By Joseph Neu
Treasurers in The NeuGroup Network spent a lot of time during the first half meeting season discussing funding strategies amid uncertainty in Europe, divergent rate policies and FX market jitters.
During the course of the H1 meeting cycle, NeuGroup member treasurers discussed funding strategies against a backdrop of uncertainty in Europe; divergent rate policies—waning expectations of a rate rise in the US and negative rates in Europe and Japan; plus currency-market jitters making non-USD funding and related currency swaps a bit of a roller coaster (though still mostly an upside opportunity). Additionally, increasing investment-grade company leverage, which is nearing the March 2002 peak of 2.29x (currently 2.23x) vs. the 1.88x average, is juicing debt-capital market volatility. Meanwhile, issuance remains near record levels set in 2015 of over $1.25T compared to just short of $1.1T in 2014. All the new supply has increased liquidity concerns for some market participants, since banks have reduced the share of their balance sheets allocated to bond trading by 62% from the peak in early 2014. Increasing liquidity concerns are the holdings of investment-grade fixed-income securities, which since 2005 have become increasingly concentrated in insurance companies, mutual funds, and pension funds.
Also, just prior to our H1 meetings, there was a period of general investor edginess driven by the migration to high-yield (with the concurrent acceleration of fallen angels globally, especially in the energy sector), and the slowness with which European banks were being recapitalized. “Were you scared back in January?” one investment banker asked our members at one meeting before admitting, “I was.”
This edginess subsided over the first half, with the help of a large issue by a NeuGroup member in February that was credited with reopening moribund bond markets. The reality of lower-for-longer interest rates in the US also helped assuage concerns about less favorable funding conditions. Still, H1 was uncharted territory for corporate bond markets in many ways and the road ahead is similarly unmapped. Thus, member treasurers looked to gain confidence in the view that the generally positive conditions for investment-grade credits would continue and determine what contingency plans they should have in place if they do not. Adding to the need for contingencies is the Brexit event at the end of H1. Many, if not most presentations on corporate funding in H1 contained some caveat about heightened impacts from global event risks, with Brexit featuring prominently as an example risk event. Since this event has now happened, there is all the more reason to revisit the funding strategy takeaways from member discussions over the first half.
KEY TAKEAWAYS
- Little fear with US rate hikes. The Fed’s December 2015 rate hike has had little impact on debt profiles as 83% of members’ fixed-to-floating rate exposures did not change as a result, according to NeuGroup Peer Research conducted in 2016 H1. Indeed, some treasurers indicated they were willing to keep a floating-rate bias, since the uncertainty in markets might continue to drive yields down or at least prevent further increases in rates in the near term. This bias was seen for example in some acquisition finance, where the debt repayment schedule with high cash-flow businesses is relatively quick. Ultimately, fixed-floating mix changes see members consider several factors, including the firm’s industry and where it wants risk exposure. Nevertheless, “a 10-year swap paying floating outperforms fixed 100% of the time, and even the 5-year swap wins 89% of the time. It’s very compelling,” one member said, adding tongue-in-cheek, “except before the Fed raises rates.”
- No impact is the expected value. According to the H1 results, NeuGroup treasurers expected funding market conditions to have no impact on their companies’ ability to finance current organic growth, finance a significant strategic transaction or maintain current/planned shareholder distributions. However, the negative tail risk is just slightly higher for the impact on strategic transaction financing and the ability to maintain shareholder distributions. This negative bias for maintaining shareholder distributions was more pronounced for our treasurers in the technology sector (Tech20), where 31% said current funding market conditions might have a negative impact vs. 46% no impact and 23% a positive impact.
- M&A opportunities for the financially strong. While the slight negative bias is there, this might also be attributed to a feeling that the M&A party may have to end, eventually. The ability to tap low-cost debt financing has clearly fueled the uptick in M&A, which had a record year in 2015 and a still very above average pace in 2016 H1. 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, which are up to 9.6 months on average in 2015 from 7.1 months two years ago), according to investment bankers at Morgan Stanley that presented to member treasurers in H1. The longer close periods come as bank capital charges climb due to bank regulations taking effect. This favors good credits able to finance acquisitions out of cash, ample debt capacity and/or able to support bridge financing with large wallets. Lesser credits need to think creatively about acquisition finance and alternatives to bridge loans.
