Don’t fear the taper

Published: Jan 2014

In early 2013, UK cable operator Virgin Media prepared an issue of two bonds in sterling and dollars for a total of £2.3 billion as part of its merger with Liberty Global. It was the biggest single bond sale of high yield debt since late 2010 and, thanks to strong investor appetite for high yielding assets, secured on extremely favourable terms.

“At the time we were facing some robust refinancing challenges given the scale of what we were doing,” says Rick Martin, Group Director, Treasury and Investor Relations. But with all that extra liquidity flooding into fixed-income capital markets as a result of accommodative monetary policies, the company not only obtained a lower rate of interest but also dramatically extended their maturities. “That is a very rare thing,” enthuses Martin. “It is not every day an issuer is able to take both coupon and tenor at the same time.”

Companies like Virgin Media benefited enormously as the Federal Reserve bought up US Treasuries in the years that followed the financial crisis. Investors who were put off by the rising price of the bonds that the Fed was purchasing – by QE3 at a rate of $85 billion a month – turned to other assets like corporate bonds, and this in turn helped to push down yields and made it cheaper for corporates to borrow. As spreads narrowed, issuance soared. By 2012, it had hit record levels. During that year, $5.4 trillion worth of bonds were issued worldwide – a 13.1% increase on the year before according to Thomson Reuters.

Stop the press

However, looking ahead to 2014, there is no certainty that corporates will continue to enjoy such advantageous borrowing conditions. Now, with the Federal Reserve considering exit strategies from accommodative monetary policies, corporates, and particularly those below investment-grade, such as Virgin Media, have begun to brace themselves for rising long-term borrowing costs in the years ahead.

“When Bernanke begins to hint at tapering the bond vigilantes begin to take over. Naturally, nobody wants to be last out of a burning room, so they all rush out at once.”

Tom Byrne, Director of Fixed Income, Wealth Strategies and Management

To get an idea of what might happen in the bond markets when QE begins to be unwound we don’t have to look any further than the events of the past year. As talk of a taper intensified last summer US Treasury notes rose to 2.90%. It was their highest level for two years, and the rise had an immediate impact on US sales of investment grade corporate debt. By early June, Dialogic data shows weekly sales of investment-grade corporate debt had fallen to $4.1 billion, down from an average that year of $23.2 billion. High yield offers also dwindled. Until the middle of May, weekly issuance was averaging around the $8.8 billion mark. By the following month it had fallen to $1.6 billion.

“I think investors were lulled into a sense of security that the Fed wouldn’t let rates rise rapidly in their faces,” says Tom Byrne, Director of Fixed Income at Wealth Strategies and Management and author of capital markets newsletter BondSquad. “But when Bernanke begins to hint at tapering the bond vigilantes begin to take over. Naturally, nobody wants to be last out of a burning room, so they all rush out at once.”

But the panic which gripped markets proved short-lived. By mid-September the Fed, fearful perhaps of the turmoil that might ensue when tapering eventually began, backed away from the guidance it had given earlier in the year. Citing continued uncertainty surrounding the strength of the US economic recovery, Ben Bernanke, the bank’s outgoing chairman delivered a speech casting doubt on the likelihood of tapering beginning before the year’s end.

US Treasuries once again began to drop-off. Yield appetite didn’t quite return to its former levels, however. The lowest the ten-year note fell to during this period was 2.478%; still much higher than its level at the beginning of the year and a full 1% above the record low of 1.4% set in July 2012. For corporate issuers in fixed-income capital markets the implication is that investors don’t have to stretch so far for yield as they did before. For this reason, Byrne doesn’t think credit spreads have room to tighten on the upper-end of investment-grade credits (A+ to AAA) because they are already very tight. “I think that credit spreads will not tighten and could even widen in lower-rated high yield credits because investors will not have to reach down to that risky area of the market to find attractive yield,” he says. “The best performing area of the corporate bond market – relatively speaking – should be the BB and BBB areas.”

