Carrier bonding: Telecom sector awash in debt issuances as providers finance spending sprees

Indian summer in the telecom corporate bond market is here. As the financial markets head into autumn, the offering calendar for carriers' debt issuances is heating up. European and U.S. service providers plan to issue billions of dollars in new bonds in the September-to-December time frame. But can the markets absorb all this new debt?

European telcos such as BT, Telefonica, KPN NV and, possibly, France Telecom hope to borrow up to $27 billion to finance their recent spending sprees on third generation mobile phone licenses in Germany, as well as to complete acquisitions and pay down short-term debt, according to a report by Merrill Lynch. The companies are going to the dollar market, not the European market, to get the money and turning to debt issuances to avoid the volatility of the equities markets.

U.S. carriers, including SBC Communications, plan to issue about $14 billion in bonds to refinance short-term debt and finance past acquisitions.

That $41 billion total of investment-grade telecom debt issues is 35% to 50% greater than the usual corporate market supply during the end-of-year four-month period, according to Merrill Lynch.

And as they announce new issues or prepare to go on road shows to market their bonds to institutions, the creditworthiness of many European telcos is coming under the scrutiny of bond rating firms such as Standard & Poor's and Moody's Investors Service.

After the Universal Mobile Telecommunications System auction in Germany, S&P's completed a major review of the European telecom sector and placed on watch or downgraded the credit ratings of several carriers.

For example, BT was expected to raise up to $10 billion in early September but postponed its dollar bond offering after its credit rating came into question. S&P's downgraded BT's rating four notches on Aug. 24, and the company is awaiting a review of its rating by Moody's Investors Service.

Another German auction winner, KPN NV, was placed on credit watch with negative implications by S&P's, meaning its rating could soon be lowered. KPN NV plans to issue a large dollar bond in late September to finance 3G wireless licenses.

Among the concerns about European operators' debt cited by S&P's analysts: the high level of license fees and network capital expenditure concentrated among relatively few operators; a cautious view of the future profitability and cash-generating ability of UMTS networks; ongoing competition and regulatory pressures that are adversely affecting the earnings streams of most incumbent opera-tors; and a "progressive deterioration" of balance sheet strength as operators pursue domestic and international growth strategies, often with negative or little near-term cash flow and earnings growth.

"They're going to take on a lot of debt to buy the [UMTS] licenses and build them out, and that means increased financial risk," said Richard Siderman, corporate ratings analyst at S&P's."The magnitude of the revenues and the cash flows is what we're cautious of."

The wave of supply combined with lowered credit ratings puts pressure on spreads - the yield difference between corporate bonds and U.S. Treasuries of comparable maturity. That raises the financing costs for the issuer because it must compensate investors for the higher degree of risk by paying higher interest rates. It also causes the prices of existing bonds in the secondary market to drop.

"Supply expectations have already distorted relative value relationships within the corporate market," according to a recent report by Merrill Lynch derivatives strategist Mary Rooney and corporate bond strategist Stephen Antczak. "Heavy telecom issuance equates to higher overall corporate spread volatility."

Despite the doom and gloom, carriers have had few problems finding buyers so far. Squeezing in ahead of the coming tidal wave of corporate bond offerings was Qwest Communications, which sold $3 billion worth of bonds in August. The rumored oversupply was one of the reasons Qwest timed its offering for late summer, a traditionally slow time of year for new issues.

"Our thought was the market conditions were good - the Treasury market had improved substantially as had the corporate spread market," said Scott Berman, executive director of treasury services for Qwest. "We wanted to price our deal prior to that supply entering the markets." Qwest plans to use the money it raised to finance existing commercial paper debt, Berman said.

Likewise, to finance the later-stage construction of its 33,000-mile fiber optic network, Williams Communications sold $1 billion of "junk" or high-yield bonds on Aug. 3. The offering drew demand three to four times the initial size. Although Williams had to offer a higher yield on its bonds than it did in a September 1999 offering, the increase was less than the rise in interest rates since last year, said Scott Schubert, chief financial officer of Williams. "We paid out about 100 basis points more for this bond offering, but that was very favorable because interest rates in general have moved about 175 to 200 basis points in the past 12 months."

Whether the bonds of European telcos will draw the same demand as big U.S. names - especially in a time of high supply - remains to be seen.