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Corporate borrowers are finding that an investment-grade credit rating makes a big difference.
Andrew Osterland, CFO Magazine
December 1, 2001
The economic fallout of September 11 is finally beginning to be reflected in production and employment figures. But for Matt Hart, CFO of Hilton Hotels Corp., the impact was immediate. "We knew right away that the attacks would hurt our business," says Hart. He also knew his bankers would be sweating bullets. With airplanes grounded for days, and the American public afraid to fly in them once they resumed service, Hart knew his hotels would lose business. He didn't expect long-term damage, but the flood of cancellations that followed the attacks would hurt cash flow for several quarters and put Hilton in danger of breaching covenants on its loans and revolving credit facilities. "The issue was, do I go to my bankers now for amendments and wiggle room, or do I wait until I'm out of compliance?" says Hart.
He took the former approach, meeting with lead banker Bank of America a week after the attacks to discuss an adjustment to the loan covenant. For a "modest" amendment fee, he got his adjustment, ensuring that Hilton wouldn't be out of compliance on its loan agreements for the next 18 months. "The banks have been supportive," says Hart. "I think they have a different attitude now about requests for relief."
Of course, it helps if you're an investment-grade credit. Many companies adversely affected by the terrorist attacks haven't had as understanding an audience with their bankers. Wyndham International, a hotel and resort chain with no rating by Moody's Investors Service or Standard & Poor's Corp., got a waiver from lead banker J.P. Morgan Chase, but it reportedly also had to suspend dividend payments on its preferred stock, limit capital spending, and use all proceeds from asset sales to repay loans.
While bankers have been relatively accommodating to borrowers hurt by the attacks, they are not ignoring trends in corporate credit quality, which have been deteriorating since last year. "There's been a pretty dramatic tightening [in the bank market] since September 11, but the trend goes back more than a year," says Daniel Gates, head of syndicated loan rating at Moody's. And it extends far beyond such travel-related sectors as hotels and airlines, which were most directly affected. Dozens of sectors of the economy, including technology, telecommunications, manufacturing, and retail, have been experiencing slower growth for more than a year. And that weakness is showing up in the asset quality of bank loan portfolios. The aggregate provision for credit losses for the top 20 U.S. banks rose to $6.8 billion in the third quarter, more than twice the figure for the same period last year, according to Moody's. Actual loan charge-offs also doubled, to $4.8 billion. With corporate credit downgrades still outpacing upgrades by a margin of 2.9 to 1 in the third quarter, and loan defaults not expected to peak until the middle of next year, bankers will be monitoring their existing portfolios all the more carefully--extraordinary circumstances or not. And as for extending new credit, CFOs can expect the recent tougher lending standards to continue.
For most investment-grade companies, the tighter credit market has not been a problem. Most of the approximately $650 billion in syndicated loans issued in 2000 to investment-grade companies are unfunded revolving-credit facilities that back up commercial-paper issuance. Credit-rating downgrades at large borrowers such as General Motors, Ford, and AT&T have restricted their access to the commercial paper market, but have also reduced their need for backup credit lines. All three companies have turned to the bond market for longer- term debt. As in the rest of the credit spectrum, investment-grade spreads over Treasuries have widened throughout the year, but the plunge in short-term interest rates (courtesy of Alan Greenspan) has more than offset the increase in spreads. As of October 31, the average long-term yield on investment-grade corporate bonds was 6.93 percent, according to Moody's--well below the 7.14 percent yield on September 10. And companies are taking advantage: Corporate bond issuance in October totaled $76 billion, all but $5 billion of which was investment grade.
Most noninvestment-grade borrowers, however, don't have the bond market to fall back on now. They rely much more heavily on the syndicated loan market for their long-term funding, and have had a far more difficult time securing new credit. After years of consolidation, commercial banks are fewer in number, and they are busy tending to existing clients. They are clearly wary of extending new credit in a deteriorating economic environment. And institutional investors, which now account for about 50 percent of the capital behind high-yield loans, are waiting to see how far prices will fall before they commit to new deals. "The market is a lot more selective now," says Gates. "The credit ratings on new loans are much higher than they were last year, and the riskier credits are getting squeezed out of the market."
Like most other assets in the capital markets, bank loan prices took a dive after September 11. Across the board, leveraged loans trading in the secondary market dropped in price, making new deals a more difficult sell. "The leveraged loan market is still finding its feet," says Meredith Coffey, director of analytics at Loan Pricing Corp.
CommScope Inc. is one victim of the more-selective market. The Hickory, North Carolinabased maker of coaxial and other high-performance cable struck a joint venture deal with Japanese conglomerate Furukawa Electric to purchase Lucent Technologies's fiber-optic-cable division for $2.75 billion. To finance its $650 million share of the venture, CommScope hired Citibank and CIBC WorldMarkets to launch a $360 million syndicated facility including a four-year, $50 million revolver; a four-year, $85 million term loan for participating banks; and a five-year, $225 million term loan for institutional investors. The institutional tranche was originally priced at Libor plus 350 basis points in early October, and was reportedly later raised to Libor plus 450 points--a good yield given that the loan is secured by assets, but not good enough to attract many takers. CommScope is now attempting to negotiate a lower price with Furukawa or a smaller stake in the venture.
