23/10/06
Improving the Function of European Bond Markets: Towards a Consensus
Today sees a coming together of buy and sell side practitioners to introduce a joint paper entitled "Improving the functioning of European Bond Markets: Towards a Consensus". Under the auspices of The Association of British Insurers (ABI), The Euro Debt Market Association (AMTE) and the Bundesverband Investment and Asset management (BVI), this paper represents an important step in searching for the sometimes elusive and constantly shifting goal of industry best practice. It is borne out of recognition of the rapid evolution in European bond markets, but a growth which has not always been accompanied by well entrenched best practices.
The impetus for challenging the definition of best practice arose from the dissatisfaction of bond investors. This cry of frustration was at least partially encapsulated in a number of papers backed by investment management groups, including one from the Bond Committee of the ABI issued back in July 2004 on Standards in the Fixed Income Credit Markets. These papers quickly found resonance and support with European investors as well as those from the UK.
Concerns revolved around three key broad areas: the flow and disclosure of information, ambiguities in understanding the true "bite" of covenant protection, and actually having covenants that did protect against "event risks" such as leverage buyouts.
The need for high standards of information disclosure is an obvious must for a bond investor but it is a need that is not always well met. The industry as a whole has become lax in terms of the circulation, availability and timeliness of information flow. A situation often exacerbated when a borrower is taken private or merged with another entity despite prior commitments to good communication with bond holders.
The area of understanding covenant protection has created genuine frustration for investors. Real value in covenants is delivered by clear wording which sets out the precise nature of the commitment being made by the borrower and demonstrates that the commitment will be observed. Clarity of meaning and hence improved transparency will allow better differentiated pricing and a more efficient market. The true worth or bite of a negative pledge clause, disposal of assets clause and change of control provision can be far from clear, especially across national boundaries. This is not to say that covenants should be harmonised to some common formula, which almost certainly will fail to recognise that each credit is unique and the formulation of covenants must reflect the individual circumstances of the issuer. It is a plea to borrowers for clarity in scope, labelling, usage and of critically, a respect for the commitment being made to investors.
In return, investors need to develop and educate themselves to a fuller appreciation of the diversity of risks involved in investing over a full credit cycle. This is perhaps particularly relevant to the growing interest in hybrid securities which frequently offer minimal investor protection – caveat emptor.
It is fair to say that there has been movement since the formulation of this paper. Credit rating agencies are looking at how key features of covenants might be better flagged to give investors greater insight as to their implications and value. In the area of protection against event risk, we have seen an increasing trend towards the granting of change of control provisions in new bond issues. This helps mitigate investors' fears regarding event risk, leaving a cleaner judgement on credit risk which is easier for the market to assess and price.
These developments underscore the constant changing nature of the market place and the consequent elusive nature of pinning down best industry practice. It also highlights the need for forums, such as the one being provided today, where market practitioners come together in an attempt to understand and remove mutually recognised obstacles. This mitigates the need to resort to the default solution of formal regulation and intervention by the regulatory authorities.
There will of course still be areas of disagreement, and the weight of conflicted vested interests will mean regulation is the only way of achieving a level, fair playing field between market participants. However, the role of these forums should allow for issues to be set in a better context, thereby making for more informed regulatory decision-making with less unintended consequences. This should in turn lead to an improvement in the functioning of our European bond markets.
Rod Paris, Head of Fixed Income, Standard Life Investments & Chairman of the ABI Bond Committee.
First published in FTfm on 23 October 2006.
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