Balance sheet overconfidence

A bit technical this one. Business Spectator column about the health of Australia's companies. All good...for now.

Balance sheet overconfidence

Corporate Australia's balance sheets are now showing virtually no vestige of the credit crunch, but they are by no means home and hosed.

Australia confirmed its status as the great escape artist in the most emphatic way this week. While most central bankers are still assuring their constituents that they had no immediate intentions to withdraw support measures, the RBA thrust us atop a pedestal by becoming the first of the G20 nations to lift rates.

But nowhere is the ability of the Australian economy to dodge a bullet more evident than in the financial metrics of Australia’s largest corporations.

Be it by good luck or good management, there are no remnants of the stress of the past two years in the sets of statistics presented by Fitch Ratings at a recent market gathering. The agency says that although gearing levels remain elevated, cash has continued to flow and credit metrics are healthier than during the last downturn in 1992.

Part of this perky outcome for Australia’s corporates is down to what Fitch calls "the residual positive impact of the resources boom" as China continues to scale up economic activity. Australia is well endowed and well positioned in the current circumstances and corporate balance sheets are benefiting.

The big get out of jail card dealt to local treasurers, and one which credit investors are grateful for, is our deep and liquid equity markets. While banks and bondholders ran for the hills, equity investors were happy to recapitalise those companies with stronger business models but whose financial profile was impaired by the downturn.

This cash injection, equal to over 10 per cent of total shareholder funds, pushed debt ratios back to 2006 levels. Without this backing, debt to earnings would have soared to a 1992 number.

With the help of the massive equity raising and a timely re-opening of bank and debt capital markets, treasurers have to some extent managed their liquidity profiles and ensured that most of their looming debt is refinanced.

But it is not time to celebrate. Finding bears at a credit rating agency gathering is not hard (it is the job of a credit analyst to fear the worst) and there is much for corporate Australia to be concerned about.

While the property sector has found its way back into favour, it continues to worry some. Commercial property values remain opaque due to a fairly dysfunctional market, while the inherent structure of AREITS means that companies are obliged to pay out most of their profits. The leverage of the sector becomes apparent when comparing like-rated corporates. While a firm like Foster's can easily pay back all its debt in several years, it would take Westfield – the most lauded of property firms – well over 20 years, even if it was allowed to halt all its dividends to clear its debt.

Another sector that has attracted attention is the energy and utilities sector. Steve Durose from Fitch ratings points out that firms in this sector are likely to need a combination of both debt and equity to meet the massive capital expenditure requirements to maintain networks' security of supply and to transition to a lower-carbon electricity generation mix. Expect to see deals done in both local and international capital markets to support the increased need for new funds.

Many of the other sectors should be alright and could benefit from the booming offshore bond markets. Borrowers in non-cyclical sectors are finding plenty of interest in their bonds. An Australian dairy firm recently tapped markets at margin that was almost half that paid by property trust Dexus, while demand for beverage companies’ bonds is said to be strong. In the domestic market, Wesfarmers has seen its bonds sought after, and perform much better than some of the other new issues, due mainly to its non-cyclical retail assets. And overnight, telco Optus priced ten year bonds 32 basis points inside of Commonwealth Bank, considered among the safest in the world.

Refinancing still remains an issue for many corporates. As James Wadell, director of capital markets origination at NAB noted: “The price that you pay on a bond issue is not important, it is the ability to access the market, and for some that access is still not there.”

Fitch estimates that over $A223 billion of refinancing needs to take place until the end of 2012, most of which is bank debt. More imminent, the ‘twin towers of debt’ loom with large spikes of corporate debt maturing in 2010 and 2011.

This massive task is for the most part expected to be handled. The figure is distorted to some extent by facilities that may never be used, and a winding down of capital expenditure in the material sector will increase the ability to pay down debt.

While the credit crunch doesn’t show in the aggregate stats, treasurers will be humbled by the experience. One lesson they would have learnt is that concentration of maturities and markets will cause headaches down the line. This could result in a strategy of tapping more markets, more frequently and in smaller amounts to smooth out debt profiles and avoid refinancing spikes.

And it is not only corporations that should be wary of celebration.

Despite the chest beating that this week’s rate rise brought, Fitch still has Australia’s foreign currency sovereign rating below AAA to reflect the reliance of our financial institutions on the continuous functioning of offshore debt markets.

Local corporates also face significant uncertainties in the context of the broader economy.

Sarah Percy Dove, Colonial First State’s head of credit research, comments: “We see the rally continuing across all risk assets until government stimulus is removed globally. There is a general acknowledgement among policymakers that it must be done. The unexpected consequences however remain to be seen.”

Bank to the future

This is article forms part of the cover feature for the July/August edition of Insto magazine. We examined the future of Australian banking from a variety of angles and created a cheesy move poster cover to get the point across that banking was going 'back to the future'.

http://www.insto.com.au/story/feature/001019/bank-future

Insto surveyed analysts and bankers on their views for the future. Their collective opinion is that a rear vision mirror will be more productive than a crystal ball, as Jonathan Shapiro explains.


