Will European corporate bond issuance continue to thrive?
16 July 2009
The first six months of 2009 has seen an unprecedented level of corporate bond issuance. Between January and June 2009, European investment grade non-financial companies issued €184bn of €-denominated bonds, nearly 1.5 times the amount issued during the whole of 2008, and higher than the annual issuance in any year for the past 8 years (see graph below). Growth in issuance has been seen across all sectors, although it has been higher-rated entities (single A and above) and more defensive sectors that have been especially active. The question now arises whether this deluge of issuance will continue. Indeed, the market seems divided over whether the financial crisis has created a corporate issuance bubble that is about to burst, or whether more structural changes are taking place that will see European corporate bond issuance continue to thrive.
Chart: European non-financial €-denominated bond issuance
Source: Dealogic. Data is for investment grade companies only.
We stand firmly in the latter camp. Indeed, we believe that the stage has been set for a fundamental shift in the way companies finance themselves. The key driver of this is a rationing of bank lending, a situation that is unlikely to change for the foreseeable future. Unlike their US peers, European companies have historically been heavily reliant on the bank loan market. According to the ECB, bank loans accounted for an average of 56% of the financing needs of the 16-nation euro area’s non-financial corporates from 2000 to 2008, compared with just 14% in the US. But as banks continue to focus on repairing (and in some cases shrinking) their balance sheets in light of escalating loan losses, loan activity looks set to remain subdued. Further, increasing regulatory pressure could demand banks set aside even higher capital buffers in the future, limiting the potential for bank lending to reach levels witnessed in recent years. In addition, there appears no imminent revival in the securitisation market, which also played a key role in the era of cheap credit. And even when lending activity does eventually pick up, banks will be much more selective about who they lend to. Loans are likely to be shorter dated than pre-crisis and include more onerous covenants linked to financial performance and credit quality. Ultimately the lack of supply will also drive up bank loan prices.
With equity capital-raising expensive and dilutive to shareholders, and other methods to boost cash flow, including working capital refinements and lower capex, providing only shorter-term liquidity, the bond markets appear the most attractive alternative. And confidence in the credit markets is improving all the time. Though equity markets have faltered over recent weeks in light of mixed economic data, corporate credit spreads have continued their overall tightening trend, albeit at a slower rate than earlier in the year. The prospect of rising default rates has failed to deter yield-hungry investors from flooding the market with cash. Even lower-rated new corporate paper has been many times oversubscribed in recent months. We have also seen evidence of companies tailoring their bond issues to take advantage of demand in different parts of the credit markets. A number of corporates have structured their bond deals this year into smaller denomination to take advantage of an increase in retail investor activity.
The longer-term need for financing will be driven by both increased capex requirements (as economic growth returns) and a return to M&A activity. Many non-financial sectors are ripe for consolidation and with equity valuations low, another wave of M&A activity looks likely to hit sooner rather than later. Bond financing is likely to play an increasing role in funding both these activities. Swiss pharmaceutical Roche has been a primary example of this. It recently accessed the bond market to raise around $39bn to help it complete its $47bn takeover of US rival Genentech. Roche specifically commented that it was impossible for it to raise a significant amount through bank loans.
Admittedly the rush by corporates to hoard liquidity in anticipation of difficult trading conditions ahead is likely to ease as economic conditions show signs of improving, while the summer months will see primary market activity naturally slow. But over the longer term, we believe that European companies will increasingly use bond financing in their funding models, especially when raising longer-term funds. This would herald sustained higher levels of corporate issuance over the coming years.
Nicola Sanders, Credit Research
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