If such turmoil can result from the Fed merely broaching possibility of an end point to quantitative easing, corporates will surely be wondering what will result when tapering begins for real. A fall in treasury yields of any significance would, of course, affect the interest paid on fixed-income debt, including that issued by corporates. Byrne’s assessment is that the market has already built in a $10 billion, if not a $20 billion reduction in asset purchases. Since perception of the risks associated with a tapering is already reflected, to some degree, in asset prices now, it would seem an exaggeration to suggest bond markets will evaporate the moment tapering begins.

There appears to be an interesting dynamic at play here, however. In a normal economy, high yield debt tends to have a very low correlation with interest rates; this is a trend which is visible in almost every single economic cycle since the mid-twentieth century. But these are far from normal economic times. Ever since interest rates began to be artificially compressed through quantitative easing, rates have begun to correlate more closely. Byrne thinks this is a trend which will persist until the Fed has withdrawn completely from the market, with the asset classes – such as high yield – that enjoyed the most credit spread tightening during the QE years seeing the most closely related movements in relation to treasuries.

The danger for the BRICs

In emerging markets, companies might be forgiven for feeling a strong sense of trepidation as the end of QE approaches. These markets after all, have been one of the principle beneficiaries of the extra liquidity injected into the global economy over the past five years. This is because the liquidity the Fed created through asset purchases did not remain exclusively in the US, where interest rates and growth were close to zero. Instead, a good deal of it flooded into the emerging markets where the potential returns were much greater for investors. This surge in capital inflows pushed down on emerging market currencies – much to the ire of export focused nations such as Brazil – and, as in developed economies, triggered a rapid growth in dollar denominated debt.

“Every time we hear a rumour or a new forecast about what the Fed is going to do we see very high volatility.”

Mikko Sopanen, Director of Treasury, Light-On Mobile

Any tightening of US monetary policy would, it follows, create some uncertainty around the outlook of capital flows to emerging market (EM) economies. “We had a taste of that over the summer,” says Colin Ellis, analyst at the ratings agency Moody’s. “In that world you would expect capital flows to partly reverse and that was exactly what we saw.” Of course, despite sharing some common characteristics EMs are not homogenous entities, and the extent to which corporates in a particular economy will be impacted when tapering begins will depend largely on the policy regime. “India is a good example,” says Ellis. If a company is operating in a country with a floating exchange rate regime, such as India, but borrows in foreign currency terms then clearly tapering will have material credit implications. “If I am an Indian company and I have borrowed in dollars then, clearly, that is going to be credit negative. But on the flip side, for a company in a fixed exchange rate regime that borrows in dollars its costs may not have moved much at all.”

As the events of last summer showed, corporates in those EMs with floating exchange rate regimes will be faced with heightened levels of currency risk. For Lite-On Mobile (LOM), a corporate that specialises in the design and manufacture of telecommunications products, increasing foreign exchange volatility has been the biggest concern since the prospect of tapering became apparent. Over the past year, the company’s Singapore and Taiwan-based treasury team has had its hands full managing the risk, which is quite substantial given the company’s presence in emerging economies such as India and Brazil, two economies which have exhibited a particularly high degree of sensitivity to rising US Treasury yields.

“Every time we hear a rumour or a new forecast about what the Fed is going to do we see very high volatility,” says Mikko Sopanen, Director of Treasury at LOM. Even day-to-day movements have, at times, been astonishing, he remarks. At the height of the FX volatility last summer, for instance, the Indian rupee or the Brazilian real both experienced swings in the 2-3% range.

Managing this volatility is helped by the fact that the company hedges 100% of its substantial foreign exchange exposure using a mixture of forward and options contracts. In India, these risk management activities are executed locally. It has always been quite costly, says Sopanen, but the expenditure has grown even more substantially over the past year because of the taper expectations.

