Low Interest Rates Continue to Bolster European Debt Issuance
European issuance volumes among financial and nonfinancial entities got off to a strong start in the first half of 2004, as borrowing costs remained at a historically low level. Refinancing higher cost debt, improving balance-sheet liquidity, and the pursuit of greater efficiencies in liability management continued to be the primary drivers of issuance activity rather than the need to finance capital expenditure. In the U.K., demand for financing was also prompted by the need to fund the expansion of consumer assets (notably mortgages, credit cards, and automobiles). On the other hand, low levels of mergers and acquisitions have constrained corporate borrowing needs in Europe during the current credit cycle. The relative flattening of the yield curve suggests that the economic recovery will remain gradual, at least in continental Europe, with continued opportunities for refinancing (see Chart 1). Indeed, the rising proportion of floating rate notes-to 56% of total issues compared with 42% and 36% in the corresponding periods of 2003 and 2002, respectively-indicates that the refinancing imperative will continue, albeit at a much slower pace than last year. The spread between the 10-year Euribor swaps and the one-year Euribor swap has remained fairly steady at about 200 basis points for several months. The lack of momentum in corporate spending will remain an inhibiting factor for new issuance activity in continental Europe. In the U.K. by contrast, the flattening slope of the yield curve indicates market expectations that the economy will slow in the coming months from its current robust pace, partly in response to the brakes applied by the monetary authorities.
New issue activity by European issuers was robust in the first half of 2004, with year-to-date volumes running 19% above the pace recorded in the same time a year ago, and only fractionally lower than the annual volume posted in 2002. A total of US$451.9 (€548.9) billion was recorded in new European bond issues in the period ended June 30, 2004, of which US$347.7 (€422.3) billion was recorded in the financial sector and US$104.2 (€126.6) billion in the nonfinancial sector. Indeed, European volumes for the financial and nonfinancial sectors combined have exceeded the activity recorded in the U.S. in 2004 year to date, possibly mirroring the divergence in interest rate trends between the two regions (see Chart 2). Evidence of stronger economic growth and rising “core” inflation led to a 25 basis point hike in interest rates by the U.S. Federal Reserve on June 30, with a cumulative total of 75 basis points in the pipeline during the remainder of the year. Growth forecasts in Europe by contrast are spottier and more fragile, with resulting stability in monetary policy anticipated at least through the end of this year.
As expected, the lion’s share of European issuance came from the financial sector, which accounted for 77% of total issuance. Financial issuers are eager to lock in funding at the current spreads on long-term debt, which are still near historical lows. Demand for financing in the U.K. was also prompted by the need to fund the expansion of consumer assets (notably mortgages, credit cards, and automobiles). Banks retained their traditional spot as leader by sector in terms of volume, accounting for 64% of new European bond issues in the year to date. German banks also retained their lead, issuing US$96 billion (€116.6) in the period ended June 30, 2004. Prominent issuers in Germany include the Landesbanks, which are issuing-and expected to continue issuing-heavily in order to reduce liquidity gaps before state guarantees expire in 2005. U.K. banks were next in line in terms of activity, issuing US$54.1 (€65.5) billion in the same period, bolstered by continued hefty growth in the mortgage lending activity and in the consumer finance market. Anticipation of further interest rate hikes in the near term is prompting U.K. issuers-both financial and nonfinancial-to lock in access to funding at relatively cheap rates, notwithstanding the increases seen year to date.
In addition to banks, the sector that showed the highest growth in issuance relative to a year ago was the broad-based industrials sector. Within industrials, the sectors that prominently displayed increases in the first six months were transportation-and to a lesser extent-automotive and capital goods. Within transportation, nearly half of the total issuance volume in the year to date was accounted for by Network Rail Ltd., a U.K.-based rail infrastructure company. Favorable market conditions prompted Network Rail to come to market in order to refinance some of its existing debt, provide the company with working capital, and reduce vulnerability to a potential increase in long-term interest rates. Continuing underperformance, public concern over safety, and the prospect of continuing growth in demand has led to a more integrated approach to the railways in the U.K. from government and regulatory bodies. Demand for funds within the automotive sector-which generally tend to be large volume issuers-is increasingly driven by the need to finance growing financial services businesses. Within the capital goods sector, the appetite for debt has improved, based on guarded optimism that the sector will recover in 2004 and 2005.
On the other hand, utilities and telecommunications recorded noteworthy declines from a year ago of 57% and 37%, respectively. The decline in telecommunications was centered on investment grade rated entities, which sank to nearly 68% of their year-ago level to US$6.4 billion. Activity in the speculative grade segment of the telecommunications sector actually increased 62% to US$2.6 billion, but the smaller size of the market failed to compensate for the loss in the investment grade segment. Last year’s issuance boom in the investment grade segment resulted from the financing/refinancing of extremely high levels of debt associated with third generation licenses (the so-called Universal Mobile Telecommunications System or UMTS). By the second half of 2003, however, investment-grade rated telecommunications operators reduced financing needs sharply by slashing capital expenditure and costs, which in turn facilitated free cash flow generation aimed at debt amortization. Activity in the speculative-grade segment heated up in the early months of 2004 as the liquidity squeeze dissipated and financing opportunities reopened after a long hiatus following the telecommunications shakeout. The decline of speculative-grade bond spreads to historical lows across all ratings categories played an important role in the revitalization of the speculative-grade market. Moreover, refinancing needs rose among a number of cable companies, which have been actively restructuring balance sheets for the last couple of years. However, recent volatility in the European speculative grade market has made the financing environment less hospitable, leading to a deceleration in activity and, in some cases, a revision in the terms of recent deals as spreads have risen to more “normal” levels. The proportion of new issue activity by the sectors most affected by the shakeout-telecommunications, media and entertainment, and high technology-still remains well below the peak levels recorded in 2000 and 2001.
Meanwhile, the decline in new bond issues among utilities was attributable to a sector-wide focus on boosting operating and free cash flow (through cuts in capital expenditures and general costcutting). The proceeds of the improved operating cash flow are being used to deleverage in addition to the sale of assets to increase cash and reduce net indebtedness.
The maturity structure of new bond issues is different for the U.K. than for continental Europe, reflecting the divergence in the interest rate pattern between the two areas. The Bank of England has already raised benchmark rates three times by 75 basis points in the year to date, and is expected to continue on this trend to ward off concerns about an overheating economy, whereas no material change is anticipated in the ECB’s monetary stance in the coming months. Anticipation of higher funding costs in the U.K. has led to more borrowers locking in rates in the medium term; the proportion of issues with a maturity profile of three to seven years increased to 45% of total new issues compared with 35% in the same period a year ago. The proportion raised in the seven to 10 year timeframe also rose to 9% from 4% