An uncertain and volatile market environment throughout 2018 has created an unpredictable backdrop for corporates looking to gain access to international bond market. Keith Mullin, founder and director, KM Capital Markets Ltd, recently sat down with Demetrio Salorio, Global Head of Debt Capital Markets at Societe Generale CIB, to discuss the market status quo and his thoughts about Debt Capital Markets (DCM).
- The impact of rising interest rates and market volatility is discussed in our latest webinar examining the challenges and trends in debt capital markets.
- Investors are pickier and able to exert much more power on spreads and maturity, meaning borrowers must think more carefully about their strategies.
- Corporates who may have delayed issuing bonds in the hope of achieving better spreads need to understand that debt capital markets have changed.
The session was a fascinating run-through of all the factors impacting on sentiment, supply and spreads. The main macro theme affecting debt capital markets this year has, of course, been rising interest rates. This is forcing spreads wider as portfolios are reconfigured on the investor side. As rates go up, markets are more volatile, almost by definition, as borrowers and investors adapt to a new norm.
This is forcing changes to the structure of demand in the bond market. “When rates go down, asset managers and short-term players represent the bulk of demand. But when rates go up, we don’t see these players to the same extent; they are replaced by long-term investors like insurance companies and pension funds. This change of investor profile also creates volatility and imposes a different way of doing transactions,” Salorio said.
In terms of capital flows, whenever rates go up in the United States, the dollar increases in value and this creates a shift in the direction of financial flows from emerging markets to the U.S. dollar-denominated asset. This exacerbates the valuation of emerging market currencies and creates additional volatility.
A fourth component of market volatility is adverse geopolitics.
Of course, when rates go up, you expect borrower behavior to change: as volatility increases, borrowers need to adopt different strategies to access markets. It’s no longer a case of issuing when they want to; it’s issuing when they can. From that perspective, the strategies that investment banks provide to borrowers in terms of when and how to tap the market are increasingly important.
The main consequence of enhanced market volatility is that not every day is a good day to issue bonds. You need a quiet day; you need investors to be able to assess where the benchmarks are. When you have a lot of volatility, the number of days that are open for business diminishes, and this has an impact on new-issue volumes.
Is the balance of power shifting from borrowers to investors?
“It’s clear that when market volatility increases and rates go up, the balance of power goes towards the investor. The last two years were like the golden age of debt capital markets from a borrower’s standpoint. You could sell whatever you wanted at any time and dictate the spread. There was much more appetite for assets than assets on offer,” Salorio said. “Right now, things are changing. Investors are pickier and are exerting much more power in increasing spreads and dictating maturity and other features. It doesn’t mean that borrowers cannot issue. It means that they need to think more carefully about what strategies they need to put in place, like what initial price talk they communicate to the market, how they choose when to issue. These elements are far more important than before,” he added.
A clear manifestation of the shift in pricing power is the average new-issue premium in the European market, which has gone from around six basis points in 2017 to close to 11 basis points in 2018.
That is the average — it has been much more pronounced for lower-rated credits. There has also been a reduction in the duration of bond transactions in Europe: with rates going up, investors, even insurance companies, are more defensive and dictate more than before the maturity at which borrowers can issue.
Overall global #DebtCapitalMarkets activity has totaled US$5.3 trillion during the first nine months of 2018, a 7% decrease compared to the first nine months of 2017.
What’s behind the decline in U.S. issuance?
But other factors have been at play in affecting new-issue volumes in 2018. Issuance from the U.S. has gone down a lot, partly because of the new tax law. Big U.S. media companies that had a lot of cash outside the U.S. have been repatriating it, leading to a 72 percent decline in TMT bond supply, for example.
And if you look at the volume of supply from emerging markets (mostly denominated in dollars), if February this year was the highest month ever, July was the lowest month ever.
A third factor is M&A. M&A in Europe, in euros for instance, has gone up this year: 19 percent of all euro corporate supply is related to M&A financing. In the U.S., it has been the reverse.