The banks that go back to basics will prosper in the 2010s.

"I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones," Albert Einstein once said. We’ll probably never know if he was right, but the prediction has rung true for global banking. The annihilation inflicted by highly complex structured products to once mighty institutions has left the industry unable to dabble in anything other than centuries old vanilla banking.

So, after the first decade of the 21st century, is the sector in retreat? And what does the future hold for Australian banks, which for the large part withstood the credit crunch? Insto’s special survey on the future of banking explores the outlook for the region’s banks from a number of angles.

A strong focus on old fashioned banking, or customer loans, was a key reason for the limited impact of credit crisis in the region. This focus looks set to continue. The way our banks do business, and the customers they seek will not change. What will be different is how they attract money. Conservative funding will prevail for years to come, restraining returns for shareholders as leverage is reduced.

But opportunities are there for Asian and Australian banks. They will develop new ways, independent of existing European and US models, to develop technologies, seek growth opportunities and service their customers.

The local regulators attained national hero status for their proactive approach to overseeing the banking system, but they can’t afford to rest on their laurels. In a globally connected world they will have to ensure that our policies still hold up after a wave of regulatory change has washed through the developed world. Regulators will also have to find the delicate balance between ensuring our four pillars stand firm and giving the next tier of local institutions a fair go.

Who will banks hire to take them into the brave new world? Banks will still attract the best and brightest but they will be enticed by the promise of stability rather than the prospect of bonuses and stock options. And it will be a person with a specific focus rather than Mr Multipurpose that banks will desire. This is the bank of the future.

Traditional is the new chic

By luck or design, a focus on age-old business products helped Australia’s banks avoid many of the massive losses their global peers suffered. What the crisis has changed, possibly forever, is the way banks fund themselves.

“For many years going into the crisis, the liquidity levels of the banking industry were not a great area of focus. That’s going to be a lasting legacy, particularly because Australian banks have a reasonably high reliance on deposit funding,” says James Ellis, Credit Suisse’s banking analyst.

“Banks have increased their focus on deposit gathering and looked to reduce their reliance on short-term funding. At the same time, capital levels have been increased significantly. While this is to some extent a function of the times, I think that even once markets settle down leverage levels will remain comfortably above pre-crisis levels,” adds Tim Roche, an associate director at Fitch Ratings.

This reduction in leverage through increased capital, and the need to hold lower yielding but more liquid assets will hurt profitability.

“All things would point to return on equity coming under some pressure. The question is: what’s the sustainable ROE using cross-cycle assumptions? Going forward, cross cycle assumptions might mean that bad debts will be higher, system credit growth won’t be as strong and liquidity might be permanently more expensive,” says Ellis.

Shareholders could eventually force banks to shed their risk aversion.

“How long this continues will depend on shareholders. They are likely to be tolerant to ultra conservative behaviour for short periods of time but as competing banks take on more risk and chase yield others may be obliged to follow suit,” says Sharad Jain, a credit analyst for Standard and Poor’s.

Guaranteed to reach its use-by date

The government’s guarantee scheme was a hastily introduced at the height of the crisis, to prevent a flight of capital away from the banks. The wholesale debt component is likely to be phased out.

‘The government guarantee for deposits and wholesale funding in its current form is unlikely to be a permanent feature of the banking system, although it will probably take a while for it to be unwound,’ says Roche.

Sharad of S&P agrees. “It is most likely to be a coordinated winding down in consultation with the governments of other G-20 countries, and after the global financial markets have sufficiently stabilized,” he says.

The guarantee scheme on deposits will stay, bringing it in line with other developed nations’ deposit insurance schemes.

“Australia was fairly unique in that it’s had no deposit insurance mechanism in place amongst the developed world. The one thing I can see potentially being changed is the current cap of $1 million, which is relatively high in a global context. A global benchmark is more like $50,000 to $100,000,” says Ellis.

Lending for more than interest

Corporate lending has been a source of pain for Australia’s banks. They’ll be demanding more than additional yield from their big ticket clients.

“Banks don’t want to do just straight lending; particularly as risk-adjusted returns are not very attractive there. I think there are more banks trying to get a greater share of wallet from institutional customers, which they are providing loan facilities to,” says Ellis.

“Because the banks have got liquidity in capital from which to provide lending they’ve used that to get additional collateral business to make a more profitable customer relationship,” he says.

The credit crunch exposed the shortcomings of some of the major banks’ wholesale operations. ANZ spent 2008 dealing with damaging fallout from their “hobby businesses” such as private equity and margin lending. Westpac and CBA had mixed success with intentions to build or improve on their equities distribution businesses and NAB took heavy hits on assets in its structured credit conduits.

“Basically they were going down the path of the ‘originate, warehouse and distribute’ models so it will be interesting to see whether they revisit that model again, because there’s been a substantial pull-back from it,” says Ellis.

