Thanks to a burst of issuance, financial institutions in mid-November were looking to finish an otherwise dreadful 2022 on a positive note. The turnaround, inspired by a lower than expected US inflation print in October, provided good funding conditions to many issuers as investors were lured back into unsecured bonds.
This improvement prompted some market participants to predict that the European FIG market will have a better 2023.
“I cannot see 2023 being worse than 2022 in credit but having said that we may still hit the low of 2022 in equities [again] next year,” says Vincent Hoarau, head of FIG syndicate at Crédit Agricole.
The late year revival in demand for banks’ unsecured debt pushed down spreads and new issue premiums. The latter fell to an average of 11.2bp as of the end of the third week of November, from 26.7bp two weeks earlier, according to GlobalCapital’s Primay Market Monitor.
Nearly two-thirds of the respondents in an outlook survey undertaken by GlobalCapital of FIG debt capital markets participants, which closed in mid-November, say bank spreads on senior preferred and subordinated bonds will continue this tightening by the end of 2023.
Expectations are strongest for senior non-preferred debt to tighten the most (82% of respondents).
With the bulk of FIG issuance forecast to arrive in the first half of 2023, spreads on various asset classes are expected to behave differently throughout the year.
As market participants prepare for the traditionally busy January, “nobody expects spreads to tighten from here, especially for harder, trickier deals on behalf of issuers that are not national champions,” says Florian Rathgeber, FIG syndicate manager at UniCredit in Munich.
“With the usual busy start to 2023, and the European Central Bank’s support [for bond buying] disappearing, these factors are likely to push spreads wider. At best, spreads will be stable in the first part of the year.”
In the first half of 2023, CréditAg’s Hoarau expects core continental European banks’ non-preferred and preferred spread differential to be around 50bp-60bp. He predicts the non-preferred bonds’ spread will range between mid-100s to high 100s over mid-swaps.
For subordinated debt, he foresees the tier two and additional tier one (AT1) fair value difference to be around 200bp for the same period.
“The current base is that spreads [in 2023] are unlikely to move much in either direction,” says Matteo Benedetto, head of FIG syndicate for Europe, Middle East and Africa at Morgan Stanley. “But, that view hinges on the depth of the expected recession in Europe and the US.”
Benedetto expects “for the FIG sector as a whole, senior spreads and those of investment grade issuers will perform the best, relative to high yield and higher beta spreads”.
As banks will issue multiple types of products for their various funding needs, survey respondents were able to choose multiple asset types where they think banks will focus most of their issuance.
Some 85% believe that covered bonds will be the most popular asset type in 2023. More expensive instruments follow: senior preferred and non-preferred debt, then AT1 and tier two debt.
Isaac Alonso, head of FIG debt capital markets at UniCredit, expects “heightened issuance of covered bonds” due to refinancing alone being around €130bn-€140bn in 2023.
He says that, depending on the type of funding required, “issuers that are going for liquidity could also use covered bonds to refinance their TLTRO (targeted longer-term refinancing operations) borrowings”.
And because of heavy issuance and Bund/swap spread tightening, covered bond spreads will gradually widen into the first quarter of 2023, according to CréditAg’s Hoarau. “Covered funding will remain strong, driven by the big TLTRO refinancing, deposit war and subsequent increase of pure liquidity funding needs,” he says, adding that after June, once banks have repaid €1.3tr of TLTRO funds, spreads will start to stabilise.
Frontloading
Whether banks will frontload their funding beyond covered bonds is a divisive topic. A little over half of the survey’s respondents expect issuance to be concentrated in the early part of the year, but no more than usual. One third of them expect there will be a higher volume than in a typical year.
Even after market conditions drastically improved in late 2022, “it looks like there will be front-loading in early 2023,” says Benedetto. “But, if the interest rate environment is little changed, with central banks not hiking or cutting, then the rationale for frontloading at current spreads doesn’t make sense.”
He, and other dealers, say that a further improvement in market conditions could be possible later in the year and this might drive spreads lower.
The refinancing of different assets will be another important development, and is linked to the debate over whether issuers will frontload or wait for better markets.
Despite the steep fall in new issue premiums in November, spreads on unsecured bonds were headed towards a historically high annual close. Because of high funding costs, market participants’ attention has been focused on whether banks can, or are willing to, call their subordinated debt.