There are some encouraging signs, however. Necessity, it appears, is the mother of invention in the loan market. Tesoro Petroleum Corp. was one of several deals in the works before September 11 that was subsequently postponed. The San Antoniobased oil refining and marketing company was in the market for an approximately $450 million term loan to help finance its acquisition of two oil refineries and other assets from British Petroleum. The stumbling block for the deal was the piece for institutional investors.
The issue, of course, was price. Libor, which most of the business sector's variable debt is pegged to, hit 2.2 percent on October 31--more than 4.5 percent below its level of just a year earlier. At a yield of Libor plus 275 basis points, the terms were not particularly attractive to institutional investors strictly pursuing yield. The solution? Establish a floor for Libor. The new term loan established a floor of 3 percent, making the minimum yield 5.75 percent even if short-term rates continue to fall.
Coffey says the Tesoro deal is the first to use such a tactic to attract institutional investors. And it illustrates how the new syndicated loan market is behaving much more like the bond market, using pricing innovations to get deals done. One tactic, so-called price flexing, which allows borrowers and their syndicate arrangers to change the pricing of a deal based on investor demand, was pioneered by Chase Manhattan Bank in the 1990s. So, for example, a loan yielding Libor plus 250 basis points can be "flexed up" to Libor plus 300 points to clear the market.
Fans of Flexibility
Another option is to employ discounts on the loans. Earlier this year, Edison Mission Energy and American Greetings, among others, employed original- issue discounts on their loan packages in order to bring institutions into the deal. Like a bond, a term loan can be issued at a price of, say, $97, and return principal of $100 at maturity. Not exactly rocket science, but a new innovation for the lending market. It enhances the yield for institutional investors and, though proceeds on the deal are less for borrowers, the absolute interest expense remains the same. "There's been a lot of innovation to deal with the dislocation in the market," says Coffey. "And the more the loan market innovates, the more capital will be available to the asset class."
One fan of the new, more-flexible loan market is Dale Parker, CFO of paper-products manufacturer Appleton Papers. "It certainly helped us get our deal done," he says. Last December, when Appleton's U.K.-based owner, AWA, indicated it wanted to sell the business, Parker and senior managers at the company decided they were interested in buying it. So, it turns out, were 2,500 other Appleton employees, who committed $107 million from their 401(k)s to execute a buyout. By early July, Parker had agreed on a sale price with AWA, and he was well on his way to arranging the financing. "We had a meeting set up with the bankers in the Sears Tower on September 13," he says. The meeting was canceled and the deal postponed.
Lead banker Bear, Stearns & Co. got busy massaging the terms, employing a discount as well as a Libor floor to the $435 million deal. That means higher borrowing costs--but at least the financing is there. Parker closed the deal on November 9.
Andrew Osterland (firstname.lastname@example.org) is a senior editor at CFO.
Most investment-grade companies don't borrow money from banks anymore: they buy the option to borrow money in the form of revolving credit facilities. They occasionally tap the credit lines to fund an acquisition or make some large investment, but typically the credit lines are used as backups for the issuance of short-term commercial paper. The expectation is that the money won't be used.
While CFOs may be loath to pay for money they don't use, backup credit lines have proven their worth since September 11. "When the commercial- paper market is disrupted--as it was--backup credit lines provide confidence to investors," says Glenn Eckert, an analyst with Moody's Investors Service, which does not rate commercial paper for companies that don't have 100 percent backup in place.
The need for these credit lines, however, has fallen along with the issuance of commercial paper this year. Since October 2000, outstanding commercial paper has shrunk from $350 billion to $226 billion. Most companies have reduced their programs by choice, opting to lock in low, long-term interest rates in the bond market rather than regularly roll over short-term paper. Many, however, have been forced out of the market because of downgrades in their short-term credit ratings: notable examples include Ford, General Motors, DaimlerChrysler, and, more recently, Kodak and AT&T.
Those companies still using the commercial-paper market, however, need the backup credit. And commercial banks are increasingly averse to offering it. "Backup lines are one of the banks' least-profitable products," says financial services analyst Kathy Shanley of Gimme Credit, an investment advisory firm in Chicago. Not surprisingly, the cost of those credit facilities has been increasing for companies in the past few years, as banks look to use their capital in more profitable ways. The facilities have also become a bargaining chip in the "pay-to-play" dynamic of the converging financial- services industry. Banks will provide the facilities if companies use them for bond underwriting or M&A advisory work. Conversely, large companies will give banks desirable fee-generating business if they also offer credit facilities.
"We expect banks to put their balance sheets on the line for us," says Brian Andersen, CFO of Baxter International. -- A.O.