The top end is awash in it

Wealth adviser Tom Murphy is upset that the $500 million Woolworths note issue now in the book-building phase is not larger. That’s because it’s been poorly priced in the investor’s favour and he’s worried his clients will be scaled back in their allocations.

Woolworths is taking advantage of its brand name and the sophisticated debt markets to rejig its debt portfolio by issuing notes that pay investors interest quarterly on a calculation of the average 90-day bill rate plus a margin to be set between 3.25 per cent and 3.5 per cent.

It’s that margin that has Murphy – the managing principal of Family Office Research and Management and former Deutsche Bank equity strategist – excited. Woolworths had originally expected to pay a margin of 3.1 per cent but its advisers, which include JPMorgan, National Australia Bank and UBS, said it had to increase the margin to make the offer successful.

The offer has now been swamped with applications well over $1 billion and Woolworths will likely issue $750 million of notes that will be listed on the Australian Securities Exchange in November.

Murphy says the issue easily could have been done at a margin of 3.1 per cent or even 3 per cent as Woolworths has such strong brand recognition and there is a large appetite for investment-grade instruments, particularly in the current risk-averse environment and amid a general lack of securities issued by non-financial institutions.

Despite paying too much, the Woolworths issue is well designed in its duration and flexibility and is an example of how good corporate balance sheets continue to strengthen and gain robustness. Despite the poor outlook and sentiment for growth and uncertainty over the direction of interest rates and inflation, large companies are considered a safe bet and in the case of top companies a safer bet than most government bonds.

In the same way that investors flock to haven companies when equity markets get disrupted, the same occurs in debt markets. In 2008-09, very few companies issued debt instruments, as there was no appetite or capability during the global financial crisis.

And with uncertainty and volatility still ruling global markets, it’s the investment-grade companies that have the easiest task of lowering their cost of capital by taking on capital management programs.

Perpetual’s group executive, income and multi-sector, Richard Brandweiner, says low demand for corporate debt during the global financial crisis was exacerbated by the exit from debt markets of arbitrage players, which buy long-term investment grade paper and then borrow against it to fund more speculative investments.

“They have not returned, so the people buying debt now are using cash they earned,” he says.

Although Australia has one of the most sophisticated debt markets in the world and leads in areas such as equity-linked, “hybrid” issues, it is not tax-efficient.

“Australian superannuation funds have the lowest exposure to fixed income of any developed market,” says Brandweiner. “Part of that is the lack of tax-effectiveness for debt as investors get taxed on their return, with inflation effectively being a double tax, and it was raised in the Henry tax review as a major issue. There has been no response from government yet but if it does act, it could change demand for fixed income.”

From a company point of view, that’s important as higher demand for non-bank debt markets will lower the cost of entry and broaden the market for different grades of debt, as well as increase the number of issuers. Coming out of the GFC, capital raising was not a problem as there was an expectation that reasonable growth rates would return and, as equity markets had already been pummelled, investors poured money into companies through scrip as they sought to repair balance sheets.

Although the low share prices of companies made equity less attractive, its sheer availability was irresistible as about $130 billion was tapped from investors over 18 months.

However, this exacerbated what Perpetual’s head of credit, Michael Korber, sees as another problem – that superannuation funds have the lowest allocation to fixed income of those in any developed nation.

The subsequent poor performance of the equity markets, combined with any tax review that makes fixed interest more attractive, will therefore see large flows from super into fixed instruments, including corporate debt. That will again deepen the corporate bond market, although syndicated bank finance is still the primary source of corporate debt.

But just like an investment portfolio needs diversification to lower its risk profile, so does a debt portfolio. Debt portfolios need to contain a mixture of instruments, from bank debt to corporate bonds to quasi debt-like convertible notes, and with varying maturities so the debt burden is spaced over a longer time.

Such a structure makes refinancing relatively easy even in difficult times, as the amount of refinancing at any given moment will not involve the entire portfolio but just the portion coming close to expiry.

The average debt profile of corporate Australia has changed significantly since the GFC, with average debt terms lengthening from three years to five. While that is sound balance-sheet management, there is also a bit of desperation involved as companies are eager to get their debt profiles set in case another credit crisis hits global financial markets.

In 1991, News Corp learnt this lesson, as it had a large portion of its debt instruments maturing at the same time. The Kuwait war broke out and banks didn’t want to refinance in the suddenly volatile global outlook. News Corp almost went bust.

The same thing happened on a much larger scale during the GFC. The crisis didn’t just pummel equity markets, it made debt suddenly very expensive as lenders didn’t trust giving their money to anyone, given the extreme volatility across the economies and financial sectors of the Western world.

Some canny investors got in quick when companies started issuing debt instruments in late 2009 and were able to get returns 400 to 500 points above the cash rate but those opportunities are gone. Yet corporate debt still offers better returns than government bonds.

With all the cheap money that was available before the GFC, even companies that had maintained good debt-to-equity ratios had likely lowered the duration of their debt portfolios, as in a stable environment refinancing is easy and competition among lenders strong to provide lower rates.

The return of risk has changed that equation and longer-term instruments now offer the security companies want in their balance sheets.

The average chief financial officer might assume that equity provided by shareholders is the cheapest form of capital available. That’s not the case. For starters, shareholders expect a return by way of dividends. They also nominate the cost of equity by how much they are willing to pay for forward earnings forecasts of a company, known as the price-to-earnings ratio. 

That ratio is substantially lower now than before the GFC – single digits for the first time since the 1970s, in fact – and the lower it goes the less attractive new equity is to corporate treasurers. New equity also dilutes other stakeholders’ interests, so in today’s environment borrowing has a number of advantages over equity. It is actually a good time for companies to be accessing debt markets, as relatively expensive as they’ve become. After all, companies usually want more debt only so they can take advantage of buying opportunities while markets are trading at lows.

BRW

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