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Feature: Promising Q1 for Capital Markets Desks

Investment Dealers' Digest

Colleen Marie O'Connor

April 10, 2006

Wall Street's underwriting desks did better than expected pretty much across the board during the first quarter. Bond issuers, seemingly undaunted by rising interest rates, jumped into the market with both feet, while investors starved for product welcomed the supply with open arms. A big pickup in equity issuance was also easily absorbed, with the S&P 500 and Nasdaq Composite indexes hitting highs not seen since the tech bubble burst.

Investment-grade corporate bond issuance jumped by a startling 36.3% in the first quarter from a year ago, while ABS issuance, widely expected to decline as the housing market slows, rose 11.5% to a new first-quarter record.

IPO underwriting, meanwhile, continues to lag, falling off even from last year's lackluster start. Secondary stock offerings, however, more than made up for the IPO shortfall, pushing total US common stock issuance up by nearly 33% from a year ago.

While high-grade bonds and stocks took center stage in the first quarter, the bump in issuance that occurred in convertibles topped them all. Coverts seemingly came back from the dead to log $12.3 billion in issuance from 23 deals, a 76.2% rise from the $7 billion seen in the first quarter of 2005 from 34 deals.

However, a $5 billion convertible senior notes offering from biotech darling Amgen accounted for a good chunk of this year's total. The deal was the largest convertible ever and gave bookrunners Merrill Lynch, Morgan Stanley, Citigroup, JPMorgan and Lehman Brothers a big boost in the league tables. Merrill Lynch ended up the top convertible underwriter in the first quarter, according to Thomson Financial, responsible for $2.7 billion of issuance. Morgan Stanley was second with nearly $1.8 billion, and Citigroup rounded out the top three with $1.7 billion. Goldman Sachs, meanwhile, ranked 12th at $970 million as of the end of the first quarter after finishing in first place for all of 2005.

Minus the Amgen transaction, convertible volume was basically flat compared with a year ago, but underwriters are still encouraged. The size of the Amgen deal indicates there is still plenty of demand for the product, they say, and the company's use of $3 billion of the proceeds to repurchase shares could inspire others to do the same. "Companies will use the convertible market to rebalance their balance sheets in one transaction," says David Ballard, co-head of convertibles at Merrill Lynch. "I think you'll see M&A financings drive the market, and I think other companies will look at Amgen, understand the merits of that transaction, and follow suit."

Rates brushed off

Companies levering up to buy back shares also helped drive the pickup in high-grade debt volume. In a pleasant surprise, investment-grade debt issuance rose 36.3% in the first quarter, climbing to $235 billion from $172.5 billion a year ago, according to Thomson. High-grade issuance has declined for nearly three consecutive years, and market participants expected rising interest rates and a flat yield curve to cause that trend to continue.

Therese Esperdy, head of high-grade capital markets at JPMorgan, expects leveraged share repurchases to be one of the factors driving issuance through the end of the year. "We also saw a marked increase in issuers wanting to extend their maturity profile," she adds, noting that there is plenty of interest in 30-year bonds. "Rate rises tend to scare issuers out of complacency, and that certainly helped fuel some of the quarter's issuance."

Aiding that, investors appear to be employing barbell approaches, with strong investor demand noted for five and 30-year maturities. Last year, the 10-year point on the curve was the most popular among buysiders.

One trend that failed to diminish the market's buoyancy was calls from investors to include more covenants in high-grade deals. While a few deals issued in the first quarter contained coupon step-ups triggered by ratings downgrades, they remain the exceptions rather than the rule.

"So far, that has been more hype than substance," says Esperdy, whose team helped price a $4.75 billion bond from Viacom last week. While certain investor groups were quite adamant that Viacom was precisely the type of investment-grade credit that needed to provide additional protection to bond investors, the transaction priced without any. "We have been able to get investment-grade deals done despite some calls for covenant protection because of very healthy investor demand, which tells underwriters that IG covenant demand is not as widespread as all the chatter would suggest," Esperdy says.

Particularly surprising was the increase in ABS issuance, a sector that was widely expected to cool off. Peter DiMartino, ABS strategist at RBS Greenwich, says the market "defied expectations", when it logged its highest first-quarter volume on record, $881 billion via 1,708 new deals, according to Thomson. That's up 11.48% from the $790 billion logged a year ago on 1,906 new issues. According to DiMartino, home-equity loans and credit card-backed deals provided the necessary firepower.

"Clearly, the US ABS market continues to attract strong global participation," says DiMartino, who expects the second quarter also to be active.

Secondary offerings soar

One area where US underwriters continue to feel the pinch is in IPOs, though the massive increase in overall common stock volume likely cushioned that blow. The number of US IPOs was essentially flat compared with the same quarter last year, and the 44 IPOs that did make it out of the gate raised just $8.9 billion, a 17.6% drop from the first quarter of 2005, when $10.8 billion worth of deals priced in 45 issues.

Tom Fox, co-head of US ECM at UBS, says the most recent quarter was the worst in the past nine quarters when it came to volume. Further troubling is that this slump in US IPO volume comes amid an increase in global IPO issuance. A portion of the slump stems from the hot M&A environment, something with which every US underwriter has to contend.

"Just about every company considering an initial public offering is operating on a dual track," says Fox. "They are asking, Is there an M&A alternative that makes sense as opposed to an IPO?'"

IPO sources note the sluggishness is not due to investor demand. As a group, IPOs from the first quarter were trading 18.7% over their offer prices at press time, according to IPOdesktop, a research firm. Furthermore, underwriters contend that deals have been oversubscribed, particularly from midcap companies. "It's not so much the reception on the investors' side, it's more building the confidence of the company" to take the IPO plunge, Fox says.

However, secondary offerings jumped 60.5% in the first quarter. According to Thomson, $31.3 billion via 133 secondary offerings priced in the first quarter compared with $19.5 billion from 105 offerings in the same period a year ago.

"Company fundamentals are robust, and their boards are now playing offense," says John Tesoro, head of capital markets at Canaccord Adams. "They are saying, We need to invest in new products, we need to make acquisitions.'"

With stock indexes hitting multiyear highs, the difference between what companies think they're worth and what investors are willing to pay have compressed. "The market is more fluid because of that narrowing," says Tesoro. "Also, investors have money to put to work and there has been a consistent rotation, beginning late last year, from value to growth opportunities."