IFR Outlook for International DCM Roundtable 2015: Part 2

IFR: That IMF study did point to dramatic increases over 10 years in emerging market issuance in foreign currencies. And that there had been a big increase in the amount of that issuance coming through the bond market rather than the loan market. The big concern was about fund flow reversals out of foreign currency EM, which had the potential to jeopardise the budgets of high current account deficit countries in particular. So you think that that’s been overplayed?

Soren Willemann, Barclays: At a macro level, we’re definitely concerned about that but from the dynamic of the secondary bond market, we’re not as concerned. The first thing you want to look at is what happened in EM FX and aggregate bonds. These have been very steady because retail investors, who in the past had been the loose ends in EM, are not really there any more so from a flow dynamic, we’re much more comfortable with EM these days than we were even two years ago.

IFR: Morven, we’ve seen very strong levels of issuance in the US. Do you think the European/international market and the US domestic bond market have decoupled or have the potential to decouple given the different stages the economies are in the recovery cycle?

Morven Jones, Nomura: I don’t know whether you would call it decoupling. I’ve always thought of European and US markets as being very different with almost two separate pools of money. The US market is, by definition, domestic. US investors will invest in foreign currencies but their main focus is dollars; that’s really what they think about. So it’s not surprising to see the US buoyancy relative to a quieter European market.

US stock prices and credit spreads certainly look elevated. There are lots of share buyback programmes; there’s a lot of M&A. Is it looking too expensive? We can debate that all day long but the reality is that the US has the capacity to absorb billions and billions of dollars of supply. And I would argue that it is certainly a more robust market at the moment than the European market from an issuer perspective. And we know that there is more supply to come.

Away from general refinancing needs, there is something in the region of US$120bn in M&A activity to be financed. Now, at least US$50bn-$60bn of that is the Anheuser-Busch InBev/SAB Miller transaction. But that doesn’t seem to be worrying the market particularly, if you’re looking at it from a macro perspective.

The euro market continues to mature. It’s still a relatively new market that’s had its fair share of challenges economically, in terms of growth and so on. But I don’t think fundamentally that it is difficult to raise money in Europe. I think the market is very deep. We’ve seen a very strong and healthy corporate bond market. But I would say that it’s not yet at the depth or the level of efficiency that we’ve seen in the US.

Soren Willemann, Barclays: In a meeting with a US fund recently, they commented that the US debt market is a grown-up market in that even if there’s volatility, issuance keeps coming whereas in Europe, if the market moves by a couple of basis points, people say: “let’s not do anything; let’s sit tight”. We are definitely seeing a big change in how investors behave. To Morven’s point about the US dollar and European markets being different markets, I think this year has seen a big change in that.

We’ve seen more and more Europeans investing in the US investment-grade market because spread differences have been so large. That’s been one of the biggest themes: in particular continental European asset managers looking to buy more dollar paper or getting access to US names via reverse Yankee issuance in the euro market.

Fred Zorzi, BNP Paribas: I’ve got a slightly different view. I think everybody’s getting a bit too casual. Yes the US market is a massive market. It’s an adult market. The euro market will not be as the US market for a long time. On that we all agree.

But we should not forget that five of the biggest deals ever done in the US market have been this year. Towards the end of the year, some of the big financings have become difficult; Morven mentioned some big M&A in the pipeline. Everybody’s very casual; some investors say there is a price for everything but what happens in a market where liquidity is very, very thin?

The same investor was telling me that second inventory has moved from US$50bn on the Street to US$3bn. Some investors tell me that liquidity in the US away from the mainstream names is worse than in Europe. What will happen when one of the big deals fails? There is a sense that we have had it almost too good.

Some investors are becoming more aware and more concerned about big supply, especially in a market where uncertainty around rates is important and where more and more investors are starting to look at alternative investments away from high-grade, such as infrastructure or direct lending. We should not be too casual and take things for granted,

IFR: Liquidity has been a huge talking point all year. We’ve heard howls of complaint from the buy side for reasons, which I think have been quite clear: lack of dealer inventory; constrained market-making; investors holding all the paper and not wanting to sell etc.

