Feature: What Are Bond Deals Made Of?

Jun. 30, 2003

Feature: What Are Bond Deals Made Of?

By Christopher O’Leary(christopher.oleary@thomsonmedia.com)

While the corporate bond markets are wide open for business to nearly any issuer that wants to hit the tape, what are the odds of that issuer getting the tightest pricing possible? Surprisingly long, as the odds tilt slowly but steadily in Wall Street’s favor and deal pricing itself takes on an air of mystery to many issuers.

Bankers privately admit that many issuers are unable to achieve truly tight pricing these days. What is more, they say, an issuer that is able to get low coupons and tight spreads is typically benefiting from an aggressive underwriter or, more likely, its own increasing prestige among buyers as an infrequent but desirable issuer.

The pricing process itself has become something of a Rubik’s Cube. On the surface, the intricacies of interest rates, plus pricing benchmarks like swap spreads and other technical market factors such as how heavy the new issue calendar is, appear to be the overriding factors in how a deal is priced. Yet the pricing of a bond is also heavily affected by less measurable influences, such as underwriter politics, issuer/underwriter relationships and buy-side perceptions, bankers add.

The result can be confusion. “Sloppy is the right word to describe the market now,” says James McKinney, head of debt capital markets at William Blair & Co. “Pricing is all over the board-everything has its own intrinsic value right now.”

In some cases, the need to preserve banking relationships is more important than squeezing out a few more basis points in yield. Take the recent $13 billion debt offering from General Motors Corp., in which the auto company named nearly every top-ranked debt underwriter on the Street in some sort of co-lead manager capacity. Several debt bankers said that the deal, while it was a blowout, could have achieved tighter pricing (and definitely would have cost GM less in fees) had the issuer winnowed the number of underwriters, but GM’s need to stay on good terms with all its dealers has taken precedence.

Looser, even erratic pricing reflects a volatile debt market defined by a crowded new issue calendar, an ongoing shift in how deals are syndicated, the increasing influence of the top 100 largest investors and growing buy-side distaste for frequent issuers. Right now, the only way to really guarantee a tightly priced deal is to be an obscure but well-regarded issuer-a “museum piece,” in industry parlance-that many investors eagerly pursue.

The pricing issuers get “really varies by issuer name,” says Peter Goettler, head of investment banking and debt capital markets at Barclays Capital. “Clearly, when the market gets as strong as it has been, there does tend to be compression in spread among credits. Some would argue that perhaps we’re seeing less differentiation than in the recent past.”

Underwriter politics

Many issuers, especially those who are irregular visitors to the capital markets, regard debt underwriters as essentially ambassadors from a sometimes daunting and confusing market and take their word as gospel. This can lead to sloppy deals, bankers say, because the underwriter’s interests often come first.

For starters, many underwriters are looking to price bonds to move quickly, and God forfend they should have unsold bonds cluttering their balance sheet. “Hardly anyone has got the guts right now to own anything,” McKinney says. “Dealers are going to price a bond where it will sell-they don’t want to own any paper, and they are not that aggressive in prices.”

This strategy reflects the problems of the past few years, when many banks were stuck with massive holdings of bonds in 2000 and 2001, which became a liability when the debt markets froze up and high-profile issuers cratered. This caused bond desks to reduce their secondary market exposure.

Even in today’s boom market, bankers fret that a deal priced too tightly will be a tough sell in the secondary market. For example, El Paso Corp. recently priced a $1.2 billion high-yield bond offering at par with a relatively tight 7.75% yield. In the aftermarket, oversupply made the bonds unappealing to buyers, and the bonds began trading several basis points below par.

Consolidation also has caused a change in underwriter attitude. When it was primarily a bond underwriting house, the former Salomon Smith Barney earned a reputation for sweeping in and buying an entire deal, and then aggressively working to sell the bonds at tight prices. Yet as more bond operations became subsumed into larger commercial/investment bank hybrids, politics, risk management and issuer relationships all became more important than competition for underwriting mandates via pricing wars. Some bankers say there is a general understanding among competing underwriters that no one is going to get too crazy and offer to price a deal at a radically tighter spread.

Other changes, such as the rise of 100% pot structures, which diminish the role of co-managers in distributing deals, have also led to inaccurate pricing, market critics contend. Further, the influence of top investor clients such as PIMCO is growing-it is easier to sell a huge chunk of a deal to one buyer than hustle to sell the bonds more aggressively to a host of smaller buyers.

“Bankers aren’t living up to their sales pitches,” says one source who negotiates with underwriters on behalf of issuers. “They go to the same 50 guys-it’s fast, it’s done, it’s gone. The underwriter has basically become a placement agent.”

Diversification gold

Though issuers may not be fully aware of it yet, the common debt market wisdom of recent years has been turned on its ear. In the depths of the market malaise, underwriters said over and over that the only deals that would price were massive, liquid issues from regular underwriters. A smaller, less frequent issuer would have to make huge concessions in pricing just to get the buy side’s attention.

Yet this strategy wound up burning a lot of buyers, as some of these massive issuers included the troubled Ford Motor Co. and the bankrupt WorldCom Group Inc. “The main thing investors are looking for today is diversification-they want new and different names,” says Bruce Widas, co-head of U.S. debt origination at UBS. “Many investors have been burned by strictly adhering to an index and are therefore not as interested in hewing to a strict index strategy-they don’t want to be concentrated in too few names.”

What is more, the most desirable corporate names are the ones that really don’t have a burning need to tap the debt markets, like ExxonMobil Corp. and Wal-Mart Stores. That is not the case with companies whose fiscal health is directly linked to regular infusions from the debt markets.

“The amount of leverage an issuer has with underwriters and investors is typically related to how desperately he needs the money and how often he expects to come to market,” says Joseph Fichera, head of Saber Partners LLC. Saber advises the Texas Public Utility Commission as part of an ongoing stranded asset securitization program.

The traditional Wall Street view has been that weak issuers “need to leave some money on the table because they’re purchasing market access-pay up, so you can always come back. But that’s not always true,” Fichera says. Rather, most investors view each deal on a case-by-case basis. “It’s always: That was then, this is now.'”