Improbable price talk on Telstra 10-year bond

The return of true corporate issuers to the domestic corporate bond market this year has been a welcome development. Investors have long suffered from a lack of diversification opportunities and still do.

The composition of current outstandings in the domestic market is such that bonds issued by true corporate issuers account for just 12 per cent of total outstandings of A$300 billion (and less than three per cent of year-to-date issuance).

With the return of true corporate issuers post the GFC, there is the hope that the domestic market might be considered a more viable source of debt funding as reliance on the banks is reduced.

However, with the news yesterday that Telstra is considering a domestic, 10-year bond issue, investors may care to be cautious.

This will be the first 10-year bond issue by an Australian corporate that is not credit wrapped or privately placed since Santos issued in September 2005. Telstra has not undertaken a similar issue since it raised A$500 million in November 2004.

Not that there is any problem with ten-year issuance. There has been a trend towards longer-dated issuance in recent months but this has been limited to more highly rated issuers.

The Financial Review reported yesterday that the pricing of the Telstra bond would be at 150 basis points over swap. Dow Jones reported in a follow up that pricing would be in the mid 100s.

This pricing is way out of line with relativities in the market, to say the least.

In terms of primary issuance, we saw Westpac issue seven-year bonds last week at 130 bps over swap. Given that the benchmark pricing of five-year bonds issued by one of the four major banks is now sitting at 100 bps over, it's quite possible that they would have to pay more than 150 bps for 10-year funds.

In fact, Westpac issued 10-year bonds in the US on Monday night and had to pay 155 bps over US Treasuries. This should convert back at 165 bps or more over swap in the domestic market.

Moreover, Westpac is rated Aa1 by Moody's Investors Service while Telstra is rated A2 and the rating is on review for possible downgrade, due to uncertainty over the credit implications of a full structural or operational separation of Telstra that the federal government is now seeking to impose.

Trying to make relative value comparisons with other true corporate issuers in the domestic market is difficult - there are no comparables in the ten-year space, but GE Capital Australia (rated Aa2) has a March 2019 bond, which is currently marked on one rate sheet at 230 bps over. The Santos 2015 bond does not appear.

Wesfarmers (rated Baa1) issued A$500 million of five-year debt in the domestic market in September, at 260 bps over. This is now marked at 190/195 bps over. Nevertheless, the pricing was considered exceptional at the time.

Leaving pricing relativities aside, Telstra has disappointed both debt and equity investors alike in recent years. There has been the collapse of its share price post T2, and T3 buyers are still deeply under water. For these reasons alone, it would be very difficult for Telstra to undertake a retail bond issue now.

As for the institutional investors that have bought Telstra's bonds in the past, they have had the pleasure of watching its credit rating slide from Aa2 at the end of the 1990s to A2 at the end of 2005.

It is most likely the unhappy experience of domestic investors that has led Telstra to avoid issuance in the domestic market since its A$500 million issue of eight-year bonds in March 2005.

With the exception of some smaller private placements since then, it has focused on international issuance and raised the equivalent of more than A$5 billion (at prevailing exchange rates). Perhaps offshore investors are now becoming more cautious or perhaps it is just the very wide basis swap that is making offshore issuance unattractive for Telstra, this time around.

Nevertheless, with its A2 credit rating from Moody's now on review for possible downgrade, the direction of the long-term trend in Telstra's credit risk profile is clear. The pricing of this proposed issue should be considerably wider than has been reported and the terms and conditions should include a provision for a coupon step-up as Telstra's credit rating falls, at the very least. A put option on the event of structural or operational separation would be even better.