It’s AA all the way

Australian banks might be cleaner and leaner but they still face challenges. While S&P has enough confidence to reaffirm the coveted AA stamp on the major banks, they see three potential risks that would lead them to downgrade the banks’ credit ratings:

the banks’ losses could be underestimated;

another disruption to wholesale funding markets could leave the banks once again struggling for funding; and the banks may shed their risk aversion through acquisitions or other strategies.

It’s been a close-run race at times, but our banks pulled through, and what didn’t kill them has made them stronger.

Trillion dollar confusion

Here is the latest piece to be published on Business Spectator. This looks at why credit and equity markets don't alway move in sync..Fascinating stuff !

Trillion dollar confusion

‘Corporate bond issuance hits new record’ ran the headlines on Wednesday. On Thursday however we were reading ‘Corporate bond defaults hit record.’ If you’re confused by news emanating from credit markets, don’t worry because you’re not alone.

Earlier in the week, data firm Dealogic reported that global corporate bond issuance had hit $US1 trillion for the year, the first time it had done so. With banks reluctant to lend and bond funds eager to invest at bargain levels, the result was a boom in bond issuance.

The volume and performance of corporate bonds masks the fact that 2009 is the worst year on record for bond defaults as 201 borrowers, with $US453 billion of debt, have hit a wall. The numbers look nasty but have, to a large extent, been priced in while restored confidence in the credit sector is allowing companies to re-finance, slowing the default count ticker.

It has however been a week of mixed signals as credit reached an ‘inflection point’.

Investors and traders are asking if the reversal in credit spread tightening is a sign of a healthy pullback or a precursor to a return of the bear market.

And it’s not only dealers who are debating but entire asset classes, with equity and credit markets agreeing to disagree. While stocks bounced back emphatically from a poor start to the week, credit indices have underperformed, trending lower.

There are a number of reasonable explanations for the disconnect. For starters, credit’s rally has been fiercer and faster than any in its history. Its current weakness may be reflecting a more profound correction relative to equities.

Another premise may be that credit markets tend to focus on suppressed economic fundamentals such as consumer spending, while equities have taken heart from what appears to be an improving corporate profit outlook.

It’s a natural bias given credit’s real gains from an economic revival are moderate compared to stocks, and the varying macro-economic views as to the shape of the recovery may be at play, resulting in divergent investment decisions by debt and equity investors.

There is a more elementary reason to explain why credit and equity markets move out of sync, however. It’s the classic conflict of interest between owners and lenders.

During the darker days of the crunch, credit and equity were in the trenches together, and both sets of investors demanded hasty deleverage.

But as the darkness lifts, the dilutive capital raisings have left shareholders with a smaller piece of a lower yielding pie. For bond investors, especially in investment grade corporates, the legacy of the credit crunch is a positive one.

This week’s set of corporate earnings highlighted the trend. Investment grade corporates such as Rio Tinto, Wesfarmers, Santos and the AREITS told investors that massive equity issues, dividend reductions and asset sales had significantly reduced their debt burdens.

But the leverage clock never stops ticking. As the environment stabilises, companies are once again seeking to appease their stockholders. This week saw a number of equity ‘deals’ with growth rather than capital management a motivating factor. There are also rumblings of some IPOs on the way, marking what would be the final stage of the recovery of our capital markets.

Blackstone's new deal

I've recently begun contributing to a far-reaching Australian finance website- 'Business Spectator' on a weekly basis, as part of our efforts to broaden the brand of our publication, which tends to be followed only by readers in debt markets.

The columns (I've always secretly wanted one!) are published on the weekends, posted after midnight on Friday and removed by 8am Monday morning for minimum exposure, but hopefully enough readers will come across them. The intention is to convey the events in credit markets for the week and their impact on broader markets.

Business Spectator - 15 August - Blackstone's new deal

Blackstone's new deal

Some say the top of the last bull market was easy to pinpoint. It was the day when the smartest deal makers in the world, known for cashing in by taking businesses private and reselling them to the public, sat at the end of a long oak table and told you to buy their own firm. That was the time to get out.

Private equity merchants Blackstone listed in a $US4 billion IPO in June 2007. The rest is black history. This week, Blackstone was back, tapping the bond markets for $US600 million of 10 year bonds, taking advantage of an incredible surge in demand for corporate bonds. Blackstone received over $US3 billion of bids as corporate bond investors scrambled for paper, allowing it to price well inside of guidance.

Time will tell if Blackstone’s deal was as ‘impeccably timed’ as its share offer was, over two years ago. It does, however, raise the question as to sustainability of credit’s rally and the window of opportunity to raise funds through a resurgent corporate bond market.

While Blackstone’s issue was well supported, there were some signs that demand for corporate bonds is waning. A single basis point slide in Merrill’s corporate bond index brought an end to a 23 day rally in cash bonds, while high yield bonds widened for three straight days after 16 positive sessions.

Credit indices also trended wider this week. The US’s CDX index was 10bps wider for the week by Thursday’s close while the Euro Main index was steadier trading around the 90 mark.

