Hitting a Wall of Debt - Global Finance Magazine

COVER STORY: CORPORATE DEBT

A gargantuan wall of debt coming due over the next few years could impede all but the highest-rated corporations’ efforts to refinance their debt.

By Jonathan Gregson

Just as the United States and other developed economies are emerging from recession, with GDP growth returning and strong corporate earnings pushing stock markets back up to pre-Lehman levels, another bogeyman is waiting to pop out of the wings. Once again, it’s a hangover from that free-spending era of easy credit that was the mid-noughties. But this time it’s not mortgage-backed securities or consumer credit that is the problem. It’s longer-dated corporate and government debt that is coming due for refinancing from 2012 onward. And the numbers are awesome.

Massive demand for new money from capital markets is going to come from right across the spectrum, from ostensibly risk-free triple-A-rated sovereigns such as US treasuries, through investment-grade corporates, to high-yield (and therefore high-risk) junk bonds.

Come 2012 some $860 billion of US government bonds will reach maturity and need refinancing. Add to that an anticipated federal deficit of $974 billion, which will also need to be funded, and the US government’s demands on capital markets amount to more than $1.8 trillion. And a further $1.4 trillion is called for each year through to 2014.

Over precisely the same period, a huge swath of companies that borrowed on easy terms between 2003 and 2008 will be seeking to roll over their debts by taking out new loans or issuing bonds—the usual maturity for corporate debt being five to seven years. Analysts at Credit Suisse estimate that $34 billion of US high-yield bonds will mature this year, but by 2015 nearly $120 billion of junk bonds will reach maturity and therefore need refinancing.

That may be a headache, but the real problem lies elsewhere, with the mountain of leveraged loans taken out by sub-investment-grade companies during the boom years. Whereas only $24 billion matures this year, from here on debt retirement rises steeply to peak at $290 billion in 2014, according to Credit Suisse.

The same is true across the Atlantic. Just €6 billion of leveraged loans will mature in Europe this year (figures include the Middle East and Africa). By 2014 that rises tenfold to €61 billion. The outlook is better for European high-yield bonds, where redemptions rise gradually from €15 billion this year to peak at €23 billion in 2014.

Mind the Gap

Clearly, both the United States and Europe are facing a huge funding gap. Credit Suisse estimates that in the US approximately $560 billion above the capital market’s normal capacity for new issuance will be needed between 2012 and 2015 to refinance retiring loans and junk bonds. In Europe the crunch comes slightly later, with some €255 billion needing to be refinanced between 2013 and 2016. The numbers may get even scarier, as these forecasts exclude “fallen angels” that slide from being investment-grade to high-yield issuers, companies that default during the profile range, and all new issuance that could crowd out refinancings of existing debt.

“There is a wall of redemptions out there,” admits Jean-Marc Mercier, European head of global syndication at HSBC, “but we are very optimistic about the market’s ability to respond.” Mercier’s confidence is partly due to the combination of negative real interest rates, quantitative easing and the rapid return to “normality” of most capital markets, which has created an exceptionally benign climate for both financial sponsors and corporate borrowers.

Then again, the move by many corporates toward paying down their debts and reinforcing their balance sheets means there is less demand overall, while today’s relatively low levels of M&A; activity translate into fewer calls for genuinely new issuance.

Nonetheless, with the high-yield sector alone facing a funding gap of close to $1 trillion globally, new money must be found to get through the “maturity wall.” And now that banks are generally much more cautious in lending to companies, the bond markets will have to take up the slack.

“There is a broad shift among corporates away from bank lending to bond markets,” says Mark Lewellen, head of European corporate origination at Barclays Capital. “Companies are increasingly aware of the benefits of diversifying their sources of funding,” he adds, noting that previously unrated companies are now looking to issue bonds.

The abrupt shift from bank financing to bond markets is even more pronounced in Europe, according to Ian Falconer, finance partner at London law firm Freshfields Bruckhaus Deringer, because most European companies have traditionally looked to their banks rather than capital markets for funding (the reverse is true in the US).

So far, corporate bond markets have comfortably absorbed rising demand. “Last year saw a record $200 billion of high-yield issuance globally,” says Mathew Cestar, co-head of the credit capital markets group in the Europe, Middle East and Africa (EMEA) region at Credit Suisse. The first quarter of this year has been the busiest ever, with $85 billion of deals done, he says, adding that “the lion’s share has been refinancing as corporates are looking to refinance ahead of the big hurdle coming up in the next two to three years.”

Many corporates are adopting the same approach, which may cause its own set of problems. Ronan Clarke, head of high-yield research at Nomura, agrees: “Many companies are dealing with maturity issues early, but this leaves the worry that, when we get closer to the cliff coming up in 2011-2012, weaker credits will all rush to refinance at the same time.” Cestar notes that in Europe alone more than €250 billion of refinancing needs to be done in the next few years. “Companies want to secure their funding to take them beyond that period,” he says.

The Calm Before the Storm?

For the present, at least, companies can still raise money relatively cheaply. “Many corporates are de-leveraging,” says Mercier, “so there is not enough issuance to meet investor demand.” In Europe, for instance, some €119 billion of investment-grade and high-yield bond issuance was completed in the first quarter last year, while for the same quarter in 2010 issuance plummeted to €50 billion. As a result, Mercier says, “the dynamics of supply and demand are moving in favor of corporates looking to raise money.”

“There is still not enough supply to satisfy demand,” says Cestar, pointing to recent transactions in Europe that have been many times oversubscribed. That is equally true of the US market where, notes Dirk Leasure, the New York-based head of BMO Capital Markets financial sponsors group, there is currently “a tremendous pool of capital—some estimate it at $400 billion—held by financial sponsors looking for investments.”