Seaking to our Tech20 treasurers, investment bankers from Bank of America Merrill Lynch noted how 2015 “mega” deals were done with bridge financing and that many companies pre-funded well ahead of closing their acquisitions. This helped to de-risk, reduce or sometimes eliminate the need for a bridge. Jumbo pro-rated transactions also played an important role in acquisition financing strategies, they noted, and the European market added incremental capacity while providing added diversification for investment-grade issuers. On the lower end of the credit spectrum, the regulatory environment has had the greatest impact, for instance, in the PE and LBO space due to heightened focus on leveraged lending.
- Still, can it hurt to hedge? Despite the general lack of fear regarding major changes in positive funding conditions, there was a contingent of members that wanted to hedge their bets; 25% of members said they were looking to hedge a planned debt issuance even though they have not generally done so. During a discussion on the subject, one member said he will pursue pre-issuance hedging up to 50%. He favors T-locks, although they lack liquidity and “banks will charge a fortune if they have to be rolled over.” He also noted that European banks’ pricing for T-locks is much worse than US banks’. Hedging the interest rate risk on bonds is also getting more flexible under US GAAP. At one meeting, Chatham Financial, a specialist debt and derivatives solutions and advisory firm, noted that recent amendments to FASB’s hedging standard enable partial-term hedging, so, for example, companies can now receive hedge-accounting treatment when swapping the first 5 years of a 10-year bond. “We think the early adoption date may be as early as January 1, 2017, they said.
- Issuer tool-kits continue to expand. Meanwhile, perhaps the best hedge to turn to is to diversify your funding sources, since the ultimate risk is a loss of access to funds, not a loss of a few bps on a rate rise between now and when your underwriters go to market. This was a trend that Morgan Stanley pointed to: how corporate issuers increasingly are making use of the full tool-kit of issuance opportunities. This includes, for example, tapping the Formosa market, Europe, yen issuance, along with other non-core global capital markets like Switzerland. The tool-kit also includes US retail targeted issues (to help fill the fixed-income mutual funds and ETFs), straight debt-like convertibles (convert with purchased bond hedge), green bonds targeting the sustainability investor class and greater maturity diversification to smooth funding needs and prevent large towers. To put this trend in perspective, however, the majority of US issuers remain content to play in USD markets; 66% of NeuGroup treasurer respondents have never issued non-USD bonds and 56% have no plans to in the next 12 months. Further, 11% of respondents have no plans to ever issue non-USD bonds. Those that do are primarily looking to take advantage of lower cost of funds (31%), diversify debt holders (22%), and/or hedge a currency [NI] position (20%). This is a lost opportunity, because, so long as favorable funding market conditions with the low-rate environment continue, the added cost of alternative funding sources is historically small, and the diversification benefit may be historically large.
- Speak with your key debt constituents. Another common-sense measure to mitigate funding risk is for treasurers to speak to their key debt constituents. Despite lip-service being paid to treasurers solidifying their role as investor relations heads for debt investors, communication with debt holders does not yet appear to be as structured as with equity investor relation efforts. The majority of NeuGroup treasurers surveyed, 65%, say they have no set frequency or meet as needed with top debt holders. Rating agency/credit analysts fair better, with just under the majority indicating meeting with them at least quarterly (38%), if not monthly (9%). It is key DCM advisors that are honored with the most frequent conversations, with 19% indicating they speak with them at least weekly, if not monthly (21%) or quarterly (25%). The key point of these conversations is to assess the market appetite for corporate bonds generally and the company’s bonds in particular to help with planning around any new issuance. Other major points of discussion include indicative pricing, peer activity and comps, and market conditions.