For the time though, the sector remains resilient with bearish traders too reluctant to bet against a general tightening bias. While the summer lull is slowing the supply of paper, those that do print deals are welcomed emphatically.

"I expect this risk rally to continue into – and maybe through – a large part of August. What happens after that? The next ugly leg of the bear market begins as we get into the July through September 'tipping zone', driven by the failure of the data to validate the V (shaped recovery) that is now fully priced into markets," said Bob Janjuah, RBS’s chief credit strategist.

Eye-catching rally

The performance of corporate bonds is attracting more widespread attention. Some equity analysts are watching for a slowdown in demand for corporate bonds, which has allowed companies to access funds at fair levels, for warning signs of a pullback in stocks. Plus credit markets have good brand as fortune tellers, having sold off sharply before equities came crashing down in 07.

The Bank of England has made a ‘mint’ from its corporate bond portfolio. As part of its quantitative easing initiative to boost liquidity, it piled into the sector in March and its portfolio is now up over 10 per cent prompting analysts at Evolution Securities to suggest it start operating as a hedge fund.

China however is perturbed by the rally which it says has made yields too low. It plans to set a minimum yield of 4.2 per cent for five year bonds to encourage investors to the market and wean companies off bank loans. There’s an idea.

Aussie credit still strong

The rally in Australian credit is showing few signs of weakness. While the Aussie iTraxx had snapped back to the 150 mark mid week, it recovered to trade back around 140bps. Corporate credits were helped by solid earnings from local market bellwethers CBA, BHP and Telstra who all reported multibillion dollar profits and strong capital positions.

New deals are continuing to come thick, fast and tight. This week saw two Kangaroo trades print well inside levels seen at the start of the year while Westpac raised a healthy $2 billion of five year senior debt at 35 basis points cheaper than they would have done a month ago.

The guaranteed space has also seen significant spread compression. Investors paid only seven basis points more for guaranteed bonds issued by 'BBB' rated Members Equity than they did for 'A' rated Citigroup. That premium is smaller than the 10bps investors demanded for bonds issued by Heritage Building Society versus like-rated regional Bank of Queensland. Both deals were printed in early July, and have since tightened by 20 to 25 basis points.

Domestically, the week ahead is another heavy one for corporate earnings but with corporate bond issuance all the range, we could start to see some of Australia’s top companies capitalise on credit’s incredible run.

Insto provides debt capital markets insight for their subscribers.

Snowmobiles on 1 April...

As the lawyers get smarter and the population gets dumber, The April Fools news item is a dying art. In the world of debt markets however, where the opposite is true, We thought we'd give it a go, telling our readers that Snowmobile deals would re-ignite our floundering securitisation market. It turned out to be one of our better articles and with abit of humour, we really engaged our readers. Even, the government's AOFM were good sports, providing us with a sharp, and funny response which they allowed us to publish.

***Snowmobiles to kick-start local ABS market***

A group of Australian investment banks are planning Australia’s first ever snowmobile
securitisation deal in an effort to revive the domestic asset backed securities market.

As demand for RMBS and auto loans has waned, banks are getting creative in attracting investors back to the ABS market and a securitisation of snowmobiles is seen as the perfect asset class to rev-up the market.

Investors have cited illiquidity in asset backed markets as the biggest stumbling block to the market’s recovery. Snowmobiles however operate better in less “liquid” environments.
Banks are eager to test investor enthusiasm for snowmobiles and are planning an off-road show for investors at Thredbo this coming winter. It is unclear as to whether the Australian Office of Financial Management will support the proposed issue, but given the snowfield’s proximity to Canberra, if the AOFM does come through as a cornerstone investor, it should be able to keep a close eye on its investment.

***Note on snowmobiles(1 April 2009)***

Some of our less astute readers may not have realised that the previous story "Snowmobiles to rev up local bond market" was nothing more than an April Fools Day fabrication.

While we have every faith in the recovery of the ABS market, we don’t believe it will be achieved via a snowmobile securitisation. In fact some suggested such a deal would receive an ‘icy’ reception, while others hinted that it didn’t have a ‘snowballs chance in hell’ of succeeding.

The AOFM issued the following statement:

“The AOFM is yet to receive a proposal regarding the transaction. As you are aware, the AOFM is only able to invest in prime RMBS. Therefore our initial thoughts are that only snowmobiles with an annex, canvas or plastic, capable of sleeping at least one person and able to be fully closed to the weather and permanently affixed to land could qualify. We are also concerned that the portfolio may have prohibitive geographic concentrations. The transaction is however not without merit. Accordingly, the AOFM thinks that an on-site due diligence over a long weekend in August is required, timing subject to the quality of the skiing conditions at that time.”

We hope you enjoyed the story. We apologise to any investors that raced out to do their credit work on the Australian snowmobile industry and to the irate bankers who rang around to find out why they were not on the deal.

Apart from one foolish email a year, Insto remains as committed as ever to timely, accurate and insightful reporting on Australian debt markets.

