Credit market headwinds a breeze for bigger banks

Two weeks ago ANZ's head of market research, Warren Hogan, told a credit market conference in Sydney there was a strong chance that wider margins on corporate credit would act as an economic headwind.

Yesterday Hogan said there was no doubt about it; the headwind had arrived.

Hogan said: "In Australia the five year swap rate has widened 25 points in a month. That is a huge move.

"The five-year swap rate has been 30 to 50 points over the government bond rate for the past five years. Now it is 70 over. The 10-year swap rate is at its highest level in a decade."

Hogan said he was not too worried about this trend. Credit spreads had been too tight, a result of risk not being priced appropriately. Spreads were being priced more realistically.

"How much will that deter corporate borrowers and ultimately economic activity? For any level of interest rates the hurdle rate for business projects will move."

Any credit benchmark you choose tells a similar story. Standard & Poor's director in charge of credit market analysis, Philip Bayley said iTraxx Australia, an index of credit default swaps written against a basket of 25 local investment grade corporate bond issuers, moved 27 points in July.

Bayley said: "At the end of June the spread over swap on iTraxx was 27 points. By July 10 it was 44 points. That is a very substantial move for that index."

How all that translates into the everyday business of corporate fund raising is still a matter of conjecture. The anecdotal evidence so far is contradictory.

Last Friday Members Equity Bank withdrew a $500 million issue of residential mortgage backed securities from sale, citing lack of investor demand. The group's CFO declared that there was "a buyers' strike".

On the same day Australian Education Trust, a managed fund that works alongside ABC Learning as the owner of the properties in which ABC operates its child care centres, announced that it had successfully refinanced a big chunk of its debt with $150 million of seven and 10 year debt securities sold to investors on the US private placement market.

Australian Education Trust chief executive, Vin Harink, said the company had no trouble allocating the debt and securing good pricing on the deal. It was the company's first issue in that debt market.

On Monday a small finance company, Impact Capital, announced that it had secured a new debt facility with BankWest, replacing an established arrangement with NAB. The company reported that it had secured a bigger debt facility, up from $40 to $50 million, on better terms.

Talk in the market is that investment banks have had to withdraw a couple of convertible note issues because investors were uncertain about how to price the credit risk.

ANZ group managing director institutional Peter Hodgson said this confusion was understandable. "No one likes an extended period of high volatility. If you were an investor pricing against market for a new issue it would be very difficult. There is going to be a hiatus while it settles."

Hodgson is convinced that once that period is over spreads will remain wider than they have been over the past couple of years. This is good news for lenders, who will be able to earn higher margins on their loans, and also good news for investors, who will earn higher yields on their credit portfolios.

While borrowers can take little comfort from this scenario, Hodgson said it was not all bad news for them either. Debt market markets should remain liquid, even if rates are higher.

Hodgson said: "As a general rule these days the institutional and corporate banking divisions of the big banks like to originate more, distribute more and hold some.

"But that changes through the cycle. We don't want to be turning the tap off and on. That is the last thing anyone wants. You then have to make adjustments to how much you hold and how much you distribute. That will be driven by the state of the credit markets, pricing and the customers you are dealing with.

"Our message is that the tap is on and in these circumstances, when demand is down, we can hold."

Some commentators have suggested that the banks will be aggressive in using their strong balance sheets to grab market share. Others have pooh-poohed this idea, arguing that the banks are creatures of the markets too; their funding costs have gone up along with every other corporate credit issuer and that will be reflected in their lending rates.

A banker on the origination side of the institutional division of one of the big four said his team was beaten on a deal by the corporate lending team at the same bank, which offered pricing that was five to 10 basis points sharper.

A director at the investment bank Calyon, Jason Lee, said he was sceptical about this being a sustained trend. "Banks the world over are not risk takers. They tend to move with the trend. The trend now is for spreads to widen and liquidity to tighten.

"Banks will not be counter cyclical, even though you would argue they should be.

"These days when a bank arranges a corporate loan it is always looking to syndicate. When you do that you have to be aware of what the market will and won't buy."

Hodgson said this was an over-simplification. "Banks are operating in a more competitive environment and they have moved their lending standards around covenants and other standards.

"There is still going to be aggressive competition for well rated borrowers in the corporate and middle markets. We look at those companies through the cycle, not on short-term market movements.

S&P's Bayley agrees: "Corporates can get better pricing from banks at the moment. Over time you would expect bank rates to go up in line with credit market trends but that is not what we are seeing right now."

BNP Paribas director Cedric Podevin said where banks had tightened up was in moving away from their previous policies on funding higher risk credits.

Podevin said: "A lot of investors have had access to finance for illiquid positions. It would be hard to get that finance now."

ANZ's Hogan said the banks' position might be different if they had borne the brunt of the sub-prime crisis, as they have in earlier financial collapses.

"If enough of the losses had been on banks' balance sheets we might have been looking at a credit crunch. We are not seeing that.

"That is because the risks are well diversified. Banks, pension funds, mutual funds, hedge funds have been funding sub-prime lenders and there has been a good geographic spread."

Antares Capital Partners' David Bickford agreed that one of the striking features of the current environment was how much credit markets had grown externally to the banks.

Bickford sad: "This growth has happened fast and there are problems associated with that growth. The market has got to get used to handling credit."

He warned that dangers were still lurking. "When you have an LBO corporates re-leverage and the security of credit goes down. Investors can't do anything about that.

"What about covenant lite? Are those loans going to hit the corporate market in the same way that sub-prime is hitting the mortgage market?"