corporate bonds

Investors may regret taking a bite of Verizon's big bond deal

September 18, 2013: 5:00 AM ET

It's a classic Wall Street game: Build a feeding frenzy to drive up a deal. And like most hype, it'll leave investors little to chew on in the end.
verizon-wireless

FORTUNE -- When you've gone hungry for a long time, even mediocre takeout dishes can look like something scrumptious from a five-star restaurant. That explains the stampede by buyers to gobble up Verizon's record $49 billion debt offering.

For years investors, especially big players like insurance companies and pension funds, have been starving for yield because of the Federal Reserve's ultra-low interest rate program. So despite being rated near the bottom rung of investment grade, the giant Verizon (VZ) offering begat a feeding frenzy, luring far more offers than there were bonds available.

Some retail investors, unable to buy into the Verizon offering directly, ended up paying a hefty premium in the open market. For example, a yield-starved friend of mine, a retail investor who had stopped by to use my home fax machine the day the issue was floated, ran out and scarfed up some 30-year, 6.55% Verizon bonds. His price: 106.261% of face value. That premium is almost equal to his first year of interest income. But he's happy because his current yield -- the annual interest he gets, divided by what he paid -- is 6.11% a year.

The size of this offer was truly stunning. Just the 30-year piece alone ($15 billion of the $49 billion issued) was almost as large as the previous biggest corporate bond deal in history: this spring's $17 billion Apple offering.

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The Verizon offering, like Apple's (AAPL) bonds and Facebook's $16 billion initial public stock offering last year, was a classic Wall Street game, played with the issuer's cooperation, to build up enthusiasm. In all three cases, there were announcements and leaks about buyer enthusiasm. The size of the deal kept growing and growing, making buyers increasingly eager to sign up, which in turn helped the issue grow and grow. Some would consider this a virtuous cycle. I think of it as putting chum in the water to attract fish.

Wall Street, of course, loves big deals. The bigger the deal, the bigger the fee -- in the case of Verizon's bonds, $265 million, which will be split by J.P. Morgan Chase (JPM), Morgan Stanley (MS), Barclays (BCS), and other players. In addition, successfully selling a big deal begets other big deals.

At Apple and Facebook (FB), the issues didn't look all that wonderful after the initial excitement wore off. And I suspect the same will be true of Verizon bonds.

Verizon needed the money to pay for its $130 billion purchase of the 45% of Verizon Wireless owned by Vodafone. This issue, combined with giving Vodafone holders $60 billion of newly issued Verizon shares, and various other transactions, gets the whole deal paid for before long-term interest rates rise even more than they have since May, when Fed chairman Ben Bernanke began his "tapering" talk.

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This offering is a very shrewd piece of work by Verizon, and whoever may have advised it to pay more than the prevailing rate of interest in order to beget a buying frenzy. The company has now locked in a ton of money at what I think will be seen to be a bargain rate.

The biggest market for the long-term paper Verizon peddled is insurance companies and pension funds that have very long-term and predictable liabilities, such as future life insurance claims or annuity payments or pensions. They've been really starving for yield. And now they're thrilled to have gotten some.

But there's a sobering side to this deal, if you look at history. Years ago, when Verizon was a regional player called Bell Atlantic, it had several chances to buy, for considerably less than $130 billion, the assets that Vodafone ultimately swapped for its 45% Verizon Wireless stake. The fact that Verizon now feels compelled to pay $130 billion for these assets shows how quickly the telecom world is changing.

Verizon's landline phone business is dying faster than projected, and technological change means all sorts of challenges to Verizon's other businesses, such as broadband. Obsolescence and new technology risks can't be measured accurately by bond raters -- or anyone, for that sake.

Apple's bonds, once so eagerly sought, now sell way below face value. Facebook stock had a steep drop before regaining its $38 initial price. (It's $44 as I write this.) I expect that, over time, Verizon's new bonds will be selling below face value, rather than at their current lofty levels. But Wall Street, you can be sure, won't give back its fees.

Additional reporting by Marty Jones

This story is from the October 07, 2013 issue of Fortune.

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