Global Capital: The Corporate FRN market returns

Global Capital, July 2014

The return of the corporate FRN market has been one of the key themes of European capital markets in 2014.

The market had all but vanished: a format through which Eu71.74 billion was raised through 229 deals in euros and sterling in 2006 raised one tenth of that total in 2009 and scarcely more in any of the three years that followed. But a modest recovery to Eu24.92 billion of issuance last year has been followed by Eu18.67 billion in the year to June 11, on track for the highest total since at least 2007.

While the days of Olivetti approaching the market for Eu15 billion in an FRN, as it did in 1999, are long gone, it is fair to say there has been a revival.

Why did the market vanish? “The corporate FRN market was huge in the early 2000s period,” says Hugh Carter, head of credit syndicate at Commerzbank. “It was a lot to do with CDS and the basis: there was a lot of trading, both fixed and floating, relative to the CDS.

“The problem then came that CDS is not really the market that it used to be,” Carter says. “Subsequently, we were in a rate-cutting environment, so it was natural for investors to be concentrated on fixed. Then rates were cut even further, 10 year yields have dropped, there has been much compression of peripherals relative to core; none of this lends itself to frequency in floating rate notes.”

But then things changed. There is, logically, no further that the ECB can go with rate cuts; sooner or later rates will rise, and that’s an environment that encourages greater floating rate issuance.

“In Europe you’ve probably hit the bottom of the rates cycle,” says Brendon Moran, global co-head, corporate origination at SG. “How long will that go for? It will tick along, but once there is a sense of momentum of growth being on an upswing, and any rate rises, we will start to see much more popularity.”

When that happens, the potential for still greater issuance will be considerable. “FRN offers investors a fantastic opportunity in a rising rate environment,” Moran says. “Investors are locked into credit spreads, but they are more insulated from underlying rates by the floating rate nature of the bond. The question becomes how long does your maturity need to be to monetize that value? If you have a view rates in Europe are going to rise in the next year, you could buy a two-year floater. If you think the horizon is longer you need to look at longer possible maturities.”

The revival in Europe is a little behind that in the US, which perhaps gives us a signal as to what will come next. Moran says in 2013 FRNs in the US accounted for just under 10% of corporate issuance, but this year are running at closer to 15%.

Others agree. “Corporate FRNs are a much bigger theme in the dollar market,” says Chris Whitman, head of global risk syndicate at Deutsche Bank. “There, it has become standard to do a three or five year fixed and floating simultaneously, with the rationale that if an issuer does that, it is addressing the largest possible potential demand.”

So should Europe follow the US pattern once rising rates are more likely? “If and when people become nervous about the ECB raising rates, you will definitely see a psychological shift from investors towards floating,” Whitman says. “Why would you not insulate yourself against interest rate risk if you are seriously concerned about rates rising?”

There is, naturally, a flip side to this; the issuer view can be a little different. “We’ve issued floating rate paper within the past year, but we are more cautious given the possibility of interest rate increases,” says Jonathan Klug, senior vice president and treasurer at AT&T.

Naturally, FRNs only make sense if the pricing is not materially different to what is available in fixed, and making a judgment on relative value is something of an inexact science. For one thing, they are generally priced off midswaps on different maturities, three months for floating and six for fixed. For another, though the headline spread on an FRN deal is generally higher than on a floater, one has to keep in mind that most fixed rate funding is then swapped to floating, which typically incurs about 12 to 15 basis points on the swap.

“In general FRNs are attractive because most European issuers consider funding on a floating rate basis,” says Duane Elgey, director of corporate syndicate at SG. “If they issue an FRN they don’t have to put in any swap.” And, with that in mind, he says this has made FRNs extremely competitive.

“Realistically, the majority of deals five years and under have been steered towards the FRN market in the last six months,” he says. “When I price a deal at four or five years now, my advice would be to look towards the FRN market because the demand has been better there.”

Among the most prolific issuers in the market are the funding arms of the big European automotive groups.

An example is RCI Banque, the funding arm of Renault, which raised Eu600 million in a floater in June, having raised Eu500 million in a seven-year fixed rate deal earlier in the year.

“We saw the FRN market opening up a year ago, more on the short side: we have seen several bond issues from competitors or other companies with a two to three years duration,” says Yann Passeron, head of the capital markets department at RCI Banque. “Recently the markets have become more dynamic. Rates reaching a bottom have pushed some investors into this market as they now forecast rates increases in the next two to three years. As a consequence, we see new FRN issues having longer maturities. Even non-traditional FRN investors are coming in, such as insurance companies.”

In its most recent deal, RCI Banque opted for three years, “to take advantage of this dynamic. We saw a lot of demand for it [a Eu950 million book] and issued EU600 million, a nice size: the normal size for RCI Banque fixed rate bonds is Eu500-750 million, so this is comparable.”

In the aftermath of the deal, there was a strong argument to be made that the funding cost had been lower than it would have been on a fixed rate. It priced at 72 basis points over mid-swaps; bankers noted that its three-year fixed paper at the time was trading at around 67 basis points, so when 12 basis points was added for the swap, that would equate to fair value of 79 basis points for a floater. Instead, it came much tighter.

“We’ve seen a huge compression of credit spreads in general in the last month, and the full credit curve of RCI Banque has shrunk like other companies,” says Passeron. “If you compare FRN to fixed there is a slight advantage to issuing FRNs: our last one was inside our fixed euro curve by about 7 to 8 basis points.”

