Wall Street's bond underwriting machine likely will remain busy in the final three months of this year and early next, say market analysts, who expect high-yield debt sales to counter a drop in fee income related to processing trades in bond, stock and currency markets.
The initial public offering calendar will continue to fill up as many private-equity firms look to sell their portfolio companies, but that does not mean the paper will come to market quickly. That will hinge on outside factors like the well-being of the equity markets and perceptions about the nation's economy in general.
"IPOs, equity deals are waiting in the wing to come to market," said Brad Hintz, a Bernstein Research analyst who tracks Goldman Sachs and Morgan Stanley and lowered his quarterly earnings estimates for both in the week that ended Oct. 1. "I'm eating crow," he said of his decision to cut his outlook for the two banking giants' earnings. "We just need somewhat better equity conditions."
Market observers said the burst of merger and acquisition deals in recent weeks — including Wal-Mart's agreement to buy a South African retailer and Southwest Airlines' deal for AirTran Holdings — came too late to lift third-quarter Wall Street profits.
From July 1 through Sept. 30, companies announced $661.2 billion of global mergers and acquisitions, the strongest quarterly total since the third quarter of 2008, according to Thomson Reuters.
Announced deal volume grew for the third consecutive quarter, rising 17% from the second quarter and 38% from the third quarter of last year.
The dollar value of deals announced this year rose 16% from the first nine months last year, to $1.74 trillion. By comparison, just $393 billion of deals closed during the third quarter, down 15% on the quarter and flat on the year.
Frank Maturo, head of equity capital markets at Bank of America Merrill Lynch, said that even though there is a big pipeline of IPOs in registration, "a number of deals are getting pushed back to the fourth quarter of 2010 and 2011" as the slow pace of the economic recovery and the impact that has on earnings caused companies to rethink the timing of their stock market debuts.
"Companies would prefer to IPO off a strong quarterly earnings number," he said. "Also, comparables are not necessarily trading at the levels they'd consider ideal."
For most of the third quarter, bond underwriting was the main event as companies took advantage of historically low interest rates to refinance higher-yielding debt, prefund upcoming maturities and extend maturities by issuing long-term debt to pay off bank loans and commercial paper.
Global debt issuance for the third quarter through Sept. 29 climbed 19.4% from the second quarter (but fell 23.6% from the first quarter), to $1.23 trillion, according to Thomson Reuters.
"Issuers are more than happy to print record-low coupons," said Brian Cogliandro, head of debt syndication at Mitsubishi UFJ Financial Group. "When I talk to treasurers, it's a question of do I have use for the money?
For example, Cogliandro said an industrial company (which he would not name) issued $300 million of five-and-a-half-year notes at the end of August and used the proceeds to refinance commercial paper with an average maturity of two weeks. "That was interesting, because they could have held off."
He recalled conversations with the company's treasurer, who "struggled with a reason to come to market" with the notes. "They were concerned about negative carry; they were paying less than 75 basis points on the commercial paper, and now paying 360 basis points" of interest on the new debt. "That was not an easy decision."
By comparison, stock underwriting, which has much higher profit margins than bond underwriting, was flat, with convertibles and follow-on common equity offerings offsetting weakness in IPOs — by far the most lucrative corner of the market.
Global equity issuance for the quarter through Sept. 22 fell 7.6% from the second quarter and 55.1% from a year earlier, to $141.07 billion.
With the exception of few blockbuster foreign issuers like Agricultural Bank of China ($19 billion) and China Everbright ($2.8 billion), most companies making their stock market debut were relatively small.
Liberty Mutual, which was set to conduct the biggest U.S. IPO this year, pulled its deal in late September.
It said it postponed its deal, which would have been worth around $1 billion, because "the stalled economic recovery, volatile stock market and undervalued property and casualty insurance stock prices create an unfavorable environment for receiving appropriate value for the business."
To make matters worse, the pickup in bond issuance did not translate into additional trading in the secondary market, which is also more profitable than bond underwriting.
