Euroweek UK report: blue chips

Euroweek, September 2013 

UK blue chip corporates have a wealth of opportunity as borrowers. They can find a receptive audience at home in sterling or overseas in dollars or euros, in almost any maturity they require; pricing is tight; and on top of that, lending appetite is growing among banks in the UK, providing alternatives to bonds if issuers want them.

The situation is perhaps not quite as benevolent as a year ago, when everything that could possibly go the way of UK borrowers was doing so.  For UK investment grade issuers in sterling and euros, “supply in the post financial crisis era hit record levels last year, principally because you were moving from a bank debt environment into a bond environment, and at historically low rates, with a shrinking universe of safe haven investments because of the sovereign debt crisis,” says Farouk Ramzan, managing director and head of capital markets origination at Lloyds Banking Group. On top of that, issuance from banks had dropped. “You therefore had a perfect storm last year for UK issuers in the bond market.”

One year on, there are some differences, but the atmosphere remains positive. “We’re certainly continuing to see extremely favourable conditions for UK investment grade corporates,” says Marcus Hiseman, head of European debt capital markets at Morgan Stanley. “For the top blue chips, with large balance sheets, who are still generating robust cash flows, they are definitely still in high favour with investors.” Last summer Morgan Stanley was one of the leads on the lowest coupon in corporate history for Unilever, which paid 45 and 85 basis points respectively for three and five year funding. “This year we are not getting the lowest coupons, but still huge deals are being done with the same level of order books.”

It helps that the sovereign has maintained its own resilience. “I think that the UK has managed, despite its elevated debt levels, to remain a safe haven country, and therefore has managed to keep its funding costs low,” says Christoph Seibel, head of corporate DCM for Europe at RBC Capital Markets. Seibel describes the international perception of UK investment grade corporates as a group as “similar to the German landscape, in that it is one of the desired, higher quality, diversified, globally operational issuer bases. It receives a good reception in the sterling market at home, but also in euros and USD.”

That said, there are some differences now to a year ago. One, says Ramzan, has been the net outflow from bond funds caused by the prospect of QE tapering – $110 billion of net outflows from US bond mutual funds in May alone, and £7 billion of net outflows from UK bond funds in June, suggesting the long-expected great rotation from bonds to equities may be taking place. “We’re sitting on that cusp right now.” Correspondingly overall volumes in the market are down this year: UK investment grade corporate issuance in sterling is down 39% year on year, and euros 13%.

Hiseman also feels that “The investor philosophy has changed somewhat. It’s the same investors as a year ago, but whereas then there was almost an indifference in terms of credit fundamentals, now you can see then being more disciplined in picking the credits they really support.” Many, particularly those backed by M&A, still have no problem, “but it has been a more challenging environment for less highly-rated commodity players.”

That said, the recent announcement by the FOMC that the Fed will not now be withdrawing QE at the rate it was expected to could change things again. “In the last 12 months a lot of borrowers have anticipated that rates will go up, so there has been a significant amount of early refinancing,” says Nicholas Denman, managing director, investment grade finance at JP Morgan. “A lot of that has now occurred, but this week’s news this week that the Federal Reserve isn’t going to taper quite as soon the market expected is significant: many borrowers might see it as a renewed opportunity for financing in this lower interest rate environment.” The cost of financing, he says, has dropped 15 basis points on the 10-year Treasury on the back of the announcement.

So where to go? Issuers are spoiled for choice.

The dollar markets remain the most popular location. This is where the truly jumbo transactions have been found: Vodafone raising US$6 billion in a five-tranche deal, covering three to 30 year durations, in February; Diageo taking $3.25 billion with more than $10 billion of demand, again at three to 30 years, in April; BP with $3 billion apiece in November and May; GlaxoSmithKline with $3 billion in March; and plenty more besides from Rio Tinto, Imperial Tobacco, AstraZeneca, SABMiller and others.

“There is a general movement towards dollars,” says Ramzan. “UK corporates who used to prefer the sterling market are now much more keen on the dollar market.” In 2009, Ramzan says, 42% of all UK corporate bonds were in sterling, compared to 25% in 2013 year to date, while dollars have gone from 38% to 51% over the same timeframe. Partly this has to do with movements in the basis swap: last year, Ramzan says, issuers could achieve a saving of 22 or 23 basis points when issuing in dollars and swapping back to sterling, although this year it has pulled back to 11-12bp. The dollar market is the largest and deepest in the world, with no questions over efficiency. “The quantum of money available means drive-by deals can be done very quickly in the dollar market,” Ramzan says. “The perception is you get deals done in a safer environment there.”