Covenant Chaos - Private Equity and the Aussie Corporate Bond market

This article was awarded the 2007 Citigroup Business Journalism Award for Financial Markets. 

My trusted editor, Phil suggested I submit an article for consideration and we were both invited to attend the function at Citigroup's offices in Sydney. On the night neither of us were in the mood after a busy day, but I thought at least one of us should represent Insto. The night, as it turned out , was a treat, good food,good wine, good company, and entertaining speeches. When the category awards were being announced, I was horrified to hear that the winner of the Financial Markets category covered the exact same subject matter as I did.. until I heard my name! My stunned reaction even prompted the MC to ask if he had made a mistake. 

The article was hardly riveting but the judges' comments were that I livened up the dull subject matter of bond covenants, which are nothing more than 'terms and conditions'.  

It was a extremely proud and satisfying moment , but I did feel humbled in the company of other winners - brilliant and seasoned business journalists Barry Dunstan, Gilles Parkinson and Stuart Washington (Stuart was not actually there on the night). It was a confidence boost for me but I knew that I still had a very long way to go before I could consider myself to be in their league. 

Published link

Citigroup Awards link

Private equity’s raid on Coles Myer has served as a wake up call to Australian corporates, and is set to have a lasting effect on Australia’s debt markets. LATE ON AUGUST 17 Coles Myer confirmed rumours that a private equity consortium had made an offer of A$17.3 billon for the company. The following day Coles Myer shareholders saw their fortunes climb. In the credit world, however, panic set in. Cash spreads on Coles 2012 notes blew out. Credit default spreads on Coles also spiralled from 30 points to 100 points. A private equity takeover, the market assumed, would place a heavy debt burden on the company and severely devalue existing debt. But by afternoon the 2012 cash spreads were back where they had started. Investors had spent the day mulling over their documents and reconfirmed that the notes did benefit from extensive covenant protection, including a change of control clause and a financial leverage test. A takeover would have limited impact on the value of the Coles 2012 notes. The covenants had worked. Bondholders could breathe easier, but the market was clearly spooked. That investors could witness one of Australia’s iconic corporations being gobbled up by PE raiders – and their bonds buried under a pile of junk – was not only possible but a probable scenario. Promises, promises A covenant, put simply, is a promise; a commitment to do or not do something and a legal undertaking to comply. “In the case of issued securities, covenants are provided to investors by issuers to ensure they maintain an adequate financial position to meet debt service obligations,” says Craig Saalman, credit strategist at ABN AMRO. This can be achieved in a number ways. Covenant protection ranges in terms of content financial ratios that need to be maintained to behavioural undertakings that ensure bondholders are treated in a certain way. Other operating covenants can be provided to protect investors and banks from a material deterioration in the operating profile of the business or issuer. Covenant protection is a standard feature in the bank loan market with bank creditors demanding financial and operating covenants. They are less common in the corporate bond market, but in an environment where all of corporate Australia is a takeover target, and the risks of noteholders falling down the pecking order are greater, this looks set to change. Takeover protection Covenants protect investors from adverse occurrences that result in the reduction of their ability to service their debt. There are a number of ways corporate credit can be affected, but the most likely trigger is when the company is a target of a takeover. Takeovers, of course, can be good or bad for bondholders. For instance, the AA rated retail giant Walmart has been linked to an offer for Coles, rated BBB. Such a takeover would significantly increase Coles’ ability to service its existing debt. If Coles did fall victim to a leveraged buyout, the opposite would occur. An LBO typically results in a highly leveraged final entity. As there is a high likelihood of a deterioration of credit risk, the value of the outstanding notes would fall. “For Coles, depending on who the final purchaser is, you have an extreme set of outcomes for the credit profile of the company,” says Sarah Percy Dove, head of credit research markets at ANZ Investment Bank. The value of the Coles 2012 notes, however, have stood firm following early jitters but other corporate credits remain dangerously exposed. Australia uncovered In a market where companies have been able to raise cheap money in easy conditions, Australian corporate bond issuance has flourished. As a result additional concessions have taken a back seat; Australian bonds have typically not had strong covenants. “It fell out of favour as liquidity and demand increased,” says Steve Adamek, credit analyst at AllianceBernstein. The irrelevance of covenant protection has been compounded by a market of highly rated issuers. “Because it’s an investment grade market, they are less of a facet,” says Percy-Dove. And the security of covenant protection has served little purpose as investors boldly hunt for yield in a benign credit environment. “On the one hand investors may be well aware that covenants are poor and don’t provide good protection but on the other hand they still want to be in the chase to get hold of decent assets,” said Robin Miller, investment manager at Member’s Equity. “It’s been hard for people to step out of the market and take the highly principled position of not