Jefferies & Co. set the tone for the Wall Street earnings season in September when it reported that its net income per share for the three months that ended Aug. 31 dropped 45% from a year earlier. Richard Handler, the firm's chief executive, cited "painfully slow" trading revenue.
Hintz said mounting anxiety about the waning economic recovery and uncertainty over midterm elections left clients paralyzed during the quarter. While that was to be expected, he said it was surprising that firms didn't trade more for their own accounts.
"The message I'm getting from companies is that they did not take advantage of the flow and make money by increasing their own bets on the market place," Hintz said. "It's fascinating … that would be exactly what fixed-income divisions would have done before the crisis. It's either a very chastened management being cautious, or regulators who are, through guidance, encouraging them not to take bets. Are we seeing an evolution in the way the Street runs itself or have all of our badly behaved traders found God?"
Bankers say there are plenty of reasons to expect M&A activity to continue picking up in the fourth quarter and into next year: Financing is cheap, valuations are low and companies are sitting on record levels of cash that they are under pressure to put to work.
"Management confidence that they can do better for shareholders than simply redistributing available cash is likely to fuel additional M&A activity," lawyers at Skadden Arps wrote in a memorandum in late September.
One financial sponsor banker (who asked not be named) said many private-equity firms are looking to sell off their portfolio companies to generate returns for their investors and to beat any changes in tax legislation.
"There's been an acceleration of M&A activity that can be traced back to the fourth quarter of last year," said Jeff Kaplan, global head of M&A at B of A Merrill. He said it's being driven by "continued strength in the debt markets, consolidation in key sectors such as energy and natural resources, and continued activity by private equity firms."
He said B of A expects the pace of deals to continue, and maybe accelerate, this quarter for the same reasons, although the year-earlier comparisons won't be as favorable in the fourth quarter as they were in the first three quarters.
There was little M&A in the first half of last year as the broader financial markets recovered from the worst of the credit crisis, but activity picked up late in the year.
Hintz, meanwhile, noted that dealmakers have been busy putting together ideas for corporate chieftains, but CFOs and CEOs are reluctant to actually act. "The message you get from all of the prominent M&A bankers [is] … 'Wow, all the deal teams of all of our respective firms are busy but they can't get client to pull the trigger on deals."
Even though some companies have pulled their IPOs, dealmakers say there is room for optimism.
"Normally, when you see the issue markets open, they shut fairly quickly if there's an overconcentration of issuance in one sector," said Brad Miller, co-global head of equity syndicate at Deutsche Bank.
"Here, the breadth of the backlog is encouraging. … In other periods this year, when the market has opened, it's been heavily concentrated in technology companies and financial companies."
The IPO registration backlog includes a broad list of health care, consumer, industrial, energy and financial companies, Miller said.
B of A Merrill's Maturo is more circumspect. "The IPO market is open, but issuers have to be realistic about valuations, as there's still a lot of volatility in the stock market, and investors want a bigger pricing cushion," he said.
Maturo said the low rate environment is holding the IPO market back as investors flock to high-yield bond funds, while they are pulling money out of domestic stock funds. "We're seeing inflows from cash on the sidelines, but we're not getting new money," he said. This affects IPOs in particular because "fund managers putting cash to work are more likely to invest in existing, seasoned companies than unseasoned ones."
There are also questions among market participants about whether the frenetic pace of bond issuance can be sustained into next year.
Cogliandro said that even though the high-yield market is headed for a "very, very busy end of the year," the investment-grade market softened toward the end of September, and some deals have struggled a little in terms of pricing.
John Cokinos, head of high yield at B of A Merrill, also says there are still plenty of speculative-grade companies looking to refinance debt or extend maturities, and there is plenty of new money coming into the market. Cokinos said there's been a good mix of companies coming to market both to finance M&A and leveraged buyouts in addition to overall refinancing activity, which is "a good indicator of the health of the market."