- Make sure your contingency plans are real. One of the biggest and broadly applicable takeaways from a discussion on interim financing for strategic transactions was how treasurers need to ensure that their contingency plans are both well understood and operational (i.e., by making use of them before needed) in order to expect them to succeed. One member company, for example, learned that actually tapping alternative funding options, including tier-2 CP is important to ensure that they will be there when needed. Also, given the challenges of non-public financial data with a SpinCo that may be part of a strategic transformation, treasury needs to have a contingency plan to go to market on an accelerated timetable when required, say, to fund the SpinCo when the pro forma financials are still valid and the parent is not in blackout. Another member company noted, as a further example, the importance of flexibility to manage contingencies of unforeseen events, like the US Department of Justice not approving your desired transaction (deal risk is never really zero) and building in contingencies for the use of financing proceeds to avoid having to turn to capital markets both to take out a bridge and raise subsequent capital for a recap. At the end of one meeting wrap-up, the Boy Scout model of “be prepared” was cited, but equally important is the EDGE method, to explain what to do, demonstrate how it should be done, guide your team to how they should do it and thus enable them to do it when it comes time to respond to the unexpected.
- Don’t cave in to market skittishness. Finally, it can be important to be bold. One member who went to market in February with a significantly timed issue noted his thinking on the need to reopen the market during a period when market skittishness threatened the favorable funding environment. “We found a B- day and decided to pull the trigger,” he noted, rather than wait. In hindsight, he could have done a slightly smaller issue to change the market trend, but you don’t know if the market would have continued to get worse without a strong statement. Another firm in his sector ended up issuing on the same day, which reflected concerns about further market fragility at the time.
Bond Liquidity Concerns: What Can Treasurers Do About Them?
While several market commentators have voiced concerns about liquidity in bond markets, the vast majority of member companies either side with the growing chorus of commentators refuting these concerns or don’t believe there is much they can do about it; 87% of NeuGroup member treasurers say they don’t do anything to address concerns about liquidity in secondary bond markets. The minority that have looked into it or done something tend to be those that are sizeable bond investors themselves. Indeed, discussions with member treasurers over the first half suggest that the most common way that treasurers are seeking to address secondary bond market liquidity concerns is to steer their own bonds toward buy and hold investors, including other corporates.
For corporate cash portfolios, the other thing that can be done, and is being done by treasurers on the forefront of this, is to strive to do a better job of forecasting liquidity needs to limit the fire-drill situations where they have to sell a bond quickly. On the other side of the coin, they are also analyzing the number of days they will need to sell various bonds in their cash portfolio without a major haircut under various scenarios, including stress scenarios, and bucket assets by their expected sell windows along with maturities to match potential liquidity needs. Banks and asset managers, which are doing this for their regulatory-driven liquidity stress-testing, are in a position to help their treasurer customers with this analysis, too.
What About Bank Credit?
One reason the majority of NeuGroup funding discussions in H1 focused on bond-market funding may be that banks continue to be willing to offer credit to investment-grade corporates on very reasonable terms, despite all the discussion of bank regulation making it more costly for them to do so. During M&A discussions, the ample availability of bridge facilities was frequently cited as a market tailwind, for instance.
During a webinar produced in conjunction with HSBC, however, The NeuGroup did address the regulatory impact on bank credit pricing and availability; specifically, in the context of a rule change proposal by the Basel Committee on Banking Supervision. The Basel Committee proposal is outlined in a consultative document released in March, “Reducing variation in credit risk-weighted assets—constraints on the use of internal model approaches.” What’s concerning is that it (1) specifically targets international banks’ risk weighted regulatory capital (RegCap) methodologies concerning large, well-rated corporates and (2) moves away from more sensitive risk-based measures by disallowing banks’ use of internal models in determining how much regulatory capital they must hold for lines of credit to these customers. The Basel Committee proposal defines large corporates as those with more than EUR50bn in total assets. For treasurers of these companies, the rule change will add to the regulatory pressure on banks to raise at least their indirect cost of credit dramatically.
Key takeaways
- Regulatory requirements increasing. While the capital requirements push up the cost of credit facilities, one corporate on the webinar noted that they have been told by banking partners that their line costs are going up due to liquidity requirements as well. Indeed, what many bank corporates customers fail to realize is that Basel and other major-market bank regulators are continuing to up the ante. “People are already talking about how banks are already facing Basel IV, before Basel III has even been fully implemented,” noted HSBC. One of the problems with getting corporates engaged on the topic of bank regulation is that it gets highly technical quickly, and simplified examples cannot tell the whole story. Also, banks have been accused of crying wolf on Basel-related impacts, largely because most investment grade corporates have not seen them impact pricing—indeed, with credit pricing, it only seems to be getting better.
