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Rocky Times Ahead? Investment Dealers’ Digest Cover

Colleen Marie O'Connor & Chris O'Leary

July 10, 2006

Like rivers, market streams may divide and diverge, but they often meet again--in rapids and waterfalls. Despite robust underwriting and price performance in both the equity and debt capital markets for the first half, that's what bankers are afraid might happen in the remainder of this year.

Already, equities have hit some rough water, dragging down the second quarter, although bonds have sailed smoothly on. But around the bend, bankers worry, troubles in other asset classes may leak through to roil the debt markets. Despite the current calm, some are discerning a few signs of investor caution.

Equities

The equity capital markets rode into 2006 on a wave of improved performance that contributed to the strong levels of new equity business this year, which is reflected in the first-half league tables. However, continued concern over the Fed's attitude towards inflation, plus the market's bumpy ride in June, have slowed the flow to the public markets, threatening business for the third and fourth quarters. And the fear that investors will pack up earlier than usual this summer is now the topic du jour at ECM desks.

"The overall markets are still open for business. However, the S&P 500 has given up its gains, essentially, and that may have an impact on timing decisions when it comes to the raising of equity capital," says Quinten Stevens, head of the equity division at Wachovia Securities. Deals are still well received by the market, but Stevens anticipates that certain issuers will back off.

Numerous underwriters agreed that many issuers in the pipeline will wait until a broader, steadier recovery emerges. Further demonstrating the markets are at a slow point, sources at numerous ECM desks confirm that vacations are being scheduled much earlier than last year. "It was pretty busy well into August last year," says one head of ECM at a prominent broker/dealer. "However, it doesn't look like that's the case with the pipeline for this summer."

The situation isn't dire by any stretch. IPO issuance, up through June 30, remained robust. Thomson Financial data shows US common stock issuance, excluding convertibles, up 31% for the first half of the year, recording $75.6 billion by June 30, compared with $57.5 for the same period last year. Convertible offerings likewise improved, up 138% to $35.7 billion compared with $15 billion for the first six months of 2005 (see IDD, "Share Buybacks Boost Convertibles Market," 6/26/06).

"From our perspective, the backlog remains very vibrant, but the hurdle rate has been raised by a more discerning investor audience," says Tom Fox, co-head of US equity capital markets at UBS. Deals are pricing and trading, he says, but Fox anticipates that while deals will continue to price through the summer, volume will be slow.

Earlier in the year, corporations were easily accessing the equity markets, buoyed by high stock prices. Many deals, of course, were driven by the ridiculously red-hot M&A market, and others were aimed at returning cash to shareholders or retiring debt.

"A lot of equity issuance this year is a result of strategic activity to finance acquisitions. Valuations are pretty strong for existing companies, and that influenced a lot of opportunistic financing-taking advantage of a strong stock price," says Joe Morea, head of US equity capital markets at RBC Capital Markets.

But just after the first quarter closed, underwriters say events began to put more pressure on equity issuance, and CFOs began to rethink strategies that were not necessarily M&A-related.

Consider that in March, $22 billion was raised in 76 common stock deals, but by April, that dipped to $9.4 billion in 44 issues, according to Thomson data. Some of that loss is attributable to jitters over Q1 and full-year 2005 earnings announcements. In May, the market performed admirably, raising $17.5 billion in 72 equity deals, but in retrospect, those got in just under the wire. As volatility killed the stock market bull run in June, equity issuance fell to $7.6 billion in 52 deals.

Jeff Rosichan, head of US equity capital markets at Banc of America Securities, explained that by the middle of the second quarter, institutional investors rotated heavily into energy and commodities. "We saw money going out of equity and into commodities, and not just commodity companies but the products-copper and oil futures, and gold itself," he noted. Subsequently, what had been equity issuance from a wide array of sectors contracted.

What Price?

The mood is particularly dour in the IPO markets, where underwriters are struggling with pricing. "The last group of IPOs saw many price below their mid-point range. We didn't see that earlier in the year, meaning the IPO market has recently turned a bit ugly," says Michael Kollender, director of investment banking at Ryan Beck. "We do not see this as a long-term trend."

