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Wednesday, 1 June 2011

Will corporate bonds decrease the influence of banks on the debt portfolio of companies? And what will be the consequences for the banking industry?

At companies in The Netherlands, there is a growing interest for the issuance of corporate bonds. This phenomena seems to be caused for three reasons:
  • The Dutch large banks like ABN AMRO, ING, Rabobank and SNS Reaal are still quite hesitant to supply large loans to companies, especially where those companies:
    • don’t have a longstanding reputation and track record, or
    • don't have business plans that supply only a minimum of risk to the banks;
    • can't offer ironclad guarantees, like easy-to-liquidize assets as collateral
  • Companies are fed up with the questionnaires, requested guarantees and collateral that the banks demand, before supplying a loan.
  • Private investors that are willing to take risks, but don’t see much perspective in the current stock markets, are looking for new and profitable ways to invest their money.
    • These investors have a lot of money available and are willing to invest in corporate bonds, even if those have a near-junk bond status, due to the very high interest payments.
The Dutch financial newspaper Het Financieel Dagblad ( reported on this phenomena on May 31st.

Here is a translation of this article, called “Hunger for risk-bearing bonds is growing” (link in Dutch).
The demand for risky corporate bonds is larger than ever. This is stated by several business bankers. According to these bankers, there has been never a larger share of junk bonds in the Dutch bond market.

“There is an impressive demand” according to those bankers. A very important reason is that investors can make relatively little money in other investment markets, like the stock market or via cash-deposits. On top of that, investors have a lot of money to invest. Looking for good yields, they are willing to invest with a larger risk-rate.

That is one of the reasons why the Rabobank, as the first Dutch bank,  could offer a Payment In Kind-loan (PIK) in 2011. That is a riskier financial instrument than a bond, as the loan is subordinated heavily and doesn’t pay a coupon during maturity. Interest is paid only when the loan has matured. The interest amount can soar, however, due to interest-on-interest.

This was the fourth PIK-loan on the European market this year. Earlier loans were placed by large American banks, like Goldman Sachs. “Rabobank underwrote this PIK-loan for Stork (a large Dutch industrial conglomerate - EL) to finance its acquisition of RBG Group”, according to Herald Top, who was responsible for the placement of the loan.

According to Top, especially hedge funds and other investment funds with a wide investment mandate are interested in these kinds of loans. “It is very special to underwrite such a loan in Europe and to put it in the market without a rating” according to Top. “But it shows that investors are willing to take more risk”.
In a radio broadcast of Dutch radio station Business News Radio (, which is closely related to the ‘Financieel Dagblad, this topic was also discussed. One of the insiders interviewed, stated that this comeuppance of the corporate (junk) bond in the Dutch financial traffic could mean the end for the large Dutch banks, as we know them. He stated that the roll of the banks in the debt portfolio of Dutch companies would diminish, as companies would rather go to private investors via corporate bonds, than to go to a bank for a bank loan, considering the array of demands that comes with it.

In my opinion, this is exaggerated. Only the larger companies of 100+ employees, or very capital-intensive companies with large R&D departments could be interested in issuing corporate bonds: for smaller companies this is just too expensive, as they need a rating from an official rating agency and needs to pay a higher interest than they would pay to a bank. These companies could better go to a bank for a loan or a current-account credit.

It might be that banks lose a little part of their loan portfolio, but I guess that will not be much more than 5%, looking at the average size of companies. To put things in perspective: from the 864,000 companies in The Netherlands, only 940 have more than 100 employees. If you only look at these numbers, you would know that the Dutch bond market will not be ‘exploding’ in the coming years.

In a way, it is surprising for me that hedge funds and other investment funds are willing to embrace higher risk in these times of austerity. The credit crisis is hardly over and everywhere consumers are keeping their hands on their wallet. On the other hand, it makes sense. Stocks have proven over the last 15 years, that these can be a very shaky investment, if an investor steps in at the wrong time. If you would have stepped in, in 1996, and kept investing in stocks until 2009, the stock yields would have been “not too pleasant” to state it mildly. The interest that banks paid on savings accounts and deposits, since mid-2009, have almost been insulting. Therefore investing in junk bonds or PIK-loans might seem like a risky, but rewarding way to make higher yields on your investments.

But I still remember the days of Michael Milken and Carl Icahn in the Eighties, when I was busy with getting my bachelor in Higher Business Education. At that time junk bonds seemed to be the greatest financial invention since the stock option. The take-over battle for RJR Nabisco, between Kohlberg Kravis Roberts & Co. and the likes of Goldman Sachs and Salomon Brothers, was like a schoolbook example of leveraged buyouts and the power of junk bonds.

These junk bonds were used by smaller companies to take over their larger competitors with 90% borrowed money and they made bankers and financial wizards, like Michael Milken billions of dollars. Until they… didn’t and the financial fairytale was suddenly over.

As long as those PIK-loans and junk bonds are used by people and financial establishments that have the right risk-profile and that are looking for a higher-yielding investment, it can be a good investment instrument.
But as soon as the Average Joe in the Street (in the Dutch case called “Jan”) gets smell of it and financial whiz kids want to abuse it to generate high profits, the same is bound to happen as what happened in the eighties: some people gain millions, but millions lose their investments.

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