Unrated bonds: Borrowers go it alone

A large number of European borrowers are eschewing the rating process and issuing unrated bonds. Credit investigates whether this signifies a permanent shift in issuer mentality or is simply a cyclical factor that will die out when the supply/demand dynamic in the corporate bond market evens out.

This year, and in particular the last few months, has seen a number of prominent companies selling bonds without credit ratings. The list of borrowers electing to go down the unrated route includes European drinks makers Heineken NV and Gruppo Campari, Danish shipping and oil group AP Moller-Maersk, German industrial firm Evonik Industries, French conglomerate Lagardère, and fashion house Christian Dior.

The slew of unrated issuance is beginning to form a trend; one bankers widely attribute to overspill from a frothy bond market. “It is often the case that when market conditions are strong, there’s demand for unrated bonds,” says Mark Lewellen, head of European corporate origination at Barclays Capital in London. “At the moment there is less corporate supply than in the first half of the year, but still significant investor demand. The surge in unrated issuance is an extension of the explosion in corporate issuance.”

After a long hiatus of investment opportunities, investors have become increasingly yield-hungry and are prepared to move outside high grade territory in search of attractive returns. This has coincided with a marked slowdown in the syndicated loan market, as banks have had to place limits on new lending to preserve capital. Both developments have prompted companies to raise long-term funding through the bond markets, many of them for the first time.

“Investors clamouring for higher returns are willing to move further down the credit spectrum and take advantage of historically high total returns this year from high-yielding assets,” Lewellen says. “Unrated bonds give institutional investors a chance to diversify. There is a search for new names to invest in. As these companies move away from the bank markets and access the bond markets, it gives investors a chance to get new names into their portfolio.”

“Some of the recent high yield issuance is unrated,” wrote Taron Wade, a senior research analyst in the European leveraged finance group at Standard & Poor’s, in an October research note entitled ‘Is History Repeating Itself In The European High Yield Market?’ “Anecdotal evidence suggests much of the demand for unrated deals comes from private banks and other relatively new players to the credit market in Europe (many institutional investors are not able to invest in unrated transactions). These investors, like many others in the market, appear to be moving down the credit curve in the search for yield.”

Borrower motivations

Borrowers broadly have two motivations for considering an unrated issue. First, they do not want to waste valuable time in volatile market conditions getting a rating since it can mean missing out on a valuable pricing window.

“It was important to take advantage of opportunities in the bond market,” says Bob Kunze-Concewitz, chief executive of Italy’s Gruppo Campari. In October, the firm sold €350 million of seven-year bonds with a 5.375% coupon to refinance the bank debt associated with its acquisition of Wild Turkey. “We had to move quickly because there’s been a lot of volatility in markets lately. Time was of the essence.”

The second main motivation is that companies with riskier credit profiles, which might be rated on the fringe of investment grade, don’t want to be penalised for not quite making the cut. While the lack of a rating might cost a borrower 0.25–0.50 percentage points in spread terms, falling on the wrong side of investment grade could be even more punitive. Furthermore, without a formal credit rating, the company may get the benefit of the doubt from investors.

“Some of the corporates that have recently accessed the market very successfully on an unrated basis are household names,” says Dominic Kerr, London-based managing director in the corporate structuring group at HSBC. “But, if they were formally rated, they would be on the cusp of investment grade or possibly even sub-investment grade. You may well have an investment grade business profile but, because of rating agency methodology, you’ll end up with a sub-investment grade rating. It is something some borrowers want to steer clear of, especially if they’re able to get good execution on an unrated basis.”

Issuers sometimes get surprises from the rating agencies. Having entered the process and done the necessary work, they can find themselves subject to more conservative appraisals than they had perhaps anticipated. This may be even more of an issue today because of increased scrutiny over the reliance of ratings in the wake of the financial crisis. Companies can feel unfairly done by when it comes to this grey area: if their bond is consigned to sub-investment grade status, it could take another year or two to turn things back around and achieve the desired rating.

“We didn’t feel we had to have a rating because our reputation is good,” says Kunze-Concewitz. “Our solidity and balance sheet meant we didn’t have to have a rating.”

When scrutinising the recent phenomenon of companies choosing the unrated route, some might ask if credit ratings are becoming increasingly obsolete in the post-crisis corporate bond market, particularly in light of the travails of the ratings industry. “There is a growing trend to reconsider the relevance of ratings,” says Peter Sack, who runs Credit Suisse’s mortgage-backed securities structuring group in New York. “Previously, market participants and regulators defaulted to ratings. That is changing.”

Nevertheless, many other observers believe ratings still play an important role in the markets and investors will continue to use them. Georg Grodzki is a credit research analyst at Legal & General Investment Management in London. He says: “As much as credit ratings have been criticised for their performance in structured securities, their track record in industrial corporate bond ratings, while far from flawless, remains good enough.”

Not having a credit rating from Moody’s, S&P and Fitch can dampen the level of investor participation in a new deal, particularly for a debut issuer, adds Grodzki. Many investors’ mandated guidelines remain pegged to credit ratings, which provide a common ground when trading securities in the secondary markets. Without a rating that investors can use for comparative purposes, unrated deals may be harder to sell on. Moody’s says it continues to rate more than 90% of the corporate and financial institution bonds issued globally.

“Even the most outspoken critic of credit ratings would be reluctant to buy an unrated bond,” Grodzki says. “They may feel the company has some hidden agenda in not getting a rating. There would also be pricing concerns. If there is a later commitment to get a rating, what happens if the rating comes in lower than expected?”