Certainly, the stellar performance of the $376 million J. Crew IPO, lead-managed by Goldman Sachs and Bear Stearns last month, has been much ballyhooed--J.Crew shares priced at $20 apiece, well above the proposed $15-17 range. But that's far from representative of the 2006 IPO market.

"What you really have is a market that has been growing increasingly conservative," says George Milstein, head of investment banking at Pacific Growth Equities. "It has been very concerned about the broader economic picture. Investors are more reticent about wading into unproven new-issue companies, and that's contributed to a tough pricing environment."

In May, the VIX, an index of volatility measured by the Chicago Board Options Exchange, spiked upward. Subsequently, six of the 14 IPOs that month priced below their share price range, according to IPOdesktop.com, an independent research firm following new issues. By June, that worsened--12 of 19 priced below their share ranges.

And the market was rattled by the dismal debut of Vonage Holdings, once a tech-sector hopeful, which tanked in its first day of trading, dropping 13% from the issue price. The Internet phone company's shares have continued to slide since then, wiping out hopes for a strong surge of issuance from more entrepreneurial technology outfits.

"In a market like this, the price of your IPO can be driven by nontechnical, nonanalytical issues," says BofA's Rosichan. Agreed a head of equity capital markets: "It's a very emotional decision."

What Impact?

Portfolio managers are having difficulty forecasting what the impact of all the uncertainty will have on earnings in the third quarter. Even credit card giant MasterCard encountered pressure over its IPO price: Initially seeking $40 to $43 per share, the deal priced in May at $39 per share and raised $2.4 billion in proceeds, below expectations. The aftermarket crowd, however, had a different point of view, and drove MasterCard shares up to $46 on its first day of trading. The stock has been up about 20% since its debut.

Healthcare was particularly hard hit by the behind-the-scenes discussions about share prices. Pacific Growth Equities' Milstein noted that average premoney valuations for IPOs from the healthcare sector have dropped from $170 million to $130 million by June. And the average IPO deal size from the sector slid by $10 million to $50 million recently. By June, postdeal performance for healthcare IPOs was down 10%.

"Investors haven't been terribly keen on new issues this year," says Jamie Brown, head of investment banking at Canaccord Adams, a diversified global investment bank focusing on growth companies. "The IPO market overall was modestly better year-to-date than last year." As of June 30, Thomson Financial data show $20.1 billion in IPOs, basically flat to last year's $19.6 billion during the same six-month period. Last year, however, 95 IPOs were done compared with 92 IPOs as of June 30, 2006. "We'll see less interest in new names," at least through the third quarter, Brown says.

Underwriters note that the follow-on market is also expressing signs of a slowdown. While follow-on issuance is up 46% to $55.56 billion as of June 30, compared with $37.8 billion for the same period last year, new business tapered off last month. Thirty-two follow-on offerings raised $4.8 billion last month, a little more than half the $8.4 billion raised in June 2005 and quite a dip from May 2006's $12 billion.

Convertibles

It's difficult to say where the market will finish up, but for the moment, many underwriters agree it will be slow going, except perhaps for the convertible market.

Share buyback programs have been a primary driver of convertible deals this year, and with interest rates going up, issuers have harnessed this defensive strategy with much success. BofA's Rosichan explained that when issuers do a buyback in conjunction with a convertible, they are effectively protecting their stock from dipping the day the convertible notes are issued. "This cycle for convertibles should last for several quarters," says Rosichan.

John Kolz, head of convertible equity capital markets at Goldman Sachs, agrees that convertible issuance will have a strong, long-term run. Business conditions have been ripe for issuing convertibles for many reasons, he notes. Among them are the call options embedded in the structure. "Volatility affects the value of the call option," Kolz says. "As that has spiked in the last few months, it helps make the pricing more attractive to convertible issuers."