Like most companies, LOM is also bracing itself for rising borrowing costs in the years ahead. Right now, the company’s main source of funding is a revolving credit facility provided by global and Taiwan-based banks in the Taiwan market, supplemented from time-to-time with term loans. Margins and interest rates in the Taiwan market have been exceptionally low for many years, even at the height of the credit crisis, but as Sopanen points out, that is likely to make the impact of an adjustment to US monetary policy all the more dramatic when it comes. “When you are so close to zero the only way is up,” he quips. Given that even a minor rise could double the company’s interest costs when starting from such a low base, the company has been quite active in the past year in hedging the risk with swaps and forwards.

But Sopanen does not expect credit to suddenly become prohibitively expensive overnight, and he adopts a philosophical tone when asked about the extent of his concern over the direction of that market. “We know that interest rates have been unnaturally low for some time now. It has been nice and we will continue to enjoy it while it lasts, but I think we will soon be getting back to 1-2%, at least.”

Managing the change

Sopanen is probably right not to overstate the risks. From the very beginning in 2009, the purpose of QE was to restore the fragile US economy to full health following the trauma of the credit crisis. If the Fed does decide the time is right to begin unwinding asset purchases in the next year, then that would imply that the US economy is once again showing signs of life and the unemployment rate has fallen below the 6.5% target.

These developments would, as Moody’s Colin Ellis points out, be “strong credit positives” for a lot of corporates. Normal levels of risk appetite may well return, driving investors out of bonds and in to equities or other riskier assets. But then again, if corporates begin to see revenues starting to grow in the region of 5-6% a year that could well be an offsetting factor to the overall health of balance sheets; particularly when compared to the anaemic GDP growth that has been perhaps the defining characteristic of most western economies for the past five or six years. But the prospect of a strong and sustained recovery for the world’s biggest importer will clearly help more than just the US-based companies. It will also be hugely beneficial for businesses in other corners of the globe by providing a bigger consumer market for companies such as LOM to tap into and sell their goods. And although the prospect of rising borrowing costs may still be concerning for corporates, there is a relatively simple way for them to insulate themselves. The key to this, says Lloyd’s Head of Financial Risk Yuri Polyakov, is to start thinking more long term. His advice to corporates is to begin thinking about locking in cheap fixed interest rates now while market conditions remain favourable. “That is often one of the first questions I ask when I speak to clients about their funding plans,” he says. “If rates in the next three years are going to rise, then wouldn’t it be more prudent to pre-fund and issue some debt today?”

“The high yield issuers are naturally more leveraged companies, so their sensitivity to interest rate changes is much higher.”

Yuri Polyakov, Head of Financial Risk, Lloyds

That would seem the logical thing to do but, surprisingly, he says that currently there are very few signs in the market of companies taking that approach. Polyakov offers several reasons for why this is the case. On the one hand, it might be that companies do not foresee debt becoming prohibitively expensive in the near future, regardless of when the Fed starts to taper. The other possible reason is that companies, realising monetary tightening will coincide with improving economic conditions, are hoping that their business will be doing better and therefore they will be able to afford more. Other companies are averse to negative carry associated with adding more funding before it is actually needed.

For moderately leveraged companies this might not be a problem. Even if the company has made the wrong judgement and debt costs do rise, the risk to the business is not likely to be critical, but it could prove to be a dangerous strategy for issuers of high yielding debt. The high yield issuers are naturally more leveraged companies, so their sensitivity to interest rate changes is much higher,” he says. These companies definitely need to start thinking about what the impact of the increased interest expense will be in the coming years. It is also imperative to make these calculations in the context of corporate strategy it is going to impact everything from the funding profile to cash flow. “This is why we advise our clients to do a quantitative exercise to understand what the impact of higher rates will be on the business, not just today, but two or three years out,” he says.

Virgin Media’s Rick Martin agrees. Although he thinks every corporation will be impacted somewhat differently, those who have planned ahead are the ones most likely to come out of the other side in good shape. “The more forward looking and proactive a corporate is with regards to managing debt, the better off it will be,” he says. “I think that our activities in the bond market over the past year with our new colleagues at Liberty Global are a hallmark of that.”

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