While mergers and acquisitions is not an everyday subject for a bond investor maybe, it is important as bonds are often used in the final funding of the deals.
For over a year now we have been reading on a regular basis about multi-billion US dollar-sized balance sheets, buying other companies of a similar size.
I won’t discuss the merits, or details, of any particular deal, but want to make a couple of points that bond investors bear in mind when thinking about M&A from a 10,000ft point of view.
The first question, and probably the one that drives all the others in the world of bonds, is regarding the quantum of debt being assumed in the financing of the deal. The polar extremities being 100 per cent debt funded from loans and bonds or 100 per cent equity funded, by new shares, the former being a lot more risky for the bond investor. This is because the financial profile of the final company is likely to be much worse than either of the two companies before the deal, if it’s is all-debt financed.
However, in reality we usually see a balance between these two extremities with a bit of cash thrown in for good measure. Ideally we would like to see a mix, such that the impact on the financial profile of the acquiring company is largely unaffected, something their banking advisors can help to achieve. We call this “ratings neutral”, wherein the “ratings” bit refers to the credit ratings of a company, and at worst this is what we want to see.
While the Rolling Stones famously sang ‘You Can’t Always Get What You Want’ it should be obvious why we want it. Probably the most widely used measure of relative risk in bond markets is a credit rating, so preserving the status-quo (no rock band pun intended) works best for us.
What perhaps isn’t so obvious is the potential disruption to the market when a lot more bond debt is issued by a single company, especially if that company has a number of bonds outstanding already.
Even assuming a ratings-neutral M&A transaction, large scale new debt issuance usually offers a premium to a company’s outstanding bonds in order to attract investors, called a “new issue premium”. Generally this incentive works pretty well, such that the deal is oversubscribed and when trading starts in the new bonds, they will improve to the level of the old ones. Well, that’s the theory anyway.
One feature apparent in a number of the mega-deals we have been seeing is US companies using the strong US dollar to buy international companies and operations. So what? Well, this has led to new bonds being issued in multiple currencies to help match or hedge the revenues and assets of the combined new company.
Sounds good in theory, but the US is in interest rate rising mode right now and Europe, for instance, is looking increasingly like it’s going to cut its rates further. This is providing some very interesting opportunities for investors as we navigate divergent economic signals. It’s not just the strong US dollar that is attractive in this instance. With rates so much lower in the eurozone, the cash cost of funding, so the bond coupon or interest rates, via the euro market is helping the issuing company keep its all-in cost that bit lower, so if the M&A deals keep coming, so will the number of bonds being issued in Europe.
I don’t know what the Stones might think about this heady mixture, but somewhere in this conundrum I think there is a balance where we can all get some satisfaction.
Tim Barker is head of credit at Old Mutual Global Investors.