There are several potential risks for the fragile equilibrium that currently exists in the European corporate credit landscape. While sufficient capacity may currently exist for corporate refinancing over the next four years, funding for growth is likely to be quite limited.
According to our estimates, European corporate issuers must refinance about $8.6 trillion of maturing debt by 2016 and an additional $1.9 to $2.3 trillion of incremental commercial debt financing that companies will need for growth. This demand for funding may compound the negative effects of credit rationing that could occur as banks seek to restructure their balance sheets and as bond and equity investors reassess their risk-return thresholds. In our view, these factors — the current euro zone crisis, a soft U.S. economic recovery and the prospect of slowing Chinese growth — raise the prospect of a “perfect storm” for credit markets. In such a scenario, a wider pool of borrowers than just the highly leveraged ones could find their future funding in jeopardy. (Larger corporate issuers are having an easier time finding debt capital.)
We assume, based on various factors, that global banks and debt capital markets should be able to continue to provide most of the liquidity that corporate issuers need to manage their forthcoming refinancing. We also believe, however, that these factors could be negatively affected by changing or newly emerging sensitivities. For example, governments and banking regulators may not be well-placed to counter another credit squeeze as they have already exhausted much of their fiscal and monetary arsenal in dealing with the economic problems of the past few years. Furthermore, many countries are implementing austerity measures to deal with their own sovereign debt and budget deficit issues, which are likely to hamper their capacity to respond to new macroeconomic problems.
Europe’s particular vulnerability
In Europe we consider that continued reliance on bank funding may pose a problem for corporations’ future funding needs, as European banks weigh up their own strategies to contend with the ongoing economic difficulties in the region, and stricter regulatory capital and liquidity requirements.
We believe the credit quality of nonbank corporate issuers has improved in recent years, partly because of the economic rebound, but also because of their higher cash balances resulting from higher discretionary cash flow and retention of earnings. This latter condition has also undoubtedly helped banks to rollover existing term loans to these issuers, particularly where the bond market could refinance a part of the lending banks’ exposure. There is little evidence to suggest that the banks would change their policy of tactical deleveraging while continuing to lend to their corporate clients in the near term, although we have observed something of a flight to quality in bank lending; the middle-market and small-business segments face greater funding challenges.
Nevertheless, with respect to new funding requirements, we believe credit rationing could restrict global loan growth in the future, especially in Europe, as new bank term loans become more difficult to secure. Not only must European banks adapt to a weak economy and uncertainties relating to sovereign debt sustainability, but they also have to do so while managing balance sheets that are more highly levered than their U.S. counterparts. The faster implementation of the Basel III timetable only compounds the challenge for European banks.
Indeed, according to the European Central Bank’s June 2012 financial stability review, various large EU banks intend to reduce their assets by approximately €1.6 trillion ($2.1 trillion) over the next three to four years. A similar study by the International Monetary Fund estimated that, under planned or baseline monetary and fiscal policy measures, 58 large EU-based banks could reduce their assets by $2.6 trillion by year-end 2013, leading to a 1.7 percent reduction in the supply of bank credit when compared to the third quarter 2011 level. If the policy actions under the baseline scenario are not taken, the IMF foresees a much higher 4.4 percent decline in euro zone bank credit. In our view, these staggering numbers could foreshadow a “lost” decade.
Making up the shortfalls
While we see the more mature U.S. debt capital markets as being able to cover potential refinancing shortfalls and growth needs domestically, the European corporate bond market remains less developed. For example, if European corporate issuers tapped the European bond markets for 50 percent of their respective new funding requirements (up from about 15 percent historically), this would imply $191 billion to $232 billion of net new annual issuance. To put this in perspective, there have only been two years in the past decade in which European corporate bond issuance has exceeded $100 billion. This presents a significant growth opportunity for European debt market investors, but also highlights the challenges confronting nonbank corporate borrowers in Europe, especially if they need to turn to the more sought-after U.S. debt market for alternative funding.
European corporate borrowers have capitalized on the opportunity offered by yield levels at historic lows. For investment-grade companies, bond volumes climbed to €221 billion in 2012, according to Dealogic. This was a 100 percent increase from 2011 levels, although not as high as the records set in 2009 (€310 billion), when European companies refinanced for balance-sheet protection during a near-collapse in trading at the time. While much of this issuance continues to be used to refinance existing debt, we are starting to see some early signs of more strategic financings — both for M&A (for instance, Heineken’s €2.5 billion loan-to-bond bridge loan to back its acquisition of Asia Pacific Breweries) and dividend recapitalizations (for instance, Com Hem’s €250 million 13 percent recent payment-in-kind (PIK) bond offering).
In 2012, the resurgence in euro zone sovereign fears was assuaged by the forceful policy response of the ECB in early September. This response created much-improved conditions for corporate issuance. By reducing euro zone sovereign liquidity risk (albeit subject to the affected country requesting a formal support program), the ECB response resulted in lower risk premiums across financial markets. As a result, we have observed an increased appetite by investors for extended maturities as well a willingness to invest in lower-rated debt in their search for yield.
Activity in the leveraged loan market remains subdued relative to high-yield market activity. Loan volumes have nearly halved, dropping from €43.5 billion in 2011 to €24.2 billion by the end of October 2012 (the latest figures available), according to S&P Capital IQ LCD. This compares with €30.5 billion in the high-yield bond market. The European leveraged finance market is continuing to evolve with several investment managers establishing new closed-end, low-levered funds with great flexibility to invest in either leveraged-loan or high-yield instruments, whichever offers the better return prospects relative to their risk assessment.
The pressure is on
Banks worldwide are under pressure to manage risk-weighted assets closely, in both their trading and banking businesses. This pressure is most acute in Europe given the economic and funding environment, the need to bolster capital ratios to meet Basel III requirements and the need to raise returns on equity above the cost of capital. An additional complicating factor is that the linkages between sovereigns and banks, especially in Europe, have become stronger. Proposed banking union measures, such as direct recapitalizations from the euro zone’s central bail-out funds, are an attempt to loosen these linkages. We expect that most European banks will prioritize domestic-market lending and potentially reduce their international and cross-border exposures.
At the same time, we think there is a likelihood that European banks could be subjected to increased capital pressures through a protracted slump in consumer and business confidence in the euro zone, a harder-than-expected landing for China’s economy, escalating oil prices, more volatile commodity prices and reemerging inflation. In such a case, banks may not be able to meet the refinancing and capital growth needs of their clients through 2016.
We are likely halfway through a decade of deleveraging: It has taken decades to build up the debt-fueled growth bubble; it will not deflate in the near term, and the transition will likely be acutely painful and volatile at times.
Jayan Dhru is senior managing director, Standard & Poor’s Ratings Services.