The dollar market’s capacity never ceases to astonish. Verizon’s $49 billion issue was a surprise to many in the market, who assumed that the volumes involved would require issuance in several different currencies. Not so: the market swallowed it whole. “Before Verizon, conventional wisdom was that a big deal was $25 to $30 billion, so raising $49 billion is exceptional and has shown just what this market is capable of for the right transactions,” says one banker. “But is $6 billion, for Vodafone or GSK, a lot? Absolutely. You do need a good market to do it in.”

Seibel says: “The dollar market is the one that is always open. It is usually the deepest market and the most liquid, and provides the greatest liquidity pool to the UK issuer base.” He notes that some European issuers are put off the US market because they find the SEC and 144A documentation cumbersome. “That has not been so much of a hurdle for UK companies: many of them have operated in the US for a long time and are already following US regulation anyway.”

And the appetite for UK names there is redoubtable. “What amazes me about the yankee market is the ability for the oil majors to come back time and time again every three to six months,” says Hiseman. The BP trades are a classic example. “They have done a phenomenal job, rationing their visits to two or three a year, and printing what investors like: a predictable and regular supply of bonds refreshing the curve and keeping benchmarks in the market.” It’s perfect, he says, for index followers and for big money managers who want liquid names to be able to trade.

Hiseman says one reason for the enduring popularity of the US among British issuers is because of synergies with the currency itself. “Many of the big global blue chips out of the UK are dollar-functional businesses, or have predominantly dollar cash flows given their footprint,” Hiseman says. Although Ramzan contends: “I’m not sure you could call the dollar a functional currency for UK corporates,” it is clearly a currency for which most multinationals have considerable use. “Many of them have very large operations in the US, and as such have sales denominated in dollars and need dollars for capex,”says Seibel. “Certain companies, like oil majors, naturally have a product that is sold in dollars.”

Euros, oddly, seem to have missed out. Seibel says that year to date, 55% of issuance by investment grade UK corporates has been in the dollar market, 23% from sterling, and 18% from euros. “That’s interesting because if you look at the UK marketplace as a whole, exports are far more into the European Union than those numbers would suggest. The euro seems relatively under-represented.” This has to do with relative pricing, but now, he says, euro funding levels are more attractive, especially in medium maturities. “As a result we may see more euro activity from the UK corporate client base.” In fact, according to Seibel, the use of euros relative to dollars has fluctuated quite widely over the years. For UK investment grade corporates, in sterling equivalent, the split was £17 billion in euros and £22 billion in dollars in 2009; £6.5 billion in euros and £13.5 billion in dollars in 2011; in 2011, £5.6 billion in euros and £18 billion in dollars; and in 2012, £12.7 billion in euros, and £35 billion in dollars.

Many recent euro deals have been successful and interesting, often combining a euro tranche with another in sterling. NGG Finance, for example, the borrowing entity for the UK’s National Grid electricity and gas transmission company, sold Eu1.25 billion of 60 year, non-call 7.25 paper and £1 billion of 60-year, non-call 12.25 paper in March, the company’s debut in the hybrid market. In December, Rio Tinto had combined euro tranches of Eu750 and Eu500 million, in seven and 12 year funding respectively, with one of £500 million in 17-year sterling funds. Rolls Royce, too, combined euros (750 million of eight-year) with sterling (£375 million of 13-year) in June. Other euro deals have included SABMiller raising Eu1 billion in November and BAT International raising Eu650 million in March, alongside $300 million from the dollar market.

In comparison to sterling, euros offer a different kind of depth. “In the euro market, because it is so broad, you have a large number of atomized buyers,” says Ramzan. “In a sense, you get better execution and price discovery, because you are using a larger number of investors to distribute the bond through. In the sterling market, it’s always been a much tighter market – very deep but small in the number of institutional investors. There are eight to 10 large investors who rule the roost.”

However, it’s still not for everyone. Hiseman, like Seibel, notes how much more competitive euros have become, saying: “That market has offered incredibly competitive terms, and has been somewhat undersupplied. We are seeing an opportunity for a lot of blue chips to price inside where they would bring a dollar trade on an after-swap basis,” says Hiseman. But that’s not the whole picture. “However the swap market has become more expensive as a result of bank regulation, and corporates are more and more concerned about entering into those trades.” In some instances, he says, “corporates are saying if my functional currency is dollars, I would rather pay more and do it in dollars than euros.”

