In the face of a bond and equity wobbles, the loan market has stayed steady. This reflects lenders’ focus on relationship rather than yield only. But with pricing stabilising after more than six months of falls, bankers warn that loans cannot remain invulnerable to longer term capital market ructions. David Cox reports.
Europe’s sovereign debt crisis may have closed the bond and equity markets to many of the continent’s borrowers, but the loan market remains – for the moment – in good health. But this willingness to lend has not translated into a busy market. Demand for new credit has been weak, with the first half of 2010 on course to be the quietest since 2002 according to data from Thomson Financial.
Disappointing volumes should not detract from what has been a remarkable turnaround for the loan market. During the banking crisis that followed the collapse of Lehman Brothers in 2008, the loan market, which was reputedly the most stable and reliable of all markets, closed. That led some to question the market’s very viability. Those fears turned out to be overblown: after a year of recovery of 2009 the market is now fully functional.
“The loan market is in fundamentally better health than it has been for some time. Underwriting is back on the agenda and retail appetite is at its strongest for the last 18 to 24 months,” said Roland Boehm, global head of debt capital markets loans at Commerzbank.
Falling back down to earth
As the market has recovered, so the elevated pricing that banks demanded throughout last year has also fallen. And with demand outstripping supply, the ferocity of the year’s pricing fall has surprised many.
As the market convalesced after the collapse of Lehman’s, margins for A– credits such as Scottish and Southern stabilised at about 150bp in the first part of 2009. Since then margins have halved: Linde, a similarly rated German industrial gasses group, signed a €2.25bn refinancing with a 65bp margin in May. Linde’s facility effectively repriced its rating category, which had been nailed at 75bp since the start of the year following successful benchmark refinancings from Philips and Henkel.
Pricing has fallen so rapidly because, in the face of continuing corporate deleveraging, where cancellations outweigh new funding requests, liquidity for new loans is deep. According to bankers syndication declines - let alone failures - are now rare. Enel, for example, increased its €8bn loan to €10m after raising €13bn in senior syndication alone.
“There’s not been a lot of activity this year and banks are generally underlent,” said Sean Malone, head of corporate loan origination at RBS. “This in part explains why lenders are reacting so positively to funding requests at the moment. If activity did step up markedly, banks could once again become over stretched.”
But even if oversubcriptions remain commonplace, difficulties in the Eurozone and wider capital market disruption mean most bankers expect pricing to stabilise at current levels in the near term. Linde’s loan is therefore likely to remain the benchmark for A- rated borrowers. Aa3 rated GDF Suez, which closed in June, serves as the benchmark for stronger credits.
At the time of Linde’s loan signing, bankers noted that returns on loans had reached risk adjusted teturn on capital (Raroc) neutral levels for most European lenders. There were therefore hopes that pricing would stabilise at these levels, even if hopes were tempered by depressed market volumes.
The European sovereign debt crisis has had only a limited impact on the loan market, which remains open for business. However, there have been increasing fears in recent months that lenders’ rising costs of funds will impact their appetite to lend. Although an imperfect guide, rising CDS levels offer insight into rapidly rising financial spreads: CDS for Barclays, one of Europe’s largest lenders, was trading in early June at around 180bp, well up from yearly lows of just under 70bp. BNP Paribas, meanwhile, was trading at about 145bp up from its 12-month low of just over 45bp.
The spike in lenders cost of funds and higher spreads across the bond market as a whole mean the loan market is once again priced well inside of the traded capital markets. Although, the bank product has traditionally priced inside bonds, the capital market has generally been the cheaper option for corporates over the past 18-months. This abundance of competitively priced liquidity has resulted in a flood of bond issuance that has allowed European corporates to balance their debt funding needs between the two markets and retire vast swathes of bank debt.
Slower to react
Unlike the bond market, where pricing can adjust either way rapidly, loan pricing tends to move in a steady evolutionary pattern. “While the bond market is primarily looking at value, the loan market focuses on relationship. This different perspective means that there is a disconnect between how each market assesses risk,” said RBS’s Malone.
Given the ructions in the wider economy and capital markets, few believe the loan market can continue unaffected indefinitely. Bankers admit while their focus on corporate relationships mean they can absorb their higher cost of funds in the short term, in the end it will inevitably translate into higher pricing for clients.
So far there is only limited evidence that higher cost of funds is feeding through into banks’ Raroc models, though there is increasing talk that banks from the EU’s troubled periphery are retrenching. While higher hurdles from peripheral lenders will only have minimal impact on the pan-European market, increased Raroc hurdles from core-Europe banks would certainly result in pricing taking a step up, rather than merely consolidating at current levels.
In an intensely competitive market few expect any significant shift in pricing soon. “Pricing is going to stay in a narrow band in the near term with direction returning once there is clarity on banks refinancing prospects,” said Commerzbank Boehm.
Even if lenders wait for clear movement on their funding costs before altering yield requirements, a weakening bond market still poses problems for the bank product: in the post crisis European debt market, new money loans typically rely on the bond market for a partial take out.
Typical here is SAP, the German software maker. It has put in place a €2.75bn bridge facility to support its takeover of Sybase. While the facility offers lenders exposure to a new money drawn credit from a brand-name European corporate, the pricing looks to be well through what SAP would have to pay in the bond market. Margins kick off at 65bp and have step ups to encourage a swift takeout into the bond market. However, these step ups still only equate to an average margin of 76.87bp – well below where SAP would have to price to sell a bond. These margins, however, looked on market just in April when the group sold a €1bn dual tranche bond.
In offering a facility that is priced through the traded capital market, the facility bucks the trend of debt-backed acquisition financing seen in Europe and the US over the past year. During this time the market has relied on the bond market to de-risk the major part of loan underwritings, with a syndication limited to any rump not taken out through the longer term capital market.
To ensure they would not be arbitraged as cheap sources of funding, lenders have deliberately priced M&A bridges at a premium. But the speed at which the bond market has repriced demonstrates that banks still need to show some caution when structuring bridges.
“Just at the moment the loan market is in a pretty good health,” said RBS’s Malone. “Banks have liquidity and are keen to do business but when underwriting new loans they need protection and clarity on how quickly it is possible to get to market.”
This is not to say that difficult bond markets mean big ticket new money deals are not possible. Bankers said the maturity of the European debt capital markets mean both bonds and loans work in tandem, not as competitive silos. In a volatile market, borrowers will have to get used to taking advantage of credit market windows when they open, they said.
“The emphasis has been on refinancing and locking in long term liquidity so far this year,” said Commerzbank’s boehm, “As borrowers look to take advantage of M&A opportunities we will see more drawn debt. As banks we accept that bond windows open and close but when we look to underwrite the credit story.”