Investors and companies now finding their footing following months of tense crisis in Europe should brace for further disruption in European credit markets, according to a new report from Greenwich Associates.
In coming months, new capital rules will continue to alter the economics of fixed income for Europe’s major dealers, reducing market liquidity and ultimately increasing costs to corporate bond issuers. Those costs might not seem significant at a time when high-quality companies are able to issue long-dated bonds at record low rates and high-yield issuers have unprecedented access to capital markets funding. But as interest rates rise, a new liquidity premium could make bond market financing much less attractive.
If that happens, companies may wish to turn back to the bank loans that have traditionally served as their main source of funding. But that route may not be as easy as it used to be. “There was an expectation among banks in early 2012 that their lobbying would be successful in pushing back against some new regulations and, as a result, a hope that things could go back to the old ways,” says Greenwich Associates consultant Andrew Awad. “But then the London Whale event broke and along with the LIBOR rigging scandal it gave more muscle power to the regulators.”
The New Liquidity Premium
As a result, European fixed-income markets are bracing for the implementation of new rules governing derivatives trading, best execution and other critical areas. Those rules will take effect as the major banks move to comply with Basel III capital requirements — a process requiring deep reductions in the size of fixed-income inventories and one that will also have a critical impact on banks’ corporate lending practices. The upshot for companies and investors: Nobody really knows what the ultimate impact of these changes will be in terms of the price and availability of credit.
While most companies and investors realize that these changes to the fixed-income market structure will increase their funding costs, the actual implications of these shifts could be much greater than some issuers realize. That’s because new capital rules and other changes will eat into bank lending capacity. There is no guarantee that European companies will be able to easily return to their traditional source of financing if reduced bond market liquidity makes capital markets funding prohibitively expensive as interest rates begin to rise.
“The first question facing the market is: How big will the new bond market liquidity premium be,” says Awad. “For companies issuing in small sizes or infrequently, it may become prohibitively expensive very quickly when interest rates start to rise. In that case, the biggest question will be: If banks can’t or won’t step up because of the new capital rules, what do companies do?”
Debt Market Headwinds in 2013
The new report from Greenwich Associates, “2012: The Year Of The Corporate Bond In Europe” provides a detailed examination of the changes now unfolding in Europe’s fixed-income markets. The report concludes that ongoing alterations to investment strategies among institutional investors will provide a sustainable source of demand for European corporate and high-yield bond issues, recommends that companies take full advantage of today’s favorable market conditions. On the other hand, the report urges investors to exercise caution. The calm we are now experiencing could just be the eye of the storm.