Is there no stopping the European corporate bond market? Never before has this sector of fixed income commanded such interest and attention as demand continues to spectacularly outstrip record levels of supply. Take last Tuesday, when Air Liquide’s Eu400m six year bond attracted an order book of Eu7bn in 30 minutes, closing at 8.30am giving Pfizer a clear market to build a book of Eu27bn and £4bn for its Eu7.4bn multi-tranche transaction. Incredible scenes even for a bond market that has already had a fabulous first five months of the year.
Even the corporate bond market’s most ardent followers — and there are quite a few of them who have spent the last 10 years preaching, at times to deaf ears, of the time when European companies would turn their backs on loans for bonds — would agree that these sorts of numbers and book sizes are approaching euphoric proportions.
Of course, the main problem with euphoria is that it usually means a bubble is brewing. And, as we have seen during this decade, financial bubbles have a tendency of bursting and leaving a nasty mess behind that needs a lengthy and costly clearing-up job.
But there is little danger of this happening to the corporate bond market — despite the euphoria this is not a classic bubble like the real estate or dotcom ones. They burst because they were not sustainable — either because they ran out of internal puff or because something external came along and pricked them. The corporate bond boom, meanwhile, looks robust and healthy.
For starters, there is plenty of internal puff left in the corporate bond world. Spreads remain a long way above historical levels whereas in classic bubbles the asset price is generally trading a long way under its long term average.
Another key point is that deal supply shows no sign of slowing down, not least because chief financial officers and treasurers will have little choice but to tap the securities market for their financing (and refinancing) needs. While the loan market is gradually regaining confidence, the vast majority of banks remain zealously protective of their balance sheets, unwilling to lend to anyone who is not on their ‘A’ grade client list. This is likely to remain the case for the foreseeable future because banks have been permanently scarred by the credit crunch. Some have or still are cutting their loan portfolios right back, others are under pressure to take a more nationalistic approach to lending while all will be subject to greater regulatory scrutiny over the use of their balance sheets. Costs of funds for banks are also up sharply versus where they were two years ago. Meanwhile, Basle II has made the loan product more expensive for banks, especially when they want to lend over the medium to long term and to companies that are not right at the very top of the ratings tree.
Happily for CFOs and treasurers, their supply looks like it will continue to be met by a level of demand the likes of which few corporate bond specialist have seen at any time during their careers. While Air Liquide’s popularity might be extreme, nearly every corporate deal over the last six weeks has secured order books six to seven times covered.
While these enormous order books can partly be explained by investors deliberately inflating orders to counter the inevitable scaling back by lead managers, the actual number of buyers of corporate paper has swelled in recent months. Indeed, whereas a year ago a top quality, well known corporate borrower getting its timing and terms absolutely right might have attracted up to 150-200 names into its deal, since the beginning of May lead managers of corporate bonds have been regularly hauling in bulging books of 350-450 investors.
Culture change
So where is all this extra liquidity coming from? Much of it comes from the retail sector where investors, fed up with their hard-earned money sitting in cash for most of last year and unwilling to return to the equity markets which they distrust, have decided that fixed income is their best bet. And within fixed income the corporate sector is the most appealing, offering decent returns on well known names, plain vanilla structures and easily digestible maturities. As one senior credit analyst told EuroWeek yesterday, “Corporate bonds are the new equity. Spreads are still extremely attractive when viewed on a historical basis. So far the names are strong and defensive. It’s a no-brainer for these investors. They saw that spreads had gapped out to crazy levels and took the quite rational view that they would have to snap back in at some stage. If they didn’t then it meant the world had ended and everyone would have gone under. It was an entirely logical decision — a one-way bet.”
The primary market is also the only place to get hold of corporate paper. The credit crisis has seen many financial institutions run down their trading books, to the extent that in many cases banks have little or no inventory to show investors, meaning the primary market is the only place that an investor can get a hold of corporate exposure. This perhaps also explains why so many corporate bond deals have performed so well immediately after the break.
Suitable alternative fixed income assets are also few and far between. Structured credit is off the menu, only the bravest retail investors are buying financial institutions — and what they are buying is only of the highest quality — while government and public sector markets offer the unlikely and unappealing combination of Spartan returns — at least, from a retail investors’ perspective — and fears about future over-supply, poor fiscal positions and ballooning government balance sheets.
Another reason why this is not a classic bubble is that much of this new-found retail investor liquidity is permanent. We might not see the same number of egregiously covered order books of the past six weeks and the equity market will no doubt win back investors’ trust but logic dictates that at least a portion of this new retail money will remain — this corporate bond boom has seen many of these investors taste fixed income for the first time and they have developed an understanding of it and a liking for it. The same argument goes for borrowers too — once they get acclimatised to the bond market the more they will trust it and use it as a key source of finance.