- Look out for phase-in cliffs. The fact of the matter is that most of the Basel rules have been phased in over time and many banks have been able to work within the new constraints as they become effective. However, as more and more of these regulations come on-line, the impacts may very well start to be felt more acutely. Meanwhile, regulators continue to propose new requirements that may exacerbate the adverse impacts, and these too are being phased in.
- Divergent impacts across banks… Related to corporates not feeling the impact is the reality that Basel rules impact different banks differently (e.g., the top two global systemically important banks face higher capital surcharges than others and US banks face different requirements than European or Japanese banks because they use standardized regulatory capital floors as part of Dodd-Frank). Meanwhile, all banks competing in various lines of business, starting with credit offerings, are doing all they can to continue to remain competitive despite the disparate impacts. They can only do this for so long and it becomes more difficult as each element of Basel III and its add-ons reaches its effective date.
- …and across business lines. Another factor in banks’ adjusting to new RegCap requirements is how they allocate them to the lines of business that ultimately price out the bank product or service. According to a recent survey of The NeuGroup’s Bank Treasurers Peer Group, banks in the group with more than $50B in total assets—the threshold at which they become eligible for the bulk of Basel III along with the US Comprehensive Capital Analysis and Review (CCAR) rules—allocate capital based on the most restraining capital measure (50%) or regulatory capital (13%) in the majority of cases. For most of these banks, the most restraining measure of capital is regulatory capital, typically that from CCAR (if they are US banks), aka stress-tested capital. But they still must factor in all RegCap requirements to consider the most restraining one. The problem is that bank treasurers and capital planning teams face challenges in working the most restraining measure into their capital allocation systems. For one, most of these systems were built for economic capital, which increasingly is the least restraining measure. Also, no line of business head wants to have their performance measured on a RegCap requirement well in excess of what risk-based economic models say the capital charge should be. So, instead, banks often compare the economic capital allocation to what should be allocated given their immovable RegCap requirements and insert a fudge and/or buffer some of it at the corporate center. Each bank may balance the competing interests differently.
Outlook
While direct pricing may be the last thing to adjust to the new rules, increasingly, corporate treasurers are becoming aware of how much more aggressive banks are getting in asking for wallet to help compensate them for use for their balance sheet (and liquidity). “As for Basel and RCF’s, we’ve studied this in quite a bit of detail,” noted one member, “and we don’t expect banks to adapt their undrawn pricing despite the increasing regulatory costs.” Instead, “they will just put more pressure on us for ancillary business—business that doesn’t exist.” According to him, a likely victim will be the corporate CP program, which as a cash-rich corporate it can likely drop in order to avoid the need for a revolver back up that will never be drawn. Or, the rating agencies will have to allow corporates “to get freed up from the RCF requirement.” Accordingly, as treasurers look to allocate wallet and manage their bank relationships, it becomes increasingly important that they understand how the rules impact each type of bank and business line and consider this in wallet allocation and bank-group targeting going forward.
Conclusion
It is ironic that funding-market concerns at the start of H1 were focused on Europe and the state of its bank capitalization needs and, at the end of H1, it is the focal point again due to Brexit. Event risk warnings about Brexit felt like afterthoughts in many presentations over H1, and few members likely spent much time considering the impact on bond markets. But now that it’s a done deal, early signs are that US investment grade issuers may actually benefit. “With global yields on sovereign bonds falling further in the wake of Brexit and central bank stimulus, US corporate bonds may be one of the last remaining pockets of relatively safe income,” says Susie Scher, head of Investment Grade Capital Markets and Risk Management for Goldman Sachs. By early July, US companies were wading back into the bond market with new investment grade offerings, underscoring the strength of the corporate bond market. “In fact, the IG market could be poised to benefit from a flight to quality,” Ms. Scher explained. Will the corporate bond markets continue to be so favorable in H2? This is something NeuGroup members are sure to want to discuss. We are in uncharted territory after all—and without a map to navigate, what better time to have the insight of trusted peers.