buying because of poor covenants. There has not been a coordinated response from bond market investors,” he explained. “You could put it down to group complacency and unwillingness to give up yield,” adds Percy-Dove. “Investors may have to built a cross for their own back which they will have to wear.” For investors, it has been a time for reflection. As Andrew McLachlan, credit analyst, Perennial Investment Partners, points out, benign credit markets have led investors to be more relaxed on covenants when they should have been paying more attention. “Ironically these are times of higher risk in some ways for investors as the risk of M&A activity, and the possibility of lower ratings attendant with this, is heightened. " Barbarians at the Barbie In offshore markets, where LBO activity is in full swing, investors have been demanding covenants for some time. “Compared with Europe and the US, Australian bond holders are typically less protected by financial and operating covenants,” says Craig Saalman of ABN AMRO. Many Australian issuers that have accessed other markets are well aware of this. Telstra’s outstanding Eurobonds for instance, carry a 25 basis point step up for each ratings downgrade. “We have been relatively insulated from the other trends that have been detrimental to bondholders. The risks have become quite distant on a lot of these things over time,” says Percy-Dove. But private equity and LBOs have arrived in Australia. The barbarians are at the barbie; and the same risks that scalded European and US investors are now becoming prevalent in Australia’s credit market. “Now they seem a little closer to home and a little more real,“ adds Percy-Dove. But investors may be forgiven for being caught off guard. An LBO for a company the size of Coles Myer has not been done in this market. A successful bid would make it the seventh largest private equity deal in history. The threat, however, has well and truly captured the market’s attention now with corporate credit spreads reacting to takeover talk. “The arrival of large private equity bids to these shores is one of the landmark developments we have seen in these credit markets in recent times,” says Chris Viol, head of fixed income credit analysis, Australia & NZ at Citigroup. “The fear has gripped other names including Fosters, Suncorp Metway, Amcor and Telecom New Zealand, with the market failing to differentiate between trade and financial buyers and the likelihood of an eventual bid succeeding,” says Saalman. Viol believes ‘the local leverage clock’ may now tick faster as more corporates examine their capital structures, and that there will be more covenant-related questions asked in corporate roadshows primarily regarding corporate protection. The effects are already being seen. Mirvac, a recent issuer into the market, incorporated a change of control clause because of investor concerns. The covenant protects investors from an event that results in over 50 per cent of the company changing hands and the notes falling to below investment grade. Transurban, the first major corporate to visit the market since the Coles announcement, has also ensured that investor’s demands were met by adding extensive covenants to its five year issue. “In some respects, issuers need the covenant to maintain market price and to maintain where they expected to issue. They have had to give it away,” says Percy- Dove. Origin Energy, the integrated utilities company, is another recent issuer that faced questions from investors on covenant protection. The notes did benefit from financial covenant protection in the form of gearing and interest cover ratios that need to be maintained. Broken promises Investors are not only asking for covenants but questioning the effectiveness of covenants themselves. Are these promises worth the paper they are drafted on? AllianceBernstein’s Adamek is sceptical. “Generally they are either so far from actuals as to be meaningless, for ratio controls, or poorly thought through leaving obvious gaps in structure and definitions,” he says. Saalman agrees: “Material Adverse Change (MAC) clauses are most often vaguely defined which leaves bond investors in a quandary with issuers.” For Adamek the issue is not with the poorly construed covenants themselves, but in the market’s ability to come to terms with pricing and valuing covenant protection. “An investment grade bond can overnight become a sub-investment grade credit on the consummation of an LBO. This type of risk is difficult to quantify and price at time of issuance,“ says Saalman. But if issuers do give up spread to investors in place of protection, does this adequately compensate investors? “Some pressure over the last month is seeing spreads in general moving out. But to date, issuers have not seen any pricing benefit for giving covenants,” adds Adamek. “Investors are not being compensated for the underlying credit risk let alone event driven risk,” says Percy-Dove. Covenant crazy LBO Mania has arrived but it might not be appropriate for Australia to go covenant crazy. Viol agrees and many of the LBOs being touted will not eventuate. “We don’t think investors should get too carried away. We would be amazed if there were more than two major completed LBOs in our local CDS/bond universe by the middle of next year,” he said. There will be speculation and scares though which creates trading opportunities in the CDS and bond markets. Also as Saalman points out, many credits in the market are unlikely to ever fall within the private equity radar. “Because of their market caps and business profiles, some issuers, for example trading banks, kangaroos and corporate names like BHP will be spared these demands (for greater covenant offerings),” he said. Lazy balance sheets While issuers and investors come to terms with covenants, there is a larger issue at hand. The arrival of private equity looks set to shake up corporate Australia and change