenfall or a Siemens, so let’s look at the subordination risk, let’s look at the price risk.

The banks and investors agreed that there’s more risk on a corporate hybrid than on a bank hybrid. Well we know what happened: three years later, bank hybrids were trading at 20, 30, 40 cents in the dollar and some didn’t pay.

Corporates went down to 75, 80. They’ve all recovered and are all trading above par. In terms of price risk vis-à-vis the banks, it was substantially better. By-and-large, the market’s intact and price risk was lower. But I think what is more curious is how the world has changed. We all felt banks were the better risk. With hindsight, it was the other way around. I think you’re going to see the corporate hybrid market double in six months.

Steven Major: I’m not sure 5% area is enough return for me, I think it should more likely be 10%. I think the return expectation for this kind of risk is going to be much higher than 5%.

Robin Stoole: I think that with the vast amount of regulatory uncertainty, it is highly unclear what the future is for certain capital issuances going forward. It’s just not clear. No-one has the answers. Lloyds was in the US market yesterday with a Lower Tier 2 bullet, so at the relatively straightforward end of the spectrum, and there were lots of questions around the implications of Basel 3, grandfathering, etc. And we dealt with those as best we could in the context of what’s currently known, and the consultations that are going on.

So that’s the obscure bit. One thing I would say is I have been surprised just how short the market’s memory is. It’s all very well saying these things fell off a cliff a while ago, we’re extremely volatile, etc. But while the market hasn’t forgotten what happened over the last two and a half years, it is choosing to ignore it right now. So, as things become clearer, it wouldn’t surprise me if this stuff did come back in full effect.

IFR: I wanted to move into the area of conventional credit issuance. Has the sterling issuance we’ve seen this year and last performed? Have corporate credits followed the contraction in Gilt yields?

Sam Hill: Well, total returns have been strong, yes, because on top of the return from the government part of the yield that’s embodied in the corporate bond yield, spreads have also tightened as well during 2010, so total returns have been strong. I would support the comments that have been made about being slightly cautious about the hunt for yield. Remember what you’re buying into and what you need to be compensated for.

From my perspective, the starting point is to go back to this theme over the course of the next year. It’s unlikely that the 10-year Gilt yield will compensate you even for inflation. And by extension, some of the other spread products also warrant a similar level of caution in terms of valuation risk.

IFR: I wanted to talk about the proposal the Treasury unveiled last January to deepen the UK bond market. Part of its thinking around this was creating a channel to disintermediate the banks; UK companies still look predominantly to the syndicated loan market for funding, and competition between bonds and loans hasn’t emerged. There is a very small universe of UK companies accessing the bond market. Now that banks are more risk averse and not necessarily that keen to lend to the companies they used to lend to, might we see more companies in the UK issuing bonds?

Robin Stoole: One of the issues is that liquidity was so freely available in the bank market in Europe for a considerable period of time until things got tricky towards the back end of 2007. As a result, most treasurers didn’t think about accessing the public term debt markets. It just wasn’t on the agenda because they had ample liquidity elsewhere, and on a relative basis it looked expensive. So why go through all the hassle?

Since the financial crisis really started to bite, since liquidity began meaningfully contracting in the bank market, we have seen an increase in borrowers that have never been to the public markets before. It struck me as quite ironic – because they arguably had a hand in the financial crisis – that the rating agencies have probably never been so busy in Europe because there are so many issuers looking to access the public debt markets. Part of that process is often to have a credit rating.

So I think the process has happened, I think that despite the fact that conditions have eased somewhat in the bank market. it was such a chastening experience for a lot of borrowers. The need to diversify has hit home, so even if they could access the bank markets, having all their financing in the one basket doesn’t make sense any more, and therefore diversifying their source of funding makes a lot of sense. There are examples: G4S is one that comes to mind; as is Motability. So it’s happening but it’s a slow process, particularly as the bank market recovers.

Click here for Part Three of the Roundtable.