Elsewhere, bankers say the market hasn't so much shut for the year as become extremely niche-focused. Energy, entertainment and consumer retail are favored, say sources, in both the IPO and follow-on markets. Hank Erbe, global head of equity capital markets at Fox-Pitt, Kelton, says the broad financial services sector will continue to provide leadership, noting that the sector represented more than 25% of global volume by midyear. "Of the top 10 equity transactions that priced in 2006, six have come from financial services companies," says Erbe.

To be sure, 2006 has seen several noteworthy deals from the financial services sector worldwide, including MasterCard, Bank of China, Sumi-tomo Mitsui Financial Group and Austria's Erste Bank, he says. And thanks to the drive for privatization in China, Erbe notes, a healthy flow of transactions led by Chinese banks will be a feature of the second half of the year. Another area of focus will be the insurance/reinsurance sector and the so-called Bermuda Class of 2005, which was formed post-Katrina. "These companies may look to go public after this summer's hurricane season," says Erbe.

But with several IPOs pricing below expectations, and some, like Gordon Biersch Brewery Restaurant Group, led by Thomas Weisel Partners, on hold, it's difficult to predict, for certain, how hard investors will continue to push price negotiations.

"We haven't seen a wholesale walking away by those on the other side of the table. There are very few deals that have actually been withdrawn," noted Milstein. "From Fed uncertainly to the Vonage IPO, these are tough things for buyers of new issues to get their arms around," he says.

Debt

Meanwhile, so far this year the bond markets seem to be unsinkable. While cross-sector volatility marked much of late May and June as commodity prices rocked violently and the equity market plunged back nearly to 2005 levels, in the debt markets the mayhem was greeted with little more than a shrug--a few deal postponements here, some slight spread widening there.

"In May, on the one of the most volatile days we've had in months, $8 billion in new issues were announced," says one head of debt syndicate at a top-ranked bank. "The market tone has been white hot. The past four to five months have been the culmination of a credit spread rally that's been with us for a couple of years."

The numbers tell the story, as all wings of the debt markets, from AAA-rated corporates to low-rated junk bonds, have experienced solid increases in new issuance. After three years of slight decreases, US high-grade corporates stand to have a colossal year of new issuance. As of June 30, there were $466 billion in new issues printed, up from the $342 billion posted in the same period in 2005, according to Thomson. If the current pace continues (and if the market has another month like this past March, in which $114.9 billion in new deals hit the tape), some analysts and bankers believe the 2005 yearend total of $674.4 billion could be surpassed by September.

"It's been an extremely strong year for high grade," says Jim Turner, head of debt capital markets in North America at BNP Paribas. "If current trends continue in terms of new issuance, we will have a record year."

Naturally the top high-grade underwriters managed to fatten their market shares and their new issue totals. Citigroup kept its title as top-ranked underwriter, with $71.6 billion underwritten in the first half compared with $57 billion in first-half 2005. Second-place JPMorgan Chase posted $59.7 billion compared with $36.2 billion last year, and third-ranked Morgan Stanley brought $49.1 billion compared with $23.6 billion.

High-yield bond issuance is also skyrocketing--there were $66.2 billion in new junk bonds issued as of June 30, compared with $50.7 billion in first-half 2005, and junk bond traders and bankers expect that level of issuance to keep going full throttle. The difference between last year's relatively sleepy performance and this year's wide-awake one is at times shocking: For example, in May 2006, there were $10.6 billion in new junk bonds issued, compared with $3.4 billion in May 2005.

Part of the reason for the boom in junk is the buyside's willingness to snap up anything thrown at them right now, given the general perception that credit quality of high-yield bonds is fairly stable. And naturally top-ranked high-yield underwriters prospered as well. JPMorgan Chase and Citigroup battled for the top position for much of the quarter, with the eventual victor, JPMorgan, ending the first half with $10.7 billion in new issues underwritten, compared with $5.5 billion in first-half 2005, while second-ranked Citigroup posted $10 billion compared with $5.6 billion in the same period in 2005. Credit Suisse First Boston and Banc of America Securities, in third and fourth place respectively, also had higher levels of new issues.