the profile of its debt capital markets. “We see PE interest in Coles as a precedent event in local credit markets, and it’s our view that as a knock-on effect, the local leverage clock could well start to tick faster,” says Viol. One of the appeals of many of Australia’s corporates is their ‘lazy balance sheets’. Companies that have not fully utilised their capacity to take on debt financing have become attractive targets because of the amount of leverage they can withstand. This creates another puzzle for investors: the better the credit quality of the company, the more vulnerable it may be to a takeover. Credit risk and event risk can be on opposite sides of the coin. Covenant protection may be more relevant where it appears not be. “Ironically, there are times when you can accept the risk of weak covenants in a highly leverage business more so than for a high quality name with a lazy balance sheet. It has probably been easier to advance the need for good covenants to the treasurer of a marginal investment grade borrower than to an apparently stronger business. Sometimes people may have been looking for strong covenant standards in the wrong places,” said Miller. “There will be other boards and corporates revisiting their capital structures,” says Viol. “As our equity guys point out, if local corporates don’t gear their capital structures efficiently, private equity will be quite happy to do it for them. “ Australia Gas Light (AGL) has acted with this in mind. “They have effectively LBO’d themselves when they have moved from A to BBB flat because if they didn’t do it there was a high likelihood that someone else would,” says Percy-Dove. Aussie Corporate Bond Covenant Checklist A list of 23 Australian corporate credits, their takeover and acquisition potential and the covenants they have in place. Many of the notes benefit from ‘negative pledges’ which prevent subordination of the notes. Information provided by Westpac Institutional Bank’s capital markets research team. (Michael Phillip, head of capital markets research and David Goodman, analyst) Company Takeover Potential* Acquisition Potential* Change of Control Covenants Notes AGL/Alinta (BBB/Baa2) Medium High No No Amcor (BBB/Baa1) High Low Yes No Hybrid notes have change of control provision which allows notes to be converted to shares if 50 per cent of shares are acquired. AMP (A/A3) Medium Low No No Negative pledge CCA (A-/A3) Low Medium No No CFS Retail Property Trust (A) Low Medium No Yes Financial covenants – total liabilities/total tangible assets (tta), interest cover, priority debt/ tta ratios Coles (BBB/Baa2) High Medium Yes Yes Change of control review event -two thirds majority can demand repayment in the event of inability to agree to new terms with the issuer. Financial covenants- secured lending/ tta, limiting secured lending and fixed charge cover ratios. CSR (BBB+/Baa1) Low Medium No No Negative pledge DBRREEF (BBB+) Low High No Yes Financial covenants - gearing, interest cover, priority debt/tta Fairfax (BBB) High High Yes No Change of control and asset sale. If 40 per cent of shares are sold and ratings falls below BBB- ,notes can be redeemed at par. Foster’s (BBB/Baa2) High Low No No Negative pledge GPT (BBB+) Low Medium No Yes Total borrowings must remain less than or equal to 25 per cent of authorised investments. Investa (BBB+) High Medium No Yes Financial covenants - total debt/tta; interest cover, priority debt/tta , total net worth. PBL (A-/A3) Low High No No Negative pledge. Qantas (BBB+/Baa1) Low Low No No Santos (BBB+) Low Medium No No Negative pledge Stockland (A-) Low Medium No Yes Financial covenants; total liabilitites/ tta, interest cover, priority debt/assets Suncorp (A/A2) High Low No No Negative pledge Tabcorp (BBB+) Low Medium No No Negative pledge TCNZ (A/A2) Medium Low No No Negative pledge Telstra (A/A2) Low High No No 2008 notes do have covenants (step ups for ratings downgrades) therefore trade tighter to other Telstra notes Wesfarmers (A-) Low High No No Negative pledge WestfieldTrust (A-) Low Medium No No Negative pledge Woolworths (A-/A3) Medium Medium No No Negative pledge Poison pill While issuers may be reluctant to issue covenants, they could potentially be used to ward off unwelcome suitors. By adding covenants that compensate noteholders, the issuer can create additional expenses for the acquirer. This is known in M&A lingo as a ‘poison pill’, which the buyer must effectively swallow. “I still think short-termism prevails. The treasurer gets most of his brownie points from basis points rather than constructing barriers of protection,” said an observer on why covenants are unlikely to appear in this form. There could be other reasons. One observer suggested that a takeover is “not the worst thing” for senior management, who may receive payouts and be able to exercise share options. Also under ASIC regulations, certain actions that could be regarded as inhibiting a takeover must be brought to their attention. In this case, issuers may prefer a looser covenant package if it results in less difficulty. Asian attraction As private equity coffers continue to amass cash, the region is attracting the attention of the some of the industry’s big guns. “Asia generally is emerging as a region of interest. Locally we have stable political, economic and regulatory regimes, and in many industries we have duopoly or oligopoly type concentrated industries that are attractive,” said Viol from Citigroup. Australian credit is sliding. The average credit rating has transitioned from a high A to the cusp of low BBB. The threat of LBOs, as much as LBOs themselves, look set to accelerate the process. “You can expect the credit quality of corporate Australia to continue to decline. Potentially it’s going to open up a high yield market,” says ANZ’s Percy-Dove. Corporate Australia and its lenders are now facing a world they had not contemplated before August 17.