Index exclusion

Another potential hindrance to more widespread growth is that unrated deals will not be eligible for the bond indices used as benchmarks by many investors. As a result, buyers will have to have a strong view on a borrower to make a commitment.

“Credit ratings came into existence because efficient markets want common benchmarks,” says Kevin Duignan, global head of corporate communications at Fitch Ratings. “Of course, credit ratings are just one benchmark that investors can include in their comparative analysis. In the absence of credit ratings, however, investors may find other objective and standardised credit risk measurements are more difficult to identify.”

A spokesperson from Standard & Poor’s wrote in an emailed response to questions: “There has always been a relatively small but steady proportion of debt issuance that is unrated, particularly among household names and issuers who mainly borrow in their domestic markets. International ratings have the greatest relevance to cross-border investors, who value them as benchmarks of relative credit risk across markets.”

Even so, some bankers maintain the flurry of unrated bonds have attracted bids in secondary trading. “Almost all of the recent unrated issues have performed well in the secondary market,” says HSBC’s Kerr. “The credit spread on AP Moller-Maersk’s €750 million five-year issue, as one example, has tightened by 20 basis points since its launch in October.”

The deal, jointly led by Danske Bank, HSBC, ING, JP Morgan and Nordea, priced at 205bp over mid-swaps. And although it attracted the expected solid demand from Danish buyers, it also saw strong interest from investors across Europe, leading to over €5 billion of orders.

Some borrowers are also finding they can have the best of both worlds – making the most of the opportunity to tap attractive pricing through an unrated issue now, while committing to getting a rating at a later date. Germany’s Evonik Industries is one such example. Its October €750 million unrated five-year issue, which was seven times oversubscribed and carried a coupon of 7%, included a unique step-up clause stating the coupon would increase by 1.25% if the company didn’t receive ratings from at least two of the recognised agencies within a year. Evonik, whose business activities include chemicals, energy and real estate, was founded in 2007 as part of the renaming of mining and technology group RAG Beteiligungs AG.

“We’re seeing some innovative issues like Evonik,” says Barclays’ Lewellen. “It’s reassuring to some investors to see a company making a commitment to getting a rating later.”

However, some say this strategy could go seriously awry if ratings subsequently are lower than expected, making the price of the bond fall. Grodzki says: “Committing to getting a rating later can easily backfire on the issuer, and investors know this. They are generally unwilling to invest in securities that have the risk of being rated below the pricing implied expectation. Should that happen, it means they are sitting on an immediate loss. So this can be a big turn-off.”

Structured but unrated

The unrated avenue has not been restricted to Europe. In July, Credit Suisse sold unrated securities backed by mortgages from lender American General Finance Corp, a unit of AIG, with a face value of $1.2 billion. “I can’t think of any significant example of non-government-guaranteed, unrated mortgage-backed securities prior to this transaction,” says Credit Suisse’s Sack. “Before then, ratings were considered a necessary, integral part of the market.”

Sack says there may be other unrated deals in the pipeline but declined to reveal details. In September, it was reported that Bank of America Merrill Lynch offered investors the opportunity to buy $239 million of unrated securities backed by subprime mortgages owned by Lone Star Funds.

Dallas-based alternative fixed income investment firm Highland Capital Management says it has been looking to invest in unrated collateralised loan obligations. “In terms of new primary CLOs, we have evaluated one that did not require the rating agencies,” says Mark Okada, chief investment officer at Highland. “However, the pricing and restrictions made the arbitrage unattractive. We think new CLO transactions will return as spreads tighten and the new issue loan calendar continues to grow.”

Most criticism of rating agencies during the financial crisis was directed at their rating of structured finance deals, many of which suffered extensive downgrades. Credit Suisse’s Sack, for one, believes unrated structured deals could help resurrect the moribund securitisation markets. “I think in some ways it would help stimulate a recovery of the structured securities market,” he says. “Criticism of and uncertainty regarding the ratings process are acting as another drag on the re-emergence of a necessary part of the financial system. If investors and regulators determine to set ratings aside for certain transactions or for certain purposes, they can do the necessary credit analysis themselves, and seek the opinions of other experts.”

Looking at the unrated market more broadly, observers are divided as to how long the increase in activity will last. “It’s too early to say whether this could become a permanent trend,” says Lewellen. “We’ll be interested to see if this is a real change or merely an extension of a buoyant credit market.”

Some feel the window for unrated issues will be limited. Eventually, there may come a time when investors will be asked to buy bonds from issuers whose story doesn’t stack up. Any attempt to take investors further down the food chain into implied single-B territory is unlikely to fare well.

“I believe the trend in unrated bonds is a temporary phenomenon,” says Grodzki. “Speaking for ourselves, we have little room to buy these kinds of bonds. It would take a sea change in institutional investor behaviour to make the trend permanent. Most investment mandates contain a credit rating provision. So there is little room for unrated bonds.”

In the meantime, borrowers and bankers alike plan to make hay while the sun shines. And there could be further innovative unrated issues in the offing. HSBC’s Kerr says unrated corporate issuance in sterling is on the cards. There have only ever been four unrated sterling issuers: John Lewis in April, Heineken in March, and less recently, the Co-operative Group and Carlsberg.

“There’s no reason why the unrated route can’t be pursued equally successfully in sterling,” he says, adding that so far proven investor demand for unrated bonds has tended to focus on euro issuance. “Watch this space.”