And what of sterling? Some are negative. “The sterling market has been incredibly uncompetitive,” says Hiseman. “The big global guys have not focused on that market too much. Demand in the sterling market is only in the longer end of the curve, whereas for issuers, that’s not the maturity they favour.”

Additionally, he says, sterling is often not the currency they need. “Many UK companies have more of a cost base than a revenue base in sterling – they have their head office here – so to add more sterling liabilities doesn’t make sense. Swapping a long-dated 30 year sterling fixed rate bond is hugely credit intensive even for the top rated bluechips.”

Sterling does, though, offer tenor for those who would like it, driven by the dominance of pension funds and insurers in the UK market. “In terms of maturity, the dollar has been pretty stable, whereas sterling is definitely going longer,” says Ramzan. “The volume of 20 year tenors and over account for 70% of total sterling issuance for UK corporates this year, up from 44% last year.” (Similarly in euros, which used to be a five and seven market in the main, “now seven years and over account for 70% of the euro market. All of this is being driven by a hunt for yield,” he says.)

And sterling is also less hung up on nice round numbers in the tranche maturities. “The dollar market is obviously the largest market in the world but it is not as flexible as sterling in terms of maturity picks,” Ramzan says. “You’ve got your standard 5, 10, 30 in dollars, whereas sterling can do odd maturities like a 26 without any problem.” Seibel agrees. “Sterling investors aren’t as concerned as US investors about debt being in standard maturities: it’s quite possible to have good demand in, say, a 13 or 17 year maturity.”

Aside from the sterling deals that have come alongside euro tranches, other big deals for sterling issuers in the last 12 months have included Arqiva, which raised £750 million in two tranches – one with 22.3 years duration, the other, just under 20 in February, and High Speed Rail Finance 1, which had raised £760 million in 25.7 year funding two weeks earlier. GlaxoSmithKline also went to sterling for £1.4 billion, some of it at a 33 year duration, in December.

And there are other alternatives too. Australian and Canadian dollars “are very overlooked markets by UK corporates,” Hiseman says. Siebel adds: “BHP, National Grid and BP have all branched out into Canadian and Australian dollars. That approach – looking for further diversification, adapting to different market environments, looking at the capital structure in a holistic context – is a constructive and positive development of the UK market.”

And, increasingly, there are loans on offer.

“In the last 12 months we have seen a significant increase in the number of participants in the market, which means there has been an increased level of liquidity, and pressure on pricing and structure,” says Simon Allocca, head of loan markets at Lloyds. Allocca says there has been a reduction of around 12 basis points on undrawn pricing for investment grade UK corporates. He notes a big difference between German and French lenders and those in the UK, citing the recent Royal Mail transaction (which was priced pre-summer) at around 55 basis points, whereas Deutsche Post attracts pricing closer to 30 basis points. “There is a huge pricing tension between the Germanys and Frances of this world and the UK.”

And that has consequences for the bond market. “If you are able to get that kind of pricing and liquidity, we go back to the dynamic of 2006, where people take cheap loans and don’t need to go to the bond market. If you look at transactions where banks provide bridges to bonds, those bonds have not always materialized, as companies have been able to refinance those in the loan market.”

At first glance, the market does appear to be moving back in that direction. Ramzan says that last year, the ratio of European funding shifted towards something resembling the US, where debt capital market funding outweighs bank lending: it moved to 57% bonds, 43% loans. “But this year it’s gone back the other way: 48% bonds, 52% loans.”

But is lending what borrowers want? “There is no shortage of bridging to bonds: banks want to put their balance sheet to work and recycle it quickly,” says Hiseman. “But generally corporates are less inclined to take a drawn loan position. They recognize that consumes valuable optionality in their ability to go to their bank and request a bridge when they really need it.” The percentage of loans as a proportion of debt in the UK has gone from 48% in 2008 to 32% in 2012, he says.

Siebel notes that the longer term trend has been for the percentage of bank lending versus other forms of debt capital to decrease in recent years as a result of the financial crisis and the deleveraging of banks. “But the large scale corporates don’t have problems raising bank funding, because they are the ones with the greatest global reach and the biggest ancillary fee pool,” he says. “Banks clearly think: if I give a dollar to one of those blue chips, the hope that I can earn equity underwriting or FX fees is larger than with a small SME that only operates in the UK. The availability of bank credit to those companies remains very strong.”