Distressed for Success - Opportunity in dislocated markets

As the ‘Goldilocks era of global credit draws to an abrupt close, distressed debt funds, and private equity, are forming a line to pick up the pieces. Jonathan Shapiro reports. They’re known in some circle as vultures, ready to feed off the remains of faltering companies. To others, they’re knights, guiding damsels out of danger to live once again. Regardless of how they are perceived, there’s plenty of skin in the game for distressed debt funds. Distressed debt is not for the feint hearted. While the rewards are lucrative, the risks are high, and skills, experience and knowledge are required to avert disaster. A distressed debt security can be loosely defined as a bond or loan that trades below 80 per cent of par value or at a spread above 1000 basis points over government securities. Distressed debt is more of an investment strategy than an asset class. Once a security deteriorates to the extent that it becomes distressed, and existing debt holders head to the exits, opportunities are created. It’s a highly complex game that remains the domain of dedicated and specialist distressed funds, hedge funds, private equity houses and specialist teams within private investment banks. “What constitutes ‘distressed’ is a very broad range of situations from straight liquidations to refinancing and even to the extent of contributing equity value,” says Tod Macri, managing director of the strategic investments group at Deutsche Bank in Hong Kong. Distressed debt is regarded as part of an “event driven” investment strategy in which a passive or an active approach can be taken. On the active side investment can be “controlled” or “non-controlled”. “Distressed investors could assume a degree of control of the company and restructure it to turn a profit. It’s more of the private equity approach,” says Urs Alder, , head of institutional sales, Man Investments Australia. (remainder of article not available) .

Big Boys & toys - Asset Finance takes off

It was once the “grubby” end of banking, but as globalisation brings economies closer, banks are seeing opportunities in asset finance, writes Jonathan Shapiro.

Every day thousands of ships, planes, trucks and trains keep the economy ticking by moving people and goods around the world.

Under the ground, earth moving machinery extracts resources which are then placed on trains and trucks and transported to ports.

On the seas, 50,000 ships carry 650 billion tonnes of goods. In the air, 72.7 million flights move 4.5 billion passengers and 85.6 million tonnes of cargo each year.

Underlying the hundreds of carriages, tankers, jets and drills is an intricate system of financing that is growing ever more important. Welcome to the world of asset finance.

Asset finance focuses on movable assets. If it can be unbolted, boxed and sent somewhere else, it falls into asset finance. Asset finance often overlaps with project or infrastructure finance but it’s the financing of trains, rather than the railway system, the aircraft rather than the airport.

“Our portfolio is quite diverse… major mobile mining equipment , exposure in passenger and freight rolling stock, ships, commercial aircraft, a good range of diversified and manufacturing equipment,” said Nick Fletcher of the CBA.

Fletcher heads up CBA’s asset based finance team of 35, which looks to structure and fund asset finance transactions for a range of clients.

In a typical asset finance transaction, the bank lends to the owner, who enters into an operating lease agreement with the user for a term – usually five to seven years. The rentals paid to the owner by the user pays down the debt, but only to a residual value.

The user has access to an asset without having to own the asset and hold it on its balance sheet, the financier earns the rental income and the difference between the residual value and the realised value and the bank or lender earns the interest on the debt, backed by a real asset.

Financing moveable objects has its nuances.

“It takes a blended view on both the credit covenant needing to establish serviceability for lease or rental payments as well as forming a critical view of the security the underlying asset provides in terms of resale or reuse,” said Fletcher. Historically, the role of an asset finance team was to optimise tax and accounting laws that can technically be operated anywhere.

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New Dimensions in Credit - the rapid growth of credit derivatives

This article, written in April 2007 explored the rapid growth of credit derivatives. Little did we know the damage these products would unleash! 

Credit derivatives continue to transform the credit world and open up new dimensions for fund managers, banks and speculators. Jonathan Shapiro reports.

It has been over a decade since the wonder-kids of JPMorgan dreamt up the notion of credit derivatives.

A group within the bank’s global derivatives department assembled in Boca Raton to brainstorm the next big thing in their field.

High on the agenda was the idea of creating securities to insure against the risk of a credit default. For the bank, it would allow them to manage the risk of its portfolio of loans and bonds, and for investors, if the price was right, it provided a healthy return.

Today the global market for credit derivatives is worth over US$26 trillion and still growing at breakneck pace. ‘‘The recent global growth in CDS has been dramatic with CDS outstandings now dwarfing bonds,” said Chris Viol, head of credit analysis, Citigroup.

The CDS universe

The most common form of credit derivatives is a credit default swap. A CDS is quite simply an insurance contract whereby one party - ‘a buyer of protection’ agrees pay another party - ‘a seller of protection’ a premium in exchange for cover if a borrower defaults on a debt obligation.

In many respects, a CDS resembles a bond exposure; the seller of protection who receives the premium is ‘long’ the credit while the buyer of protection, who pays the premium is ‘short’ the credit.

The price of a CDS is quoted by a basis point spread, which just like a bond spread widens as the credit is perceived to weaken and tighten as it strengthens. If a company’s credit worsens the CDS spread which reflects the price of insurance will rise and will increase the value of an existing contract. If the credit improves, the price of insurance will decrease and the value of an existing contract will fall.

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