Debt capital markets: a growing reliance
The rise in bond funding by European corporates
In our magazine we have published several articles regarding the deleveraging of the banks’ balance sheets and the corporate shift to an American funding model. As of 2008 we see that large European corporates have decreased the level of bank lending in their total funding landscape and see an increase in alternative funding such as debt capital markets and private placements.
This development is in line with what we call the American funding model, which refers to the heavy reliance on debt capital markets. Furthermore, Basel III and Solvency II regulation provide banks and insurers with stringent capital and liquidity requirements which limit the leverage potential and therefore the available liquidity.
Mid July this year Fitch presented a report on the ‘corporate funding disintermediation’, which provides a solid investigation on the altering funding landscape of European corporates1.
Fitch examined funding behaviour for 201 European corporates across the European Continent over the past five years.
According to Fitch, corporates have invested much of the last five years decreasing the dependence on bank loans and increasing reliance on alternatives, like debt capital markets and private placements. According to Fitch however, the usage of the debt capital markets has peaked for the larger investment grade rated corporates, whereas an enormous opportunity for smaller and lower rates corporates to tab the debt capital markets for non-bank funding is still unused.
Overall, bond funding by European corporates as part of total debt has risen from 65% in 2007 to 73% by the end of Q1 2012. Excluding emerging economies, where banks tend to have more liquidity at hand and bank lending is seen as a critical lifeline by corporates, the percentage is as high as 79%.
In the United States approximately 70% of all corporate debt is provided by (debt) capital markets. For American large caps this percentage is higher; approximately 80-85%. It is still expected that Europe will move more and more towards this American funding model, however the shift has slowed down. Although the nominal value of bond issues still increases, the percentage of bond funding as part of total corporate debt is declining. This is clearly visible in figure 2.
For large British corporates and investment grade rated European corporates there even has been no increase at all in bond issues, relative to loans. However, emerging economies as well as Spain and Italy show a significant increase in debt that is raised via debt capital markets. In the first half of the year, corporate bond markets outstripped loans for the first time in nominal value, with public markets accounting for 52% of total new funding.
Although the investment grade corporates have steadily increased funding from debt capital markets over the last five years, the recent increase is mainly explained by the explosive growth of bond funding for below investment grade rates corporates.
Below Investment Grade
The sense that the shift in funding from bank loans towards debt capital markets is slowing down, and perhaps reached a new equilibrium, is even stronger when you realize that investment grade corporate bond percentages actually ticked down in 2011. As shown in figure 3: growth in bond issuance is coming from below investment grade firms.
Fitch sees a stronger increase in bond issues for lower rated companies. For BB rated corporates the percentage of bond financing as part of total debt has increased from 33% in 2007 to 52% in 2011. For B rated companies this increase was even stronger, with 3% in 2007 to 66% in 2011.
The transition for below investment grade and SME companies to start issuing bonds is moving slowly, as bank lines may be in place for 5 to 7 years. European banks that are scaling down their balance sheets due to stringent capital and liquidity requirements may even encourage corporates to look for alternative funding. There still is a significant potential in extending the European bond market for lower rated companies.
However, there needs to be a shift in both the perspective of investors and the relationship a corporate has with the bank.
Currently European corporates tend to have a relationship based model instead of a market based model. Investors need to familiarize themselves with a new breed of products, like the initiatives to create a market for retail bonds in The Netherlands.
At the end of July, two very successful deals came from the retail bond market in the UK. Two Portuguese companies tried tapping into the UK retail bond market. Since the bailout in May 2011, it has been impossible to issue public bonds in Portugal, even for the larger investment grade corporates. However, the UK retail bond market has proven to be a reliable alternative funding source. For example the bonds of ICAP (Portuguese IT company) were successfully issued and listed on the London Stock Exchange for Retail Bonds with a GBP 1,000 minimum investment size and GBP100 denomination.
Our view on the funding landscape
The Fitch report is very much appreciated as its analysis provides a comprehensive and clear bottom-up data on disintermediation. We share their view that “The continent embraces bonds”. We already noticed the change in the funding landscape (ref: Shift towards an American Funding model, Zanders newsletter) but we also see some below investment grade corporates (especially SME – small and medium enterprises) struggling to raise funding. The shift towards an American funding model within Europe continues, but the shift is slackening off and even stabilizing (and in 2011 declining) for investment grade borrowers. Growth in bond issuance will come from SME and below investment grade corporates. We still see a growing demand for retail bonds from our SME clients.
This market has significant potential, but is still in a premature stage of development, especially in The Netherlands. Together with a growing search for yield, more investors are interested in high yield SME bonds. We are currently active in the retail bond market for a few of our clients.
1 “European Corporate Funding Disintermediation; The Continent embraces Bonds”, Fitch Credit Market Research, July 19th 2012