Inaugural tMega meeting covers capital markets, rating agency relations, and counterparty risk, as well as member roles and responsibilities, China, and notional pooling alternatives.
The NeuGroup’s new Treasurers’ Group of Mega-Caps got off to a great start by ringing the opening bell for Nasdaq at its inaugural meeting. During the meeting, all tMega members demonstrated the ability to draw on the shared insight and collective wisdom of experienced peer practitioners to help them create greater value for shareholders, starting with the following areas:
1) Capital Market Scene-Setting for Funding Strategies in Uncharted Territory. Mega-caps need to understand the new landscape, stay strong, and expand their issuer tool kits.
2) Managing the Rating Agencies. Be firm and let your organization’s narrative set it apart for better ratings.
3) Managing Growing Risk, Especially Your Risk to Others at Risk. Treasurers will need to review and smarten up their counterparty risk monitoring, mitigation and reporting frameworks.
Capital Market Scene-Setting for Funding Strategies in Uncharted Territory
Seeking a greater understanding of the current situation in debt capital markets, members heard from an investment bank debt capital markets team about the state of the capital markets. The good news is that demand for investment-grade corporate bonds remains stronger than supply, but the start of the year forced everyone to think about market fragility, whether sparked by concerns over European bank capital-raising needs or private wealth seeking an exit from China.
Key Takeaways
1) Structural drivers of volatility. Debt-capital-market volatility is being enhanced by four major structural themes: (1) increasing investment-grade company leverage, (2) issuance is at record levels, (3) bank reductions of allocations to bond trading, and (4) the holdings of investment-grade fixed-income securities that have become increasingly concentrated in insurance companies and mutual funds and pension funds.
2) Debt investors adapting to new realities. The good news is that debt investors are adapting to the new market structure. As examples, they are: (1) picking up yield as the divergence in spreads between A and BBB corporates grows; (2) seeing new issuance well supported by growing inflows into bond-related ETFs and mutual funds; (3) holding fixed-income securities longer on average; and (4) moving into the non-daily bucket of liquidity instruments. Another new reality for fixed-income investors is that the corporate/financial spread relationship has reversed, so that financials now outperform corporates.
3) Issuer tool kits continue to expand. Another clear trend that Morgan Stanley pointed to is how corporate issuers increasingly make use of the full tool kit of issuance opportunities, which includes tapping the Formosa market, Europe, and Yen issuance, along with other non-core global capital markets like Switzerland, the US and other creative issues.
4) M&A opportunities for the financially strong. The ability to tap low-cost debt financing has clearly fueled the uptick in M&A, but there is also an uptick in the time it takes for transactions to close (due to the duration of US anti-trust investigations, for example). The longer close periods come as bank capital charges climb due to bank regulations taking effect. This favors good credits — lesser credits need to think creatively about acquisition finance and alternatives to bridge loans.
Outlook
Well-rated mega-caps will likely continue to benefit from favorable debt-capital market conditions, so long as investor demand for quality bonds paying some yield far outpaces supply. This does not mean they should rest on their laurels. Instead, the future will smile on those who continue to deploy the full tool kit of available financing options (investigating the new ones that come into being, such as green bonds targeting the sustainability investor class), and work to diversify their debt-holders to limit fragility.
Mega-Cap Treasurer Roles and Responsibilities
To set a baseline for subsequent benchmarking for the new tMega group, members spent time discussing their roles and responsibilities, plus those of their direct reports, in the context of each of their treasury organizations. NeuGroup Peer Research created profile information for each member to use as a starting point to provide further detail and context.
While no two treasury organizations are exactly alike, all members agreed that having a strong team led by an experienced assistant treasurer or senior director is vital to support treasurers facing a growing list of challenges, and indispensable for those rotating into the treasurer role without a lot of recent treasury experience.
Members see growing opportunities to increase efficiency by finding synergies between treasury and other financial shared services, such as (often) lower-cost shared services centers. Several member companies that had been more centralized are adding a regional component and leveraging existing SSCs.
The one area of responsibility that topped the tMega treasurers’ wish list, that only very few had currently, was to have a team of M&A valuation experts, independent from corporate development, reporting to them.
Managing the Rating Agencies
The pre-meeting survey revealed that nearly four-fifths of members address top debt holders only on an as-needed basis, but more than one-third speak with rating agencies/credit analysts at least quarterly. When one tMega member shared with the group his takeaways from recent discussions with rating agencies, his comments sparked further member sharing on recent experience with rating agencies.
Key Takeaways
1) Separate the company from the sector. In this member company’s case, its credit concerns are exclusively a result of its exposure to sectors facing tough economic times. However, the management of the company is solid, and it has a proven track record of managing through down cycles effectively. Its history suggests that the company will experience a rapid rebound when the cycle turns. This buys time with rating agencies before they downgrade the firm’s rating. Management credibility is maintained by cost-cutting moves that were made quickly before market prompting.
