In the first quarter of 2016, Europe’s corporate bond market will be in thrall to monetary policy. The first US Federal Reserve rate hike in just under a decade and renewed quantitative easing (QE) from the European Central Bank (ECB) will define the beginning of the year.
“If the Fed raises rates it will probably be taken as a sign of confidence and that will be good for spreads,” says Wolfgang Kuhn, head of pan-European strategy at Aberdeen Asset Management in London. “Whether that applies long term we’re not so sure but the first half of 2016 should be a good one. That is obviously supported by new QE noises out of the ECB so both effects will be positive.”
That may sound like the market is due a return to the bull run of the first quarter of 2015 but this time round some important caveats apply. Markets may have notoriously short memories but the lessons of 2015 are severe enough to temper any excess enthusiasm this year.
“QE is a support for credit and especially for IG credit but it is not a panacea,” says Craig MacDonald, head of credit and aggregate at Standard Life Investments in Edinburgh. “We reduced a lot of risk in March when credit spreads got too tight because while QE is supportive it doesn’t resolve other issues. If you are only buying risk because of QE then you are going to have a few problems.”
Negative headlines over Greek debt and Chinese growth brought the bond market to a series of grinding halts in the second half of 2015. This year begins with neither of those situations resolved for certain and plenty of other disruptive forces to contend with.
So while QE will support markets, as last year showed, it will not fully protect them. Negative headlines provoked bad market reactions in the second half of 2015 and ultimately overwhelmed the impact of QE.
Such headlines can come out of the blue, as the Volkswagen and Glencore credit events showed. But most likely to be on the list of challenges to ECB monetary policy is the Fed’s imminent rate hike.
How the decoupling of ECB and Fed policy will play out is unclear though. Rate hikes are likely to be cautious and US Treasuries yields are unlikely to rise steeply. Concerns around volatility in emerging markets could cause a rush to US Treasuries, while the attractiveness of US debt for foreign investors also stands to subdue long-term rates.
“In general, even if there is a lift-off in December, many people see a downside risk in US Treasury yields,” says Tomas Lundquist, managing director and head of European corporate debt capital markets at Citi in London. “There will likely be lots of interest from Japanese and European investors that are crowded out of their markets for higher yielding US bonds, so we’re unlikely to see a steep increase in rates.”
Lundquist’s point on European investors is pertinent. While rate rises are unlikely to be aggressive, they can still impact the European bond market by luring cash away from it.
Marco Baldini, head of European corporate and rates syndicate at Barclays, is wary of this. “In the same way that international borrowers are coming to Europe for the coupons, European investors would need to seek alternatives if the spread differential becomes much larger with the US,” he says.
Low spread nerves
Investor behaviour shifted quickly in 2015. The Bund sell-off and a series of similar shocks throug the second half of last year showed how fast markets can move in periods of artificial spread compression. With fresh QE expected this year, markets run the same risks.
“When you are in such a low rates environment it is very difficult for investors to make decisions,” says Stéphane Tortajada, group head of finance and investments at EDF. “When there are any macro uncertainties during these low levels of absolute yield people change their minds very quickly.”
That means the potential for volatility this year is high. The condition plagued the European corporate bond market throughout the second half of last year as windows for issuance became increasingly short and unpredictable. Priscilia Bouton-Peignoux, financial markets director at Sanofi in Paris, experienced the condition first hand.
“We issued a €3bn bond in September 2014 and then a €2bn deal exactly a year after,” she says. “In 2014 the book was tremendous; close to five times oversubscribed. Even after we reduced the spread, investors kept asking for Sanofi paper. It was an amazing experience.
“But in 2015 it was different. Orders came in at a slower pace, with lower tickets. The top ticket size was €50m, compared to 2015 when top orders were much larger and more numerous.”
Situations like Sanofi’s are likely to happen again, but not for a few months at least. The beginning of this year will be a good one for issuers, able to lock in long dated maturities at low yields again. That said, conditions are unlikely to be as good as last year.
“The one thing that QE definitely gave us was that access to very long duration paper for lower grade corporates than would normally have access to it,” says Sarwat Faruqui, head of corporate syndicate at Citi in London. “To some degree that can happen again with QE2 but the pain that investors have had during the past year means memories won’t be so short that we get to the same aggressively flat credit curve that we had in Q1.
“But the longer than 12 year part of the curve should open up to higher quality names at more effective prices than we have had in the second half of 2015.”
The world’s playground
Nonetheless, locking in long term rates in Europe will still be attractive, especially for the US issuers that rushed to the old continent in the first half of last year. The reverse Yankee phenomenon, of US corporates issuing euro denominated bonds, was one of the defining themes of 2015. Despite dropping off in May, the trend had picked up in November and will keep pace this year.
“It was the first year that US issuers had been the largest funders in euros, it was a massive shift,” says Baldini. “US issuers used to come here for arbitrage or net hedge purposes, now they are driven by lower coupons instead.
“There are still more US companies which have not issued in euros than those which have and as long as the rate differential remains we will see more of the same coming. Given the Fed is expected to hike soon and the ECB is likely to ease soon it seems quite remote that the interest rate differential will close up.”
US corporate issuers printed $57.7bn of paper last year, according to Dealogic data. That represents about a 57% increase from 2014.
The reverse Yankee trend boomed until May, as US borrowers rushed for euros on the back of bullish sentiment.
The low coupons on offer in Europe attracted many, while others sought to hedge the cost of currency swaps by matching euro debt to their assets and revenues in the currency.
Those reasons to come to Europe remain valid for many non-European corporates and not just those from the US. Australian and Chinese issuers are also set to join the low coupon party.
“Issuance from China is about to grow,” says Christian Reusch, co-head of global syndicate at UniCredit in Munich. “There were five or six issuers assessing the market last year. Non-European issuance will only gain further momentum in the European landscape.”
That prospect is enticing for banks keen to book juicy fees but as last year taught the market, non-European issuance can jam supply. US corporates’ surge of issuance eventually caused a glut that widened spreads on both sides of the Atlantic.
“Significant corporate bond issuance has been the main driver for the credit spread widening we have experienced in the US,” says Eve Tournier, head of European credit at Pimco in London. “In Europe there was some spillover from the US, even though the technical factors are better.”
Oversupply wasn’t the only influence that US issuers had on European spread widening. Culture also played its part. US issuers were generally more relaxed about paying higher new issue premiums to get the deals they wanted. That stood in stark contrast to European issuers and their devotion to tight new issue premiums.
“US issuers are very happy to pay an extra few basis points to get the deal done and get the size they wish,” says Tortajada. “It’s a cultural thing: they want the deal to get done and all in all it’s a good deal in the long term because the absolute yield is very competitive.
“But in the European market, the players are looking at new issue premiums. In normal market conditions it will be 5bp-10bp but when it goes above 15bp not many want to issue.”
Those European issuers may be due another round of grimacing this year. A substantial pipeline of US M&A related deals is due in 2016. For example, SABMiller, Teva and Dell are all expected to refinance M&A debt in the bond markets, with euro tranches also likely. Given the urgency of event-driven financing and the expected size of those deals, widening new issue premiums are likely.
“There is an argument that says not all of the potential M&A deals for 2016 can get funded entirely in the dollar market, which implies that some of these will come to Europe,” says Baldini. “M&A refinancing deals would be done in a size that matches the required funding need which could lead to an impact on spreads.
“The average European borrower will have to expect new issue premiums to remain elevated with that background of US issuers coming here and coming here for size as well.”