Driving that investor demand is the search for enhanced yield in today’s low-interest-rate environment. Or, as Rik Fennema of Nomura’s investment-grade research group puts it, “Money needs to be put to work, and there’s a lot of retail money that entered the market because savings accounts offer so little return.” Mercier adds, “Only a massive rally in yields when short-term rates start rising will dampen that demand.”

The same momentum is present in Latin American markets, which, says Michael Fitzgerald, head of Latin American practice at Milbank attorneys, have been arguably the best place to invest over the past year. He points to a string of high-yield eurobond offerings coming out of Mexico, Brazil, Colombia and Peru, beginning last July with the Mexican group Javer sporting a 13% coupon. “Since then,” Fitzgerald says, “we have seen close to 40 high-yield issuers out of Latin America, and the spreads have tightened, with the Mexican pulp and paper group Scribe paying less than 9% after its oversubscribed bond issue was increased from $200 million to $300 million.” He adds, “This market is really on fire, and Latin American companies all want to go ahead now.”

Some investors, notably the Japanese, are more cautious. “Investors looking outside their home market are generally more selective and go for lower-risk credits,” says Fennema at Nomura. “Don’t expect to find Asian investors dipping into Mittelstand or smaller, unrated companies soon.”

Investors Seek Yield and Influence

Strong investor demand in high-yield corporates is enabling sponsors to become more creative in how they deploy capital, Leasure says. “Many prefer to invest in a company’s debt,” he says, “and use that as a tool to help the company restructure its balance sheet.

For example, rather than going for a straightforward equity capital injection, thereby becoming an investor with a minority ownership position, some sponsors are buying up a company’s debt in the secondary market and then exchanging it with the company for new equity, and perhaps a larger ownership position.”

Convertible bonds, where bondholders can convert into equity in the company, are also broadening in scope. “Whereas last year it was mostly investment-grade companies issuing convertible bonds, as the cost of financing has fallen more, high-yield or unrated companies are entering the market,” says Simon Ollerenshaw, head of European convertible origination at Barclays Capital. He sees a window of opportunity for companies to issue convertibles based on today’s high stock prices, either to replace existing senior debt or to finance M&A; activity without having to go back to shareholders with another rights issue.

CFOs must work out in advance the immediate cash-flow benefits of convertibles’ lower coupon against the diluting of shareholders when the bonds convert to equity. “There exists a wide group of unrated companies for whom convertibles are a more natural home than straight debt markets,” says Ollerenshaw.

Buoyant capital markets are currently permitting private equity and other leveraged investors to cash in. Clarke points to the re-emergence of “dividend deals,” where LBOs issue a bond or raise new debt in order to distribute cash to shareholders rather than for investment purposes or restructuring the balance sheet.

At the same time, investors are seeking greater protection in the wake of the financial crisis. “The way European bonds are structured has improved, so that with senior secured bonds broad-based investors virtually step into the shoes of bank lenders,” says Cestar.

Lewellen notes that often the terms and language are more specific, to provide a greater level of comfort for investors. “For instance, unless the bonds are rated within a specified period, the coupon [rate of interest] steps up. Alternatively, if the company loses its investment-grade rating, then the coupon is increased,” he adds. Among investors, Lewellen sees tremendous liquidity and appetite for a broad range of assets. “Rather than just appealing to high-yield specialists, they are now attracting a broader range of investors,” he notes.

Fitzgerald says bond investors are also enjoying a tightening of legal protection, although “very few of these bonds are secured against assets as bank loans would be.” With better-structured bonds attracting the broader investment community, he sees “a new international asset class emerging.” However, Falconer points out that the restructuring of debt and tighter covenants can mean that some bondholders further down the chain are effectively being “equitized.”

Many companies are already addressing their funding needs ahead of the impending wall of redemptions. “A string of highly rated companies issued bonds last year, raising more than they immediately needed, just in case of another financial meltdown,” observes Mercier. For smaller corporates that have traditionally appealed to local investors, the higher yields currently being demanded by the market for new bonds issued by troubled governments such as Greece, Spain or Portugal is effectively raising the price of their own refinancing. Some major players like the Spanish telecom group Telefónica refused to pay a higher price, says Mercier, and waited for markets to normalize.

Falconer points out that there is a mountain of bank debt that also needs to be rolled over from 2012 onward, and that further calls will be made on equity investors through rights issues. “There is a possibility of a bottleneck from 2012 to 2014,” says Mercier, “but corporates are already very busy solving that problem.”

Jumpy Buyers Prompt Volatility Spike

Possibly the greatest threat to successful refinancing at competitive rates will come not, as previously, from high-profile companies defaulting or a string of downward ratings movements but from weakness in the market for government bonds. “Sovereigns crowding out the market could have some effect on corporates’ issuance plans,” says Mercier. And if returns on sovereigns and highly rated bonds start rising, more leveraged entities might be expected to have difficulty in accessing the marketplace.

That almost happened last February. “The high-yield market faltered earlier this year,” says Mercier, “because spreads over safer bonds had tightened too far.” The root problem this time was the Greek government bond issue in January, which turned sentiment in all markets, according to Sean Taor, head of rates syndication at Barclays Capital. “With the return of risk aversion, volumes of new issuance dropped by 50% across all sectors in February,” he points out.

Since March, sentiment has bounced back, though heightened volatility still poses a problem for corporates planning to tap the market. And with the success of further auctions of Greek bonds still looking uncertain, Taor warns that we are not out of the woods yet.

“Truly global investment-grade corporations that can count on investor demand have time to arrange their refinancing,” says Mercier. But for less highly rated companies with redemptions coming up, he advises that “they should be taking action now, while yields are low and margins compressed.”

In other words, groom the company and issue the bonds while the window of opportunity is still open. Those who fail to act now may find themselves driving full speed into the wall of redemptions.