A new unrated bond market

Mark Paton outlines the two debt questions that boards ignore at their peril and reveals a new pathway to the bond market for unrated Australian companies.

As the ultimate arbiter of a corporation’s strategy and goals, the board must keep in mind the bigger, long-term picture and this is especially true when it comes to debt management.

Typically, a company’s finance executives and managers are focused on the short-term performance of the business and for that reason they look mainly at the immediate cost of any borrowing solution.
Unfortunately, this approach downplays two aspects of a company’s financing arrangements that have big implications for its longer-term stability: the diversity of funding sources and the duration of debt.

Therefore there needs to be a good dialogue going on between the board and management about balancing the short-term cost of debt funding with long-term protection of the business.

CRISES HAPPEN

In extreme circumstances, the failure to have sufficient diversity and duration of debt can spell the end of an otherwise viable company that finds itself needing to renew debt in a negative market.

This is not a case of bad luck because it is predictable that crises will occur regularly even if we do not know the exact form they will take.

I have been in the markets for more than 30 years and have experienced at least a dozen events that resulted in tightened lending.

I can tick off, in no particular order, high inflation, high interest rates (when mortgages were over 17 per cent), the issuing of foreign bank licences, credit crunches, several recessions, the Asian economic crisis, the global financial crisis, major property development collapses and overheated asset or property values.

During this time, companies that were  borrowing at the standard bank duration of two or three years found themselves frequently trying to renew debt against a backdrop of crisis.

So it is important for boards to impress on their managers that crises are not freak events. They are a regular feature of the market that they need to prepare for even if it means sometimes paying a bit extra for longer-duration debt.

SIZE MATTERS

When company boards consider their managers’ plans to borrow, they need to ask them what strategy they have in place to deal with the next capital market event, when borrowing will suddenly become harder, more expensive and will have more onerous conditions.

Specifically, they need to ask what they are doing to increase the duration of their debt and the diversity of debt sources.

Frequently, if they are managing an unrated company, the answer is that they are doing very little of either because until recently there were few good options.
By contrast, larger rated companies have always had very good choices available.

Australian companies with a credit rating can get long-term commitments out to seven years and beyond from the domestic and global bond and securitisation markets, diversifying their sources of capital while also getting a longer-term commitment than they could get from a bank.

Rated companies in Australia tend to get their long-term finance from bond markets and their transactional finance from banks.

They do not rely on banks for everything. Overseas, the same also applies for unrated companies.

Borrowing in the local bond market has until recently been impossible for unrated Australian companies. This has driven some to seek funding in the US debt capital markets. But tapping these markets incurs significant extra costs and risks, including exchange rate swap costs and associated risks.

A NEW OPTION

Most companies have just been forced to accept that debt concentration and refinancing risk are a permanent part of life.

Thankfully, in the past 18 months a new pathway to the bond market has been opened for unrated Australian corporates, giving them exactly the same solution as the larger rated companies.

They can now get long-term finance either at the senior secured level or the senior unsecured level as an adjunct to bank finance, fitting in between bank debt and equity.

Depending on the company’s credit profile and industry, it can issue notes on terms ranging from five to 10 years, and at either a fixed or floating rate.

These notes are traded in the over-the-counter market and issued to wholesale investors only, in exactly the same way as rated issues approach the market – via an information memorandum and without the need for an ASX-listed prospectus.

It is not a drawn out process and can be completed within a two-week timeframe once mandated, following a standard credit risk assessment/due diligence process.

The documentation requirements are straightforward with standard bond agreements and a concise information memorandum that can be re-used for subsequent issues.

Over the past 18 months, companies that have taken this route include Silver Chef ($30 million), Mackay Sugar ($50 million), G8 Education ($70 million and $50 million), Cash Converters ($60 million), PMP ($50 million) and Payce Consolidated ($50 million).

In the next 12 months, we expect more issuance. The total pipeline of demand is over $1 billion, including a new move into infrastructure funding.

ASK the question

I believe boards need to be asking their finance executives if they have explored this option to improve both the diversity and duration of their corporate debt and if not, why not.

In addition to the relative newness of the unrated bond market, one factor that may be causing some finance executives to hesitate is a fear of damaging their relationship with their banks.

In my experience, finance executives speak highly of the role of their bank(s) and value the stability of that relationship.

So anything they might do in terms of provision of credit or ancillary business, they want to do in partnership with their bank(s), not in opposition.

This should be applauded as banks have a very important role to play in financing companies. However, managers have to put their company’s best interests first and consider diversity and tenor. Bank funding lines should be available to fund working capital, liquidity and future growth, including acquisitions (bridge funding).

Banks that have examined the recent bond issues have come to see them as supportive of their position as they help to fund the company from a different position in the capital structure and without the threat of another bank entering the relationship and wanting to share in the
cross-sell opportunities.

The problem for companies relying solely on banks is only going to get more acute in the near future as the Basel III regulatory standard on bank capital adequacy, stress testing and market liquidity risk takes effect.

Basel III allocates a much higher capital allocation burden to banks for longer-term lending to unrated companies.

Banks will pass this higher capital charge on to their clients so if the borrower wants long-term finance it is going to cost it significantly more.

However, the banks are likely to try to compete by encouraging their clients to instead borrow at shorter duration which will only pass on the stress risk from the bank to the client who is already suffering from lack of diversity and short duration.

In this situation, I believe the role of the board is to ensure that management understands the trade-off between lowest cost financing and diversity and tenor, and that it is probably worthwhile not having all of its eggs in
that basket.

Identifying that proportion of debt which is non-current on the company’s balance sheet and paying a bit of a premium so the company can ride through some of those economic cycles is well worth it.