Mounting Europe’s corporate bond refinancing wall
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Mounting Europe’s corporate bond refinancing wall

Credit markets are poised on a knife edge, with a huge pool of European corporate debt needing to be refinanced in the coming years in an era of scarce liquidity, fear some market players. But others believe market innovation will enable borrowers to scale the refinancing cliff.

As any European debt capital markets banker will tell you, European companies have traditionally relied on bank loans to cater for the majority of their financing needs, in stark contrast to the dynamism and liquidity offered by US bond markets. With structural deleveraging by European banks likely to continue in the years ahead – driven by new regulation and shifts in business models – fears are growing that European corporate borrowers will be competing for scarce capital in the years ahead, further imperiling the economic recovery.

David Rubenstein, CEO and chief investment officer of BlueMountain Capital

European companies must refinance about $8.6 trillion of maturing debt by 2016, according to Standard & Poor’s, and might require an additional $1.9 trillion to $2.3 trillion for growth. At the same time, banks have made substantial efforts to reduce leverage, with global asset to equity ratios falling to 17 in 2011, from 21 in 2007, according to a McKinsey & Company report published in October 2012. Meanwhile, banks’ loan to deposit ratios fell from 97% to 85% over the same period. The deleveraging cycle is not over. European banks, which account for about 80% of lending to companies and households, are seeking to cut more than €1.6 trillion in assets in the next three to four years, according to a European Central Bank (ECB) report published in June, in a bid to meet regulator demands for relatively higher levels of capital.

European banks’ business models are in crisis, with many unable to generate a return on equity above the cost of capital, leading many institutions to wind down their fixed-income exposures and reduce risk-weighted assets.

European banks cut holdings of securities other than shares to €1.35 trillion in November 2012, according to the ECB, compared with €1.54 trillion at the end of 2010, a decline of 12%.

As banks struggle to recover the verve of the pre-crisis years, corporates are also pulling in their horns, with the level of outstanding private sector loans and corporate bonds relative to GDP declining from a peak of around 150% in 2009 to around 145% in 2010, according to Thomson Reuters. When confronted with these grim statistics, it’s not hard to bearish. However, some analysts reckon markets will adjust to the prospect of supply, while new sources of demand – and deal structures – will fill any funding void.

The supply risk might be overstated too, according to David Watts, a European credit strategist at CreditSights. “There is certainly less lending by banks to corporates but it’s worth remembering that for the most part corporates are looking to borrow less as well,” he said.

In that light, last year presents something of an anomaly, with European corporates going on a borrowing binge, particularly in the bond markets, which saw record issuance.

Some $590 billion of European corporate bonds were sold in syndicated deals in 2012, according to data provider Dealogic, while publically marketed investment grade and leveraged loan issuance totalled $525 billion, the lowest level since 2009 and the second lowest since 2003.

Investment funds increased their holdings of non-financial corporate securities other than shares to €202 billion in the third quarter of 2012, the ECB said, compared with €168 billion in the fourth quarter of last year.

“The banks have been disintermediating but what we have seen is plenty of liquidity coming from investors, which means that companies have had few problems raising funding," said Duncan Sankey, head of credit research at Cheyne Capital in London. "In Europe that is unlikely to change in the near term."

Institutional flows into corporate bond funds have proceeded at a record pace in recent months, peaking in November when there was some $2.25 billion of cumulative flows into western Europe high-yield bond funds, according to EPFR Global, compared with around $600 million at the end of 2010.

Hedge funds have also been jumping on the bandwagon, with managers such Cheyne Capital, Chenavari and Avoca Capital attracting billion of euros to corporate credit strategies or direct lending vehicles.

“Private hedge fund capital can and will be a source for European corporate borrowers going forward ... either through direct lending from the hedge funds themselves or by the hedge funds investing capital in non-bank specialty finance companies that will lend then lend to corporates,” said David Rubenstein, CEO and chief investment officer of BlueMountain Capital. In recent weeks, investor appetite for European corporate debt has remained undiminished, evidenced by the sale of 10-year bonds by Spain’s Telefónica and Gas Naturel, which were both more than six times oversubscribed despite continuing concern over Spain’s economy.

With interest rates at historical lows, it makes sense for investors to seek the additional yield found in corporate bonds, compared with assets such as government securities. Default rates also remain low. However, the favourable environment is unlikely to last forever, and at that point the flow of credit to European corporates might slow.

"What we are seeing now is yields coming down, capital structure pricing compression and many unrated leveraged loans trying to go to market," said Chetan Modi, managing director, leveraged finance, at Moody’s. "However once that dynamic changes and we see policy rates start to rise and default rates ticking up, there will be increased concern among investors. For the most solid companies, borrowing costs will go up, but for some at the bottom of the credit spectrum prices will be marked much higher to a level they cannot afford."

Market players have lived for years with bearish pronouncements over the refinancing risks in the European corporate bond market.

When central banks finally remove the liquidity punch bowl, bankers and issuers are hoping that markets will innovate, by generating new sources of demand and deal structures. 

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