Winner: J Sainsbury

This month's innovative deals in the debt capital markets are a CMBS offering from J Sainsbury, Comcast's $2.25 billion deal and RBC's Logan CDO II

UK supermarket group J Sainsbury's £2.07 billion issue of secured debt backed by commercial mortgages on the group's property portfolio was a shrewd move designed to overhaul the group's long-term funding strategy. The proceeds of the debt issue will be used to buy back £1.7 billion of the company's outstanding unsecured bonds and to make a £350 million cash injection into its underfunded pension scheme.

Darren Shapland, CFO at Sainsbury's, says: "These proposals provide us with cost-effective long-term finance by unlocking value from our property portfolio. We are retaining ownership of these valuable assets and keeping them on our balance sheet." The securitised properties represent around half of Sainsbury's portfolio of owned stores, leaving the company with room to issue more commercial mortgage-backed securities (CMBSs) in future.

Over the past few years, price wars and rising costs in the supermarket industry have taken their toll on Sainsbury's, leaving the company with a BBB-/Baa3 unsecured debt rating and raising its cost of financing. With £800 million of unsecured debt maturing over the next 24 months, switching to secured funding allows Sainsbury's to substantially lower funding costs. After a one-off payout of £37 million to buy back the outstanding unsecured debt, the company estimates that issuing secured debt will cut its interest bill by £12 million a year.

Those interest savings can then be applied to the goal of plugging the £582 million hole in the Sainsbury's defined benefit pension plan. After an initial cash injection of £350 million, Sainsbury's has committed to increasing its annual deficit payments by £18 million to £38 million per annum and bring in changes to employee contributions and benefits to help remove the shortfall. Conor Hennebry, who covers Sainsbury's within the global capital markets group at joint bookrunner Morgan Stanley, says: "Since the agencies and the accountants view the pension shortfall as a type of debt, applying the cashflow savings of the new financing to pay down the pension debt will serve to reduce Sainsbury's leverage."

Christopher Rees, head of liability management at Morgan Stanley in London, suggests other companies may follow Sainsbury's example. "Sainsbury's approach has highlighted that some corporates can unlock value from their balance sheets to have more efficient financing, especially if there's a material difference between the value of their assets and their unsecured rates," he says.

The transaction is backed by a total of 127 Sainsbury's-owned stores and is issued by two special-purpose vehicles. The first is Eddystone Finance, which contains £1.2 billion of 12-year floating-rate notes with a seven-year issuer call, including a £400 million equivalent euro-denominated tranche. If the issuer does not refinance the transaction at the end of year seven, there will be an increased coupon and accelerated amortisation. The notes are backed by approximately 75 freehold and long leasehold supermarkets with a market value of approximately £2 billion via a secured loan structure.

The second special-purpose vehicle is Longstone Finance, which contains £870 million of 25-year fixed-rate notes. The notes are backed by approximately 52 freehold and long leasehold supermarkets with a market value of approximately £1.55 billion via a secured loan structure.

Cecilia Tarrant, a senior banker in the securitisation group at Morgan Stanley, says: "There is significant flexibility built into both transactions in terms of allowing them to move properties in and out of the property pool and increase the size of the deals in the future."

Hennebry adds: "This transaction will also give the company security of financing, because the shortest-term debt under the new funding will be seven years and almost half of it will be 25 years, giving management the freedom to concentrate on the operational plan rather than worrying about debt redemptions."

Tarrant adds that the Sainsbury's deal is coming to the European CMBS market at an ideal time. "The CMBS market in Europe has been growing substantially and we're expecting record issuance this year. But there hadn't been a great deal of issuance this month so Sainsbury's was entering a relatively uncrowded market, with only a couple of other transactions coming to market at the same time. And given that this deal is backed by high-quality property assets with low loan-to-value ratios of 56%-60%, there was substantial interest from investors," she says.

Issuer: J Sainsbury

Date of issue: March 24, 2006

Underwriters: Morgan Stanley, UBS

Total size of bond issue: £2.07bn in two transactions

Eddystone Finance: £1.2bn, 12-year floating rate notes, including a £400 million equivalent euro-denominated tranche with a seven-year issuer call

Longstone Finance: £870m, 25-year fixed-rate notes

Rating: Each CMBS transaction will include tranches of notes which are expected to be rated AAA/Aaa, AA/Aa2 and A/A2 by S&P and Moody's respectively

While the rationale for Sainsbury's refinancing plan was broadly understood by bondholders, investor reaction to the plan was mixed.

Andrew Chorlton, portfolio manager at Axa Investment Managers in London, says: "We thought that Sainsbury's unsecured debt was cheap relative to the underlying credit story and could have gone a lot tighter, so it was a real value proposition for our clients. Replacing that with a stable, lower volatility, event risk-remote structured deal is much less interesting for active managers."

Chorlton adds: "But the fact remains that the rating agencies were not giving Sainsbury's any leeway, so its refinancing costs for the maturing 2007 and 2008 bonds were going to be significantly higher. Whilst we were not happy with the outcome, we can see why Sainsbury's has taken this route."

Among bondholders like Chorlton, who held the view that the Sainsbury's unsecured paper was undervalued, there was some disappointment over the terms of the buyback. Although all the bonds were bought back at a premium, Chorlton says that in his view, the terms did not reflect the potential upside in the bonds if they had been held to maturity.

However, Alastair Ross, credit analyst at Threadneedle Asset Management in London, says: "I can understand that frustration, but we've seen companies like Tesco securitise parts of their property portfolio without doing anything to their unsecured bonds, leaving them to become structurally subordinate. So in my view, the terms of the buyback were fair. It could have been a lot worse."

Joe Biernat, director of research at European Credit Management in London, agrees: "In these situations there's always a tug of war and as an investor you wish you could have got a bit more. But despite the fact that investors didn't get every last pound out of their view on the credit, in terms of what could have happened, the buyback was probably reasonable."

Rating agency comment

Both of the Sainsbury's CMBS transactions will include tranches rated AAA, AA and A or the equivalent by Standard & Poor's and Moody's. Jonathan Braidley, credit analyst at S&P, says that since the ratings on both transactions exceed Sainsbury's own rating, they are not credit-linked to Sainsbury's. "The rating analysis instead focused on the inherent strengths of the property portfolio and the ability to relet or sell the properties upon the insolvency of the tenant whilst using the liquidity line drawings to cover property and transaction costs, swaps and debt service on the notes."

S&P affirmed its BBB- corporate credit rating on Sainsbury's, but placed the supermarket group's BBB- senior unsecured debt on watch with negative implications, reflecting the structural subordination of any outstanding unsecured debt to the new CMBS paper in the capital structure. Any unsecured bonds that are not bought back will therefore be downgraded to non-investment grade status.

Sainsbury's also provides the primary source of funds for two other CMBS deals: Dragon Finance and Highbury Finance. In these transactions, the ratings on the notes are credit linked to the corporate credit rating on Sainsbury's, but Braidley explains that since the corporate credit rating is not affected by the CMBS refinancing, S&P has affirmed the ratings on Dragon and Highbury.

Credit says... The Sainsbury's deal was justifiably hailed as a judicious long-term financing solution for the group. By unlocking the value in its property portfolio, Sainsbury's has been able to lengthen the maturity of its financing, reduce funding costs, make significant steps towards covering the shortfall in its pension fund and focus on its long-term recovery plan. If liability management was the name of the game, then Sainsbury's scores a perfect ten.