Corporates Prefer Bonds

All grades of the bond market are open again, and companies are taking full advantage.

Institutional and retail investors in the credit markets are binging on corporate debt, and issuers are only happy to oblige. Bonds are fast becoming a large percentage of the total debt on corporate balance sheets, outstripping bank obligations.

According to first-quarter data from Capital IQ and analyzed by CFO, 89 U.S. companies increased their outstanding senior bonds and notes as a percentage of total debt by more than 10% year-over-year. The median increase was 45%. Combined, the companies had $65.6 billion of senior bonds and notes outstanding at the end of the first quarter, a 41% increase compared with Q1 2009 and double the amount outstanding in Q1 2007.

In contrast, only 42 U.S. companies, accounting for $5.5 billion in corporate debt, increased their bank debt as a portion of total debt by more than 10% in the first quarter, according to Capital IQ data.

For many of the companies on the bond list, 2009 and 2010 were the first years they conducted a sizable offering. Cloud-computing and managed-services company Terremark Worldwide, for example, tapped the bond market for the first time in June 2009 for $420 million, and did a follow-on offering in April. It now has $470 million in senior secured notes outstanding.

“There hadn’t been any companies in our sector that had tapped the bond markets going back 10 years before the dot-com bubble,” says Jose Segrera, Terremark’s CFO. Terremark repaid $254 million in bank credit facilities with part of the proceeds.

Issuing bonds had several advantages, says Segrera. For one, “once you’ve tapped the bond market and become a known quantity, it becomes relatively easy and efficient to execute another offering,” he says. Also, having bonds trading in the market gives investors another data point, says Segrera. “Even the equity investors look at it — it helps the market assess the company’s value.”

More CFOs are coming around to that belief. Investment- and speculative-grade issuance declined in the second quarter, but it picked up as the Greek debt crisis waned. Speculative-grade issues, in particular, have come back strong. Last week was a record-setter for high-yield issuance globally, with 26 offerings with a value of $14.3 billion, according to Thomson Reuters. Year to date, high-yield-bond issuances in the Americas are up 74% from 2009.

But investment-grade companies find the market to their liking, too, especially the historically low interest rates. This quarter glassmaker Corning priced $300 million of senior unsecured notes with a 10-year maturity at a spread of 145 basis points over Treasuries, and 30-year notes at a spread of 175 basis points. IBM, meanwhile, issued 3-year notes at an outstandingly low coupon of 1%.

For high-yield issuers, bond covenants are less restrictive than bank loans and most debt is unsecured, providing future flexibility. Using bonds to repay bank term debt also usually improves the company’s debt-maturity profile, points out Chris Taggert, an analyst at Credit Sights.

In the investment-grade space, replacing commercial paper and revolving debt with long-term bonds adds an element of safety for investors and strengthens the liquidity profile of the issuer.

Of course, there are downsides to bonds. Risks can be higher for investors based on the reason for the issuance. “[Risk rises] when the new bond deals increase leverage without the end goal of increasing the asset base or profitability, or when new bonds are issued at a more senior level,” says Taggert. For issuers, also, bond debt is more difficult than bank debt to amend, and the bonds may not be callable for the first couple of years, carrying a high redemption premium.

But with the Federal Reserve as much as two years away from raising the federal funds rate, it’s unlikely that the cost of corporate debt will fall much lower. So over that time, companies will probably have little need to redeem bonds to lower the interest rate they’re paying.

The unspoken risk to companies, of course, is the vagaries of the market. According to many experts, corporates are benefiting from investors’ low expectations for the economic recovery, which makes them willing to take small amounts of yield. But if the economic tide turns, those investors may flee the corporate bond market quickly and in large numbers.

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