With interest rates at or near historic lows and central bankers clear in their commitment to maintaining stimulative policies for the foreseeable future, hedging interest rate risk is not high on the list of priorities for companies around the world. These conditions have slowed activity in interest rate derivatives trading to a crawl despite the continued strong flow of new corporate bond issues that serve as the traditional drivers of activity in this market.
A report, Central Bank Policies Deflate Interest Rate Derivatives Market, released today by Greenwich Associates shows that notional trading volume in interest rate derivatives declined 8.5% last year. That global drop follows a year of stagnant trading volume in 2010-2011 and a 20% plunge in volume the prior year. Last year’s decrease in trading volume occurred across Europe, the Americas and in Asia (ex-Japan), and among all types of market participants, including corporates, finance companies, and European government agencies.
No Recovery in Sight
There is little reason to believe that trading volumes will rebound any time soon. All the major developed economies have adopted policies to keep real interest rates low in order to stimulate domestic demand and consumption. The U.S. Federal Reserve has not only expressed its intention to keep its aggressive policies in place, but for the first time in its history the Fed last year tied rates to specific numeric targets, saying that it would continue taking steps to bolster the economy until unemployment falls to 6.5% or the inflation rate hits 2.5%. In Europe, dismal economic data released in February seemed to have increased the chances of yet additional easing by the European Central Bank. In Japan, the incoming government of Prime Minister Shinzo Abe pressured the Bank of Japan to announce its own policy of open-ended government bond purchases and raise its inflation target to 2%.
“Given the current environment, it is hard to envision any scenario in which companies would feel the need to accelerate traditional hedging programs in the next 12 months,” says Greenwich Associates consultant Brian Jones.
In fact, corporate demand for interest rate derivatives could actually weaken in 2013 if bond issuance levels off. Global corporate bond issuance increased 20% from 2001 to 2012, according to Bloomberg. The $3.8 trillion in total issuance last year broke the record for corporate bonds set in 2009. Although rates will remain favorable to potential issuers, many companies have already satisfied funding needs and refinanced higher-cost debt, leaving open the question of whether issuance levels can be sustained. “Given the fact that interest rate derivatives trading volume has been slumping even as corporate bond issuance breaks all-time records, we see this market at risk for a further reduction in trading activity as issuance inevitably moderates,” says Greenwich Associates consultant Woody Canaday.
One factor that points to an eventual slowdown in corporate bond issuance is the favorable overall credit environment for companies. Greenwich Associates research in U.S. corporate banking shows that bank credit is in ample supply for large companies as well as for mid-sized and small businesses with relatively strong credit ratings. Although some smaller European companies and companies in troubled, “periphery” countries like Greece and Spain experienced difficulties in obtaining credit in 2012, large European companies generally reported favorable credit conditions last year. “Unless the global economy experiences a strong rebound that triggers a bout of corporate growth investment, it seems likely that corporate bond issuance will eventually slow as companies continue to enjoy access to a large supply of affordable bank credit,” says Greenwich Associates consultant Peter D’Amario.