Ashish, perhaps changing the focus of the conversation a little, on this point of after-market liquidity or secondary market liquidity more broadly, to what extent is it really as bad as everyone says? And what do you think the impact is? Does it change the nature of the way you do business.

Ashish Dafria, Aviva Investors: It does. I know we talk about it a lot but the reason we talk about it a lot is because it is quite impactful. And we see it on both sides of the trade. To Fred’s point, what happens when something goes wrong and everyone tries to exit? Clearly that’s a concern.

But we see the impact of liquidity on the other side: when you are looking to buy paper, it’s not available in the size you want. To an extent, everyone has similar trades on and the sell-side is much smaller than what the buy side has become. We don’t necessarily have a solution for it, other than to keep it as an active factor in our investment thinking.

It has moved us more in the direction of being longer-term investors, so really knowing what we own and really knowing what we buy, which speaks to the value of underlying fundamental credit analysis. Anything you buy now you buy with the mentality that you own it until it matures because the chances are when you want to sell you won’t be able to.

IFR: What does that do to the notion of price discovery? The liquidity premium has always been part of the overall new-issue premium.

Ashish Dafria, Aviva Investors: There are clearly some tensions, even within investment firms. Just on our own side, there are tensions on the one hand between the abundance of liquidity from the perspective of the funds that we need to invest and on the other hand, the lack of liquidity in terms of being able to trade positions that you have. And there’s a balance.

Very high inflows, very high levels of cash and liquidity almost force you to have smaller new-issue premiums and forego the ideal liquidity premium that you would want. But on the other hand, you have to be cognisant that there is no secondary liquidity.

IFR: Does that skew the market?

Soren Willemann, Barclays: Yes, absolutely. As a market maker, liquidity is close to our heart. In the case of big names where suddenly there is bad news and people want to sell their bonds, having liquidity is wishful thinking. If there is bad news, there are no buyers at any price. Dealers are not particularly altruistic in that sense; we won’t buy things at a price that’s not the real price. It doesn’t matter how big our balances are.

But the balance sheet capacities of dealers today – ourselves included – have been constrained. So internally, we tend to be very disciplined with our balance sheet. US$1bn of capacity these days is not what it was, say, five years ago. We have to be much more diligent with how we trade, and the positions we keep ourselves in and push our traders to keep shifting that inventory around. That’s one aspect.

We also see a lot of changes in behaviour from investor, who are basically doing two things. First of all, they have much larger cash balances so they can meet redemptions without having to sell. As a consequence, to be flat with their benchmarks they need to buy higher-yielding paper, which drives demand for corporate hybrids and the like. If you have 5% more cash than you had historically, you’ve got to have some higher Beta paper in your book. That’s one thing we’re seeing happening more and more. Bigger cash balances.

The other thing we’re seeing is increased use of credit derivatives. Of course, back in 2004-06, we saw an increased use because people wanted yield. These days, people use derivatives because they want liquidity.

I was talking to someone recently who in turn had been talking to a family office that wanted to give them €200m and they told them if they couldn’t trade CDS or options with them they didn’t want their money because they didn’t think they could do very well. They said: “we can buy bonds and we can sit on them but you can get other people to do that. If you want your money here, you’ve got to allow us to trade derivatives to manage your money appropriately”.

This is not just anecdotal; it shows up very clear in the data. If you look at, say the iTraxx crossover or high-yield CDS, the change week-on-week in how people are positioning in that index correlates extremely well with fund flows in high-yield. So this is not just a marginal thing; it’s a big deal that drives flows in the market.

IFR: In terms of the syndication process, Fred, and keeping in mind this issue of liquidity and price discovery and the extent to which the mark you have on your screen is a real price or a phantom price or whatever, syndicate managers still push out price whispers, price talk and you tighten talk etc. In light of the way the new-issue market has evolved, do you think this will stop at some point because it means less?