Passeron sees the opportunity remaining intact for a while. “Traditionally when people expect rates to go up, they are keen to invest in FRNs,” he says. “I would say this is a window that opened a few months ago and won’t close in the next few months.”

This is a good outcome for an institution like RCI Banque, since floating rate funds are a perfect fit. “Our business model is to lend to people or companies that want to buy or lease a car,” he says. “That means we lend at an average maturity of approximately two years. Then we fund ourselves.” In the fixed rate markets, that has involved borrowing at tenors as long as seven years. “When you issue five to seven years and lend to two years, you have risk. In order to hedge this position, you swap your seven or five years to Euribor three months. Then, when you want to hedge the sensitivity coming from your loan portfolio, you need to book another swap on a two years maturity.” Accounting-wise, the swap hedging the bond is considered as a hedge but the second one is considered as a trading position, which implies volatility in the P&L.

“Issuing directly on a floating basis enables us to avoid this constraint,” Passeron says. “Only one swap is needed to hedge the sensitivity coming from the loan portfolio and this swap is counted as a hedge, not trading, so there’s no P&L volatility. That’s why there is an advantage for us to do FRNs: one less swap.”

A rarer example is Société des Autoroutes Paris-Rhin-Rhone, the French motorway group, which raised Eu500 million in a 4.9 year deal in late April. “It’s the second one we’ve done in the last seven years,” says Xavier Ombrédanne, head of treasury, financing and investor relation at Eiffage, which handles funding for APRR. The other was in April 2013. “We have been looking for three-to-five year FRNs since 2007, essentially as an alternative to floating rate bank debt.”

Having waited this long, “we decided it was wise to seize the opportunity rather than letting it pass by. These things tend to come and go: you know when it is available, but you can never tell for the future. A long-dated FRN seems to be an animal that comes out and then quickly disappears.”

All told, the company has about €7 billion of debt, most of it fixed rate; this deal allowed it to mix some floating-rate funding into the total. “The underlying intention is to have between a billion and two billion of floating rate debt,” he says. “In the good old days we got that from the bank market; now we have to make do without.”

Ombrédanne says he doesn’t know how long the window will remain open, “and we don’t have to take a view on whether it’s open tomorrow morning or not. If it is, then great, but if not we are equally fine with it because we are happy with the size.” If the window is still open next year APRR is likely to issue again, “but not on a rolling 12 to 24 months basis like the car manufacturers do, we are after more long dated issues”

On pricing, allowing for the fact that floaters are priced against three month and fixed against six month mid-swaps, “it compared well. Not massively cheaper, nor massively more expensive. It’s on a par.”

A more prolific issuer is the Volkswagen group, which has been active in floating rate issuance this year both through the automotive company itself, and its banking arm.

“We are oriented on one side to satisfy our P&L, and on the other to go along with the wishes of investors,” says Bernd Bode, head of group treasury and investor relations at VW Financial Services. “For that reason we are very flexible when it comes to fixed and floating rate coupons. We take the issuance that is offered to us if the all-in prices are interesting.”

Like the Renault bank, Volkswagen sees that advantages of floating rate funding go beyond pure cost of funds. “From time to time you get a couple of basis points more attractive financing from floating rate notes. And a nice side effect is that we save on the swap volume we have in our books.” The reduction in swaps “helps us with our limits with the banks,” Bode says.

Yet in contrast to some bankers and corporates, VW is cautious about expecting the growth of FRNs to continue in the short term.  “When there is light on the horizon, and if Draghi mentions in his language that he foresees the end of the low yield environment, there would be more interest from investors in floaters,” Bode says. “But as long as he continues with his liquidity measures, I think the interest will be more on fixed rate issuances.”

Dirk Bauer, head of debt capital markets & rating at VW Financial Services, takes a similar tone. “Since floaters have a rather short maturity, I imagine that some investors could struggle with floating rate notes, based on the assumption that interest rates will not increase in the near future,” he says. “I would expect that floating rate notes will not be absorbed as they were in the recent past.”

“If an investor expects interest rates to remain at this level or even decrease, why should he buy floating rate notes?” Bauer adds. “But there is a bulk of investors who will still buy floating rate because of internal rules, and when the opportunity occurs we will certainly look at it.”

FRNs don’t offer a huge change in the investor mix compared to fixed, though there are distinctions. “The majority of investors in the book will be almost exactly the same as in a fixed rate deal,” says Elgey at SG. “The difference is that one or two central banks and sovereign wealth funds will be present at the high end of the ratings spectrum, and a bit more in the way of bank treasury, because their natural home would be floating rate.”

So what can be done in the FRN markets? Carter says issue sizes of Eu250 million to a billion are realistic, depending on market sentiment, and says single A or better is the best rating since money market funds – drawn to shorter-tenor instruments like FRNs – often cannot or do not take BBB. “The longer you go on floaters, the relatively smaller the investor base gets,” he adds. “Five years to six years is probably the maximum at this stage.”

Within that, there are variations. “When it comes to a private placement, the difference is not huge between floating and fixed pricing,” adds Bauer at VW. “When it comes to publicly offered benchmark bonds, allowing for the fact that the basis swap is about 12 basis points, we have seen several times that one could save up to five basis points.” And in a tight funding environment, that’s not to be taken lightly.