“The refinancing of subordinated debt will be a leading topic into [2023],” says Benedetto. “The focus will remain on the tier two calls, which in the vast majority of cases should take place even if spreads do not rally significantly.”
There are different expectations on the refinancing of AT1 and tier two. The former is the riskiest form of FIG debt capital and the most expensive but, unlike tier two, it does not lose its regulatory treatment if left uncalled.
“We don’t know if the market will improve, but at the current levels expect more AT1 refis not to happen in 2023,” says Benedetto.
Indeed, some 75% of the survey’s respondents expect banks to refinance more tier two debt than AT1. A notable 17% said that, while banks will refinance tier two, they will not do the same for the riskier product.
Part of that reasoning lies in the AT1 market having become “mature enough to handle a series of non-calls” in 2023 based on economic reasons, according to Hoarau. But he says that if a frequent issuer does not call its tier two bond that will “surprise the market”.
Hoarau expects core issuers to call their tier two debt, even for non-economic reasons. But he adds that “some second tier issuers may not call, as they will be forced [not to redeem early] by the regulator and they won’t be punished by the market”.
He adds: “This will continue to illustrate the fragmentation of the credit market.”
Thus, the funding cost of subordinated debt is expected to remain elevated in 2023. Alberto Maria Villa, a FIG syndicate manager at UniCredit in Milan, expects AT1 refinancing to range between 9%-11%, with lower levels for tier two.
For another type of refinancing, the first wave of calls from banks’ senior non-preferred debt issued in 2018-2019 will come due in 2023. And as refinancing will be “the overarching theme” of the FIG market next year, according to Villa, “this will be telling vis-à-vis refinancing of capital and subordinated debt”.
Hence, “the quantum of refinancing will be for senior preferred and non-preferred debt,” says Villa.
Most European banks will also need to raise senior funding for regulatory reasons for their deadline to meet minimum requirement for own funds and eligible liabilities (MREL) imposed by regulators for the end of 2023.
More than 45% of the survey’s respondents expect banks will raise more senior debt than in previous years. Under 40% said banks will also print more subordinated debt than they previously did, a larger number of them think it will be a smaller volume.
Different diversifications
While uncertainties abound, respondents were split over what will be the single biggest risk for the FIG market in 2023. The largest share of respondents (45%) expects this to be worsening global macroeconomic conditions.
As issuers witnessed all too often in 2022, market shocks may quickly turn issuance schedules into short windows of opportunity.
“Finding the right window will be an art,” says Alonso. His desk’s message to issuers: “Be ready to issue, be flexible and have your docs ready.”
He adds that it is “better” for issuers not to use standalone docs when they are looking for the “right” window.
Andrew Chaplin, managing associate at Linklaters’ capital markets team in London, echoes Alonso. “Have your docs ready to be able to take advantage of issuance windows at short notice,” he says. “This is one of the key takeaways for 2023 as the issuers that did well this year were the ones that were ready with their documentation.”
He says that a deal issued under a programme could be done within a couple of days, whereas it could take “a month-long process” for a standalone trade.
In case of volatility flaring up and restricting market access, issuers can find funding diversification in foreign markets. After euros and dollars, European banks are most likely to tap the sterling market, based on 90% of the survey’s respondents.
“The realignment of fiscal and monetary policies has been very important for the sterling market’s outlook for next year,” says Nick Hughes, head of capital markets at Lloyds Banking Group. “An alignment of the two policies should mean a more positive international reception for the sterling market. This comes at a time when higher yields and spreads are already attracting investors, as well as more international borrowers looking to access the sterling market.”
He adds: “It is helpful to see strong sterling in terms of G3 [issuance]. While it is a small percentage of overall markets, its credibility in the G3 markets remains very important.”
Meanwhile, banks are expected to add a different type of diversity to their funding mix in 2023 through higher issuance volume of green and social bonds.
“ESG issuance in FIG will definitely pick up again,” says Hoarau, “as 2023 evolves towards normalcy and ESG will come back on people’s agenda after everyone was more focused on securing funding [in 2022].”
He expects ESG volume across all FIG products to be more than 25% higher compared to 2022, matching 18% of the respondents’ views. Another 27% expect that it will be less than 20% higher with 45% says it will be about the same. GC