As we approach what seems to be the end of the cycle in the U.S., M&A is decreasing. An important factor in terms of the reaction of volumes is coming from lower M&A activity.
Another factor is liability management. When rates go down, corporates refinance with new issues at lower coupons. When rates go up, that activity obviously stops. We have seen a big decrease in liability management transactions in Europe. That’s adding into the lower volumes.
On the high-yield side, the effect that we are seeing both in the U.S. and Europe is that there are alternative financing products that offer better terms and conditions than high-yield bonds: the Term Loan B.
Over the last few years, banks have been forced to increase capital and are now in a much healthier state. They have more capital to deploy and are willing to buy loans from non-investment-grade corporations that offer very good spreads and a very good return on their capital.
Investors are also willing to enter the loan business. Some of the reduction of volume that we’ve had in the U.S., and to some extent in Europe, is not because borrowers need less money, it’s because there are instruments like loans that are very competitive for borrowers.
“In summary, the reduction of volumes is not due to lower economic growth, lower capex or lower need; it’s driven by technical factors,” Salorio said.
How would you define the mindset of European corporates?
“European corporates are a bit late in coming to terms with the fact the power has drifted towards investors. That’s one of the reasons we saw a reduction in volumes in May to July, which are typically quite active,” Salorio said.
“We knew that many corporations needed to issue bonds and we were recommending that they do so, but they refrained because they didn’t like the spreads and were hoping that market conditions would be better later on. But market conditions are not better later on. Now we’re seeing – I wouldn’t say a rush – but we are seeing the high-grade market getting active again. August was one of the most active on record in terms of supply.”
The market saw 20 billion euros of supply in August, which is slightly more than double the average that we saw in previous months, because corporate borrowers wanted to issue ahead of potential volatility; September started quite active as well.
“Corporates now understand that the world has changed for good; rates are higher and as such, they need to start issuing,” Salorio said.
“One characteristic of the European market which is not great is that if supply continues to be strong, at some point the market will need some respite to digest everything,” Salorio cautioned. “But the pipeline looks quite healthy; I’m expecting that the next few weeks will continue to be very active.”
The outlook for Triple B rated corporates
There’s been a lot of chatter this year and some concern expressed about Triple B rated corporates in the context of rising interest rates. The thesis put forward is the Triple B universe is potentially exposed to downgrade risk, which could pull them into sub investment-grade territory.
Salorio is sanguine: “Triple B borrowers will only be downgraded if and when the economic cycle turns. That is not going to happen any time soon. When we look at the economic data in Europe in terms of growth and what the forward projections are, they’re extremely robust. We are not predicting a general downgrading of corporate ratings in Europe. It’s true that if many corporates in Europe were to be downgraded to non-investment-grade, the market would need to adjust. But again, we don’t see that happening any time soon.”
Is the market environment conducive to debut and unrated borrowers?
Salorio believes the market is and will continue to be extremely receptive. The problem with unrated borrowers will be if economic prospects start to weaken. The fact that the market is more volatile and the fact that interest rates are going up in itself is not making investors be more cautious in terms of credit.
“Investors will be more demanding in terms of coupons. But they continue to have a lot of money to invest and non-rated corporations — which are sometimes listed so you know a lot about their financials or are well known brands and are very successful corporations — will continue to attract a lot of demand,” Salorio said.
Are you positive for the remainder of the year?
“I’m not wholly optimistic for the rest of the year. I am neutral.
There are plenty of mines in the field. The Italian budget situation, the emerging market complex, Russian sanctions, trade wars etc. We don’t know what the short-term impact of all that will be but in terms of market sentiment, there are plenty of things on the horizon,” he said.
“The only thing that I can say is that there’s a lot of money to be invested and borrowers still need to raise financing. My experience tells me that whatever happens in the world, if people want to issue bonds and other people want to buy them, that will happen.”
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