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Strategic Finance

Using the bond markets

Monday, 27 November 2006

As the popularity of shares continues to wane, Anne Lowe points out that bonds are back in favour as an alternative source of finance for companies Depressed share prices have made equity issues either difficult or expensive: there is little investor demand for equities, especially for rights issues that have the whiff of rescue about them, and companies have no wish to issue shares for acquisitions at low prices.

The low interest rates of the early years of the new century have encouraged companies to lock into cheap finance while they can, and the simultaneous creation of the European single currency has allowed a euro-denominated market to develop that did not exist when Europe was split into a myriad of currencies. The European bond market now has a depth and liquidity that did not exist when issues were in francs or lire and that is reflected in keener pricing and greater investor demand. It also allows a wider range of bonds with, for instance, a market developing in 30-year maturities that were previously available only in ster-ling or dollar-denominated bonds.

Such is the revival in both supply and demand that there are now more euro-denominated bond issues than dollar issues - even if most of them are issued through banks in non-euro London or Switzerland. Indeed, more than half the bonds issued in the EU are issued by non-EU organisations, such is the new popularity of the European bond market.

Ironically, the revival in investors' demand for bonds has been caused by the weakness in stockmarkets. After the 9/11 terrorist attacks in 2001, the world's central banks, already worried by the plunge in share prices following the bursting of the dot.com bubble, deliberately cut interest rates repeatedly to avert an economic collapse. Bank finance thus became cheap, and bond rates fell because they had less to compete with. But if a further sharp fall in share prices was prevented, there was no great rally and insurance companies and pension funds are suffering huge deficits on their portfolios against their liabilities. Some pension funds, notably Boots's, anticipated the fall in equities and sold their shares to buy bonds; most, however, left it too late and were forced by prudency rules to sell shares - so ensuring that equity prices remained depressed - and buy bonds. In many cases, regulators demanded this swap from risky equities to the relatively safe haven of bonds. The introduction of the FRS17 accounting standard highlighted deficits on pension funds still further, adding to the pressure to switch into bonds.

The creation of such demand for bonds has been a blessing for companies, which have provided a ready supply by issuing new paper. It has provided the finance no longer easily available from stockmarkets.

Indeed, some companies have specifi-cally issued bonds to plug the gap in their pension funds. After a huge issue for that purpose by General Motors in the US, Marks & Spencer issued a £400m bond in Britain in 2004 to wipe out the majority of the £585m deficit on its final-salary pension fund. And - in a self-feeding move - once they received the bond issue, the investment committee of the M&S fund used it to buy bonds in other companies so as to re-weight the investment portfolio from shares to fixed-interest stocks.

Even companies without pressing capital needs have exploited the strength of the bond markets, either by refinancing other forms of funding such as bank borrowing, or to gear up to return capital to shareholders. AWG, the Anglia water group, is just one of many quoted companies that has issued bonds so that they can buy back shares or pay special dividends.

There is a cost to issuing bonds, however, just as there is with share issues. And that cost is not merely the coupon that has to be paid to investors, which, for a blue-chip corporation, is likely to be about one percentage point - 100 basis points - above the yield on a similar dated government bond. In other words, if the Treasury can borrow at five per cent, a FTSE company would expect to pay about six per cent, and the greater the perceived risk on non-payment, the wider that premium becomes.

But there are arrangement costs as well. Underwriters and their lawyers would expect to receive about £75,000 for their services on a typical issue with another £20,000 for the issuer's own lawyers and £10,000 for the auditors. There could be £10,000 to cover listing costs too, plus as much again to pay for the printing of the prospectus, and although obtaining a credit rating is not essential, most companies do and benefit from a lower coupon because investors are more confident buying bonds that have been assessed by an outside agency. It is usual practice to have two credit-rating agencies from the three main firms - Standard & Poor's, Moody's and Fitch - and paying for the rating is likely to cost a further £25,000.

There will also be roadshows to explain the issue to investors, certainly in London, probably in Edinburgh, usually on the continent and sometimes in the US - so set aside a further £30,000 or so for that.

And the investment bank making the issue will demand a fee too, typically 0.4 per cent for a medium-term dated stock. For a £500m issue, total costs could be about £2.2m therefore. But if finance directors are now thinking that they will need to make a bond issue simply to pay for those costs, they should consider that issues in Europe are often just one-third of the expense of making a similar issue in the US where legal costs and regulatory hurdles are much higher.

The opening up of the European bond market because of the single currency has cut costs however. Whereas companies used to have to issue in currencies or maturities that met investors' needs rather than the issuers', and then had to pay to swap the bonds into a form that suited them, the companies can now usually issue bonds on their own terms without adding the further cost and complications of swaps. A Spanish company no longer needs to issue its bonds in deutchesmarks and swap them into pesetas to avoid currency exposure; it can issue them in the same euros that it uses to pay its wages and in which it sells its goods. Or a German utility company wanting to fix its finance costs for 30 years need no longer issue a bond in sterling and swap it into its own currency; it can now issue 30-year euro-denominated bonds directly.

And while the cost of issuing bonds can seem high, the cost of servicing the bond is not so high as it seems. The coupon paid on the bond can be offset against corporation tax, thus bringing down the cost of the finance. If the company raises capital by issuing shares, it cannot offset the associated dividends against its tax bill.

Bank interest can be offset against tax too, of course, but at a time when banks' lending rates are rising without notice, bonds allow companies to lock into current rates for periods of five to 35 years and thus avoid the increases.

Bond finance is especially popular with companies that can predict their revenues with some certainty for several years hence and want to match that cashflow against an equally certain finance cost. Telecom firms, utilities such as power and water companies, subscription television channels or banks and leasing groups are therefore keen to take advantage of the bond markets. Property companies are also pleased that they can raise long-term money at a rate less than the yield from letting a building, thus avoiding deficit finance and negative cashflow, but many manufacturing companies and retailers are sufficiently confident of the return on investment that they can achieve from investing the proceeds of a bond issue that they can cover the cost of the coupon without diluting earnings.

Fashions in finance come and go. Equities will have their day again and interest rates will fall at some point. Investors' appetite for bonds may diminish too, either because government gilt issues are sufficient to satisfy their demand or because the pressure on life assurance and pension funds deflates. But until then, the bond market offers finance directors a chance to replenish their balance sheets on favourable terms.

Anne Lowe was managing director of a London business consultancy and has also run a consultancy based in the US. She now writes for financial and trade publications including The Business.