Filling the gaps
The European debt capital market has been growing to fill vacuums as markets around it shrink. With European bond issuance overtaking loan volume for the first time this year, has the loan market outlived its usefulness?
To view the digital version of this report, please click here.
In the first half of 2012, European corporates borrowed more from the bond market than the loan market, the first time this has ever happened. Since the introduction of the euro the split has been about 30/70 for bonds versus loans. In 2012 the split was 50.8%–49.2% in favour of bonds, of a US$679.5bn debt pile, according to Thomson Reuters.
The plight of Europe’s sovereigns is making investors less keen to put their money into the traditional safe-haven investments. Corporates have been in a sweet spot for at least six months and are now seen as a better bet; better even than the countries in which they are domiciled in some cases.
Corporates also offer more pick-up than sovereigns. With yields on 10-year Treasuries at sub 1.5%, central banks in particular are looking to diversify away from Treasuries and other sovereign holdings.
Equities have been unpredictable and covered bond issuance cannot keep pace with demand, leaving corporate bonds as the destination of choice. Companies such as Unilever have come to be seen almost as surrogate Treasuries, with three-year paper coming at Euribor plus 50bp–60bp, once swapped into euros.
On the other side, DCM is picking up more business that traditionally went to the loan market. The headline grabbing cause is the reluctance of commercial banks to lend, both for fear of losses and in order to comply with regulations that demand they grow their capital bases or shrink their balance sheets.
This forced corporates to look for capital in new places, said Marcus Hiseman, head of European corporate fixed-income capital markets at Morgan Stanley. Institutions like UBS and BNP Paribas have been candid about the need to deleverage, which has naturally led to a drop in lending business.
Banks have become disintermediated, as the bigger and more recognisable corporates have discovered they can go straight to the capital markets themselves, rather than borrowing from the banks, which had in turn raised the money in the capital markets.
The corporate bond market had become incredibly busy, with “unprecedented liquidity”, said Hiseman. Always an important market for many investors, it has recently seen increased participation from all sorts of investors, including pension funds, insurance companies, central banks and other corporates. And corporate DCM activity is likely to be buoyant for as long as central banks keep supporting the global economy with injections of liquidity, he said.
“The changing regulatory landscape means it is less viable for banks to lend for long durations in particular. Banks rarely borrow in durations of more than 10 years themselves, so long-term loans also cause problems from an asset liability matching perspective,” said Priya Nair, managing director of corporate DCM at RBC Capital Markets.
DCM has been the natural substitute. Many DCM investors, such as pension funds and insurance companies, actively seek investments with longer durations, because unlike banks, it does suit their ALM profiles.
However, “the real driver for the trend is less about the banks than issuers themselves”, said Mark Lewellen, head of corporate DCM at Barclays.
“The decline in loan volumes is partly a hangover from a heightened level of activity in 2010, when corporates took advantage of favourable conditions to refinance their core facilities. At that time, certain Continental European banks were still pursuing volume-driven business strategies and expanding their balance sheets.
“The loan market is far from redundant. Corporates are just using them in a different way, using DCM for drawn debt and loans for liquidity”
“In the absence of significant M&A volumes, many companies simply have no need for incremental bank market funding at the moment, and are in very healthy positions financially,” added Lewellen. “We will probably see a cyclical uptick in refinancings in 18 months’ to two years’ time.”
Corporates are also changing the way they structure their debt, taking loan facilities but keeping them undrawn to maximise flexibility, while terming out in the capital markets.
“The loan market is far from redundant,” Lewellen said. “Corporates are just using them in a different way, using DCM for drawn debt and loans for liquidity.” Corporates would always value having undrawn loans available to ensure they did not run out of money, and to enable them to prepare for the unexpected, he added.
From a price perspective, loan margins had been gradually creeping up in line with bank funding costs, while bond spreads had been edging down, to the point that the loan market and DCM for five-year money were now closely aligned, with DCM sometimes marginally better for some borrowers, said Lewellen.
The decline of the loan market has had little impact on large well rated corporates. Banks were arguably not making the best use of their capital before, using loans to win ancillary business. It also brings Europe closer to the US, which has always had a greater share of lending done via capital markets.
Finding its niche
That is not to say the loan market does not have its place. It will remain the funding route of choice for smaller SMEs that do not have the recognition or the track record to convince investors to buy their bonds. Banks retain legions of analysts and resources that can be well deployed researching smaller credits to deduce a fair price for money that investors would not be well positioned to accomplish. The same is true for companies with complex business models that cannot be easily communicated to, or understood by, investors.
“The big commercial banks should now focus on SMEs, deploying their large teams of credit analysts where the economy most needs it, and where the capital markets are least equipped to compete,” said one DCM banker.
The loan market will also continue to be an important source of bridge funding for M&A deals, where an acquiring company needs to come up with large sums relatively quickly. “Banks will continue to provide these kinds of facilities as long as they see the corporate has the ability to term out in the capital markets,” said Hiseman.
“Lending to corporates is the essence of what banks do, and they will continue to provide such loans,” said Lewellen. “Some banks might step away from certain relationships for many different reasons, but I can’t think of a recent investment-grade corporate loan in Europe that has failed due to lack of bank participation.”
Yet the loan market is no longer the first port of call for some of the biggest and most recognisable businesses. If they have demonstrably stable cashflows which investors can easily understand and predict, the lure of DCM will be strong. International businesses, with operations in dynamic economies, are also likely to fare better in the capital markets than businesses with a pure domestic focus, given the concerns surrounding the European economy.
The eventual result of the trend was likely to be a European debt market that looked more like its US counterpart: corporate borrowing is split 60/40 between DCM and loans in the US, and had traditionally been roughly the opposite in Europe, said Nair. “What we are seeing now is the rebalancing of Europe along US lines.”