Fred Zorzi, BNP Paribas: It’s a very good question. First of all, I don’t like the term ‘new-issue premium’ because that implies that the secondary market is an invalid reference but yes you can have positive premium or a negative premium, as happened with SNAM [in early November]. But what does that mean? Does it mean that the market is red hot or does it mean that the secondary market was mis-priced? Similarly, with Hammerson in sterling, the deal tightened by 20bp.

We need to be careful with these notions. In some markets, volatility needs a premium. Perhaps I shouldn’t say but this has on occasions been a very lazy way for some people on the buy-side to generate Alpha.

Having less liquidity is not necessarily an evil; it means people need to be disciplined and more selective. Having fewer ‘passengers’ in the new-issue book will force the real accounts to do their homework, and the bonds will be better placed. There will be less volatility and trading will slowly improve because it will be easier to manage the flow.

Referring to one interesting fact, everybody has been taking about VW. When [the scandal broke] the senior debt senior widened a lot more than the hybrids when in a stressed situation the logic would have been for the hybrids to have widened more.

There are several explanations for that. One of my guesses is that a lot of investment in the hybrid, as per the EM story, came from true credit buyers with a stronger view on the credit compared to rates funds, for example, who were buying VW as a proxy for Germany. The question for those guys is: do you really get paid at less than 1% at five years for the risk you’re taking?

For me, this issue of liquidity instils discipline and it’s not necessarily negative for the market. On the contrary, I think that it can be positive to bring better discipline into this market long-term.

Morven Jones, Nomura: The other point to add, vis-a-vis levels of subscription and liquidity in the primary market, is how much have they really contracted? Just because you’ve got an order book which is three times, four times, five times subscribed, it doesn’t mean to say that the investors that have put in those orders really want all the bonds they’ve asked for.

What it means is that they’re anxious about whether they really get their right allocation. And so there is this tendency sometimes to put in very big orders. When you have a market where there is maybe not that level of frothy behaviour, then of course, orders are maybe a bit more conservative. But at the same time, the amount of liquidity that’s truly available, or that people really want to commit might not be that much smaller.

Fred Zorzi, BNP Paribas: Going back to your question and what this means for syndicate, the way I see it; it puts more ownership on the banks, on the bookrunners. I think a lot of banks have been lazy in the past, in terms of the way they allocate bonds, trying to please every investor in the book and saying: “we’ll deal with it in the secondary market”.

This puts more ownership on the banks to do their homework and know their accounts. When you have a drive-by issue with 350 accounts, it cannot be that 350 accounts are keen to buy paper at this time. The job of the bank is to make the difference, to make sure that the bonds are well allocated because no-one can rely on secondary trading to make sure that the issue will perform.

And as we all know, volatility and momentum are key. A couple of bad transactions, and suddenly the new-issue market shuts down so in that sense the banks have a lot more responsibility in the way they allocate the books.

IFR: I’m keen to bring you in on this question, Ashish. The banks say they go to great lengths to distinguish between natural holders and flippers. Your fund managers inhabit this world of inflated orders. There needs to be a natural tension out there but is there anything the buy-side can do or needs to do in terms of making the picture better understood by the sell-side?

Ashish Dafria, Aviva Investors: There is, as you say, clearly a natural tension but there are very clear synergies or partnerships between the two as well. To Fred’s point, it’s in the interest of the buy-side in general that the issues that we buy perform well and are priced appropriately for the risk. I do think we need a stronger dialogue between buy side and sell side around how the allocation happens and where the real interest is, given where it gets placed is mutually beneficial.

As Fred said, there is a bigger responsibility the banks need to own; but it is probably also true there is a higher responsibility that the buy-side in general needs to own, which is if you’re buying an issue, you’ll be a long-term holder of that issue as opposed to be a flipper.