It seems the bond markets' streak of good luck shows no signs of running out. For one thing, the supply of new issues is not turning off any time soon, given the blockbuster activity occurring right now on the M&A front. On June 23 alone, $110 billion in M&A deals was announced, including Mittal's takeover of Arcel and Pfizer's purchase of Johnson & Johnson. Thomson Financial is now estimating that $3.5 trillion in M&A could be announced by year's end, the biggest year for acquisitions in history. "We are seeing a steady flow of more and more LBO and acquisition activity, which could result in more bond deals in the future," says Mark Fedorcik, Deutsche Bank's head of high-yield capital markets.

M&A Funding

Debt market players are rubbing their hands in anticipation of the possible billions in new debt issues launched to fund some of these acquisitions. "M&A has been the primary driver of issuance, and it already has brought many infrequent issuers to market," BNPP's Turner says. Among those infrequent issuers are Cisco, which hit the market in February with $6.5 billion in bonds to help cover its purchase of Scientific Atlanta, and Oracle, which sold $5.7 billion in bonds in January to cover its purchase of Siebel Systems--a deal that not only was Oracle's first trip to the bond markets in nearly a decade, but was the largest corporate bond issue since 2004.

The success of such offerings will likely inspire other issuers to attempt to hit high grade or high yield in force, bankers hope. "Large benchmark issues are back in favor again," Turner adds. Just a few weeks ago, Telefonica Emisiones, a Telefonica subsidiary, offered a $5.25 billion deal geared to hit every flavor of investor, offering one-year, five-year, 10-year and 30-year bonds.

And even if the US buyer base begins to turn on corporates, issuers have an alternative--foreign bond buyers have been increasing their holdings of US corporates extensively throughout the year so far, a trend that shows no signs of ending. It's a great tool for a bond underwriter--one head of debt syndicate said recently that his bank announced a deal at 5 p.m. EST so that the European and Asian investors had a first crack at it, in the hope of exciting US investor demand when the markets opened again at 9 a.m. It worked. "When we rolled back to New York, there was a good percentage of the deal spoken for already," he said.

However, the market is not entirely unconcerned about macro factors like inflation and the direction of interest rates. These worries have caused a boom in shorter-maturity bond issuance, bankers note. "There has been a proliferation of short-term floating-rate issuance," one debt syndicate head says. "The type of investors who are playing in those short floaters continues to expand, and pricing has held firm throughout weeks of fairly volatile activity."

But buyer interest in longer-maturity bonds is far from waning either, says James McKinney, head of debt capital markets for William Blair, in part because some buyers are tired of having shorter-term bonds called by their issuers, often for debt refinancing. So something like a call-protected 20-year bond seems quite stable in comparison. "Investors have money to spend," he says. "But they have had so much stuff get called that they don't want to buy shorter-term paper."

Watching for Rocks

While issuance should continue to steam ahead, and credit quality on both the high-grade and high-yield markets remains a fairly minor issue, that is not to say that bond market players believe the market is completely rock solid. For one thing, there appears to be growing investor belief that the pricing volatility of other markets, such as commodities, could eventually be replicated in secondary trading of bonds.

The most clear-cut example of that is the return of the new-issue premium-- essentially, when investors demand that new issues be priced wider than the issuer's outstanding bonds. Back in April, by contrast, "new issues were pricing not only with no new-issue premiums, but sometimes they were pricing tighter than their secondaries," says one bond trader. "It really was evidence of a frothy pricing environment. Now you are consistently seeing 10-15 bps new-issue premiums."

Now, however, there is some concern that bear market conditions and greater spread widening could take effect at some point later this year. The result could be a more conservative investor base in the second half, bankers say.

A warier mentality has taken hold in the new issue market over the last few weeks. "Investors want to build in more of a cushion on any particular purchase. If they are going to take $25 million of a new issue, and next week there is going to be something just like it but wider, they're going to want protection," the debt syndicate head says.

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