2) Re-evaluate the business strategy that relies on the importance of a high rating. The company’s rating is important because it is linked to the rating of its finance company that the company relies upon to help customers finance their purchases. This business strategy, however, needs to be challenged internally and revalidated. Otherwise, activists may come in to challenge the notion that the rating-captive finance company is really necessary and call for no pause in share buybacks, for instance. It is better to work through that idea internally, rather than wait to defend it from activist calls.
3) Set level payment with the rating agencies. The rating agency discussion prompted another perennial treasurer topic: the pricing practices of the major rating agencies. No matter what pricing a firm has previously agreed to, the rating firms seem to always look for a reason to increase it and invoice for the new amount. The practice has driven one member to say to rating agencies, “We will pay you $XX per year and no more.” Then, no matter what the invoice says, the member added, “We simply wire them that amount.”
Outlook
With rating agencies in transition, the power of your narrative is going to tend to hold more sway. A convincing story with a management track record to support it will help firms win a better rating than their peers. Another powerful narrative is the push-back member treasurers say they are making on rating agency price increases. No treasurer wants to help fund rating agencies’ business transitions, especially when the value of their product is perceived to be still at or near an all-time low.
China: Capital Flight and Market Volatility
One tMega member shared his experience with China as the government moved to curb capital flight and respond to the resulting market volatility.
China’s moves, such as the “window guidance” that the Chinese authorities gave earlier in the year on the ability to take cash out of the country and the possibility of CNY-CNH decoupling, underscore that its officials are not all-knowing in how to deal with financial markets, as they seek to cautiously implement reforms to internationalize them. The trade-offs between growth and stability and reforms and stability are becoming tougher for Chinese officials to make. A harder landing than anyone wants may result, but China will remain a high priority for MNC treasurers.
Several members noted that the recent market turns have highlighted how Chinese banks are gaining preference over Western banks. You can find that Chinese banks have greater access to foreign exchange in crisis periods and that the documentation restrictions in line with “window guidance” can be less severe for local banks. And some can also prove to be effective sellers/distributors of your product in China. Thus, treasurers should go out of their way to foster Chinese bank relationships.
Managing Growing Risk, Especially Your Risk to Others at Risk
Market fragility was also the underlying theme of members’ discussion of updates being made to counterparty risk evaluation frameworks.
Key Takeaways
1) Credit default swap spreads still valuable. Despite the thinning of single-name CDS trading, five-year CDS spreads are still the number one counterparty risk indicator for tMega members, according to the pre-meeting survey. The discussion at the meeting corroborated this result, with several members noting how CDS spreads (combined with other market indicators), continue to serve as an early warning signal.
2) Separate the notional vs. net, as well as value-at-risk and mark-to-market exposure numbers from the settlement amounts at risk. While not every member has two-way margin credit support annexes with their financial institution counterparties, those that do noted that having margin exchanges helps separate mark-to-market risk from settlement risk. This can be a good nuance to include in counterparty risk reporting: notional vs. net exposure limits. Another consideration is right of setoff.
3) Make sure policy guidelines are workable. One member noted a desire by the risk committee to have a percentage of tangible common equity as well as a two-cent risk-to-EPS threshold for trading counterparties. However, his current exposure to several trading counterparties is way over that now, and it will be impossible to do trading business under such limits. Hence he had to push back on such a limit.
4) Reach out to the treasurers of financial counterparties. To get further context to the counterparty credit risk signals, one member noted regularly reaching out to the treasurer of his key trading counterparties. These relationships can prove to be quite insightful and “give an extra level of comfort” to complement the counterparty risk indicators, the treasurer noted.
Outlook
The unprecedented conditions in financial markets and the changing nature of how credit risk is being measured, especially at heavily regulated, globally significant financial institutions, are cause for treasurers to review and up the sophistication of their counterparty risk monitoring, mitigation and reporting frameworks. None of this should take place without peer dialogue with the treasurers of those counterparties, and we should expect that more such dialogue will be taking place on a regular basis. In the process, both sides can exchange information to improve each other’s credit view. For treasurers on the non-financial institution side, this dialogue should also underscore the importance of collateral and internal risk models to credit pricing going forward.
Challenges for Notional Pooling
One member shared his findings on the challenges confronting notional pooling due to new banking regulations, making services more costly for banks to provide. The capital charges alone, which banks will have to pass on in some way, will force most MNCs to look for alternatives, and the liquidity coverage ratio restrictions on non-operating deposit balances only add to pooling cost structures.
One factor in the extent and degree to which banks will curb notional pooling, or raise their pricing, is their governing regulatory jurisdiction. The US (the Fed), the UK (FSA) and Eurozone (ECB) all have varying interpretations on right of offset.
While a viable, regulations-compliant alternative to notional pooling has not yet emerged, services combining virtual account structures with enabling automation technology seem to offer promise. However, banks will likely press to update contractual language — possibly including parental guarantees, right of offset and settlement priorities favoring local entities — to their advantage in dealing with current bank regulations.
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