Credit crunch

Pumping up the volume.

Can 26 bond investors change the face of the credit markets? That’s exactly the process that a group of leading UK and continental European fund managers (let’s call them the G26) tried to set in motion last month when they produced a wish list of measures designed to improve market standards and efficiency in the European credit markets.

If the intention was to provoke a reaction, then the signatories certainly achieved their aim. The document has been the main talking point throughout the markets.

But the reaction from many sides of the market has been largely sceptical and at times highly negative. That was only to be expected from issuers, whose flexibility to access the markets may be reduced by the demands the group made. And from investment bankers, who only really have their issuing clients’ best interests at heart.

What may not have been expected was the reaction from a number of investors who did not sign up to the proposals – and joined the chorus of disapproval warning that prospective bond issuers may be forced to other markets or even put off coming to the market altogether.

Nobody doubts that the proposals are well intended. Poor covenant protection can indeed leave fixed-income investors hostage to fortune in the fast-changing world of corporate Europe. Further grist was added to the investors’ mill when rating agency Fitch subsequently published a document detailing the gradual erosion of the meaningfulness of the negative pledge clause – a crucial sticking point for many investors.

But the problem I have with the proposals is the way in which they were presented (albeit unintentionally, I believe). The proposals are intended to be a panacea for investors, a complete cure for their ills. But the wish list was interpreted as a set of demands. And only in an ideal world would all of their desires be implemented across the credit markets. It’s simply not going to happen.

Much better would have been to present the document in the following way: “These are the clauses and covenants that we would ideally like to see in corporate bond issues. We understand that in reality market practices dictate that not all of these features will be incorporated into bond deals. However, as bond investors, we will look much more favourably on those issues that include some or all of these covenants than those which do not.”

Another problem for these investors is that there could hardly have been a worse time to issue this statement. The imbalance between demand and supply is such that credit fund managers simply have to be invested in, and keep buying, corporate bonds – covenanted or not.

Shortly after the statement was released, a landmark deal came to the primary market – the largest ever unrated corporate bond in Europe, issued by the Dutch brewer Heineken.

Now, this bond should be anathema to investors seeking better market practice. Firstly, Heineken’s debt was issued at the holding company level, whereas most of the company’s existing debt was held within the operating subsidiaries – just the sort of thing that usually makes alarm bells ring for investors.

Second, not only was Heineken unrated, but it remains a family controlled business, and as such the imperative to fully disclose may be weak.

And yet Heineken and its lead managers sold more than e1 billion of bonds to a highly receptive investor community. The issue was, apparently, four times oversubscribed. UK, French and Benelux-based institutions were among the main buyers of the bonds.

Did members of the G26 participate in the deal? I’ll hazard a (reasonably well-informed) guess that a fair number of them did.

Why? Herein lies the problem. The Heineken issue offered rarity, diversity, liquidity and potential spread performance – and those are the criteria, rather than a wish list of covenants, that will fundamentally drive an investor’s buy or sell decision.

Bear in mind that we are now far removed from the market abuses of the 1980s, where the likes of Canadian insurance company Confederation Life could issue a deal and neglect to tell their investors that the bonds were in fact subordinated.

Let’s accept that the market could be much more disciplined, even today. But let’s admit too that it is a free market, based on the principles of supply and demand. Let’s also admit that the main driver of disclosure in the US securities market is not so much the SEC, but the threat to corporations of class actions and private lawsuits.

The market will only change if a sufficient number of investors demand it. At the moment, most either cannot or will not. But let’s applaud the G26 for stimulating a healthy debate. If and when they become the G260, they may well get what they desire.

Clive Horwood is former editor of Credit and a director of Financial Issues, a specialist fixed-income communications company.

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