Devil is in the documentation as regulators scrutinise bonds


Why has the trend for property firms to raise finance via retail bonds stalled? Asks Virginia Blackburn

Following a slew of retail bond launches of all sizes last year, only two £100m-plus issues have been completed so far in 2013. One market insider who does not wish to be named adds that since the summer, “it is thought two listings have been held up because the Stock Exchange has queries about their documentation. The suspicion is that after the high volumes of bond issuance last year, there will be greater scrutiny of what is still an emerging market.”

There have also been question marks about banks’ willingness to market bonds sold to the public. “It is thought that banks don’t want to be involved after the scandals associated with mis-selling PPI and swaps to the public and small and medium-sized enterprises,” says the insider. “On top of that, there are calls for the bonds to be rated, but that will make them more expensive to issue.”

There are further concerns that the Order book for Retail Bonds (ORB) will suffer if bond listings are moved overseas, especially since it will now be possible to trade retail bonds on the London Stock Exchange even if they were listed elsewhere. Another problem, the source says, is that too many retail bond issues were carried out too quickly last year. “Brokers prefer to deal with one at a time.”

Commenting on the UK Listings Authority’s new documentation requirements for retail bond issues, Adrian Bell, head of UK debt markets at Canaccord Genuity, says: “What the UKLA is trying to do is laudable; to produce a prospectus in plain English. Unfortunately, this has led to agony for the lawyers involved in changing the format of documentation used for frequent borrower programmes.

Dilemma over documentation

“The new requirements are no more onerous in legal terms – they are just written in a different way and in a different order. Borrowers are very unhappy, as this makes it difficult to use the same document for repeated issuance in the wholesale market and the retail

“Some of the larger, better rated borrowers in the sterling market, such as National Grid and Severn Trent, which issued retail eligible bonds under their frequent borrower programmes in 2011 and 2012 respectively, have abandoned retail eligibility when renewing the programme because of the expenses involved.

“While these companies still retain the ability to carry out a ‘stand-alone’ issue, the chances of this happening are much reduced because of the work involved. This deprives retail investors of the opportunity to invest in higher-quality credits.”

There were 16 retail bond launches on ORB in 2012, whereas so far this year there have been seven, of which two – an £80m Helical Bar offering in June and Bruntwood Investments’ £50m issue in July – are in the real estate market. Real estate now accounts for 18% of the total retail bond market, according to Investec/Bloomberg.

Helical Bar’s was the first issue to use the new style of documentation, which is believed to have held up the issue, although eventually broker Numis resolved the problem. Numis is also said to be involved with the launch of another deal stuck in the pipeline, although Numis analyst Michael Dyson refuses to comment on this.

Greyling, Barry Investec“Ordinarily, the UKLA sends draft prospectuses back two or three times, but the new ones have been coming back five times, with more queries than expected”Barry Greyling, Investec

Asked why there have been so fewer launches this year than last, he adds: “Demand is there – investors would like more fixed-rate bonds – but there are a lot of choices for borrowers in the market. There is a strong equity market, the convertible bonds market (see p18) and private placements, plus bank lending has picked up. “There is not a problem in the market. The regulator is well intended: it wants documents to be more clear and for the investor to understand the risks.”

Barry Greyling, a member of Investec’s debt capital markets team, says that at the very least, the new requirements are causing problems. “Ordinarily, the UKLA sends draft prospectuses back two or three times, but the new ones have been coming back five times,” he says. “They have been coming back with more queries than expected, but now precedents have been set.”

More options for property borrowers

He also believes the fall in issuance is partly down to increased bank lending and a growing number of private placements. “The property market is recovering and if a company’s share price rises, its leverage is much lower and it can raise money elsewhere,” he says. “Another consideration is that the real estate sector is starting to get overweight in some retail investors’ investment portfolios.

Bell predicts: “There is a risk that this will end up as a protracted war of attrition, at the end of which the UKLA will modify its stance. If it doesn’t, more issuance will take place in Dublin or Luxembourg. Meanwhile, the Stock Exchange is under pressure to extend eligibility to be traded on the market to all retail-eligible sterling securities listed on a European exchange.

“Originally for a stock to trade on ORB, it had to be listed in London, whereas it could then be listed elsewhere and still trade. This is a re-run of what happened in the 1970’s when onerous LSE listing requirements drove many borrowers to Luxembourg.” ORB is said to be holding discussions and forums to address this problem. However, Greyling argues that the option to list retail bonds overseas will not necessarily have much impact on the wider market.

“I don’t know if I would call it a danger that listings will move to Luxembourg,” he says. “Sometimes it’s more advantageous to list on, say, the Irish Stock Exchange, as Quintain Estates did. Different exchanges have different regulatory requirements and investors are indifferent as to where something is listed. The danger is to ORB itself, not the retail bond market.”

p17.1ORB’s advantage is that it is a totally transparent and simple trading platform that can be followed on a daily or weekly basis, and it has lent liquidity to the market. But the lack of clarification as to what is to happen next about trading foreign-listed retail bonds must be a concern for ORB.

When it comes to the issue of applying ratings to retail bonds, there is a suspicion that banks are very wary of selling this product to investors, who might not properly understand the risks involved, and that banks will end up having to pay out huge amounts in compensation for mis-selling, as they did over PPI.

Rating bonds might alleviate these fears, but the industry has taken a somewhat negative view of the idea. Ratings would also increase the cost of retail bond issues, further depressing the market.

Many market participants are very unhappy at the idea of a ratings system. “An increasing number of distributors say that in the absence of proper credit analysis, they need some form of verification and an increasing number are looking to get ratings,” says Bell.

“But there is no requirement for this. It would make issues more expensive, while the methodology used by ratings agencies is often weighted against small and medium-sized companies. Furthermore, they look primarily at the risk of default and don’t look at the risk of recovery, which is just as important to an investor.”

Greyling is similarly cautious. “Generally they are not considered an absolute requirement,” he says. “A couple of people require ratings, but most don’t. It will assist in marketing bonds and could allow for the comparison of differentials, but not all bonds need them and the danger is that one will suffer.

“If a company already in the market, such as Workspace [which raised £57.5m in 2012] came to the market again, it wouldn’t require a rating, but if a brand new one needed to target investors and was not specific about a rating, it would need to be more coupon focused.”

A further problem, says Dyson, is that ratings favour very large companies. “Some smaller ones won’t get a rating that reflects the true quality of the company,” he says. “Getting a rating is a lengthy and expensive process. It would be better if investors were expected to do their homework by first looking at the bond, doing the credit work and then, if they had to, looking at the rating.”

p17.2Rating threatens catch 22 situation

The catch 22 situation is that while a bond with a rating is more attractive to investors, getting that rating will make it a more expensive way for issuers to raise money, thus acting as a brake on the market.

However, one market insider argues: “Each bond should have a rating, even if it is more expensive. It does make it more expensive, but if it isn’t rated, it makes it a lot more difficult to market. Investors need to think more about the underlying issues and be open to the best in class.”

With so many considerations to deal with, investors are likely to be cautious when it comes to investing in retail bonds.

A general recovery across the economy – and the property market in particular – in the past year has also produced a seismic change in the relative attractiveness of retail bonds. Previously, they appealed to investors with few other options, with a sluggish equity market and a moribund cash one.

Borrowers, meanwhile, were doing everything in their power to find fresh funding sources in a market in which lenders were simply refusing to lend.

All that has changed, and with it the investment and borrowing market. Now, “the banking and wholesale markets are a lot more accommodating”, says Bell, “offering terms that could only be dreamt about nine months ago. Mid-size borrowers’ options have got a lot larger.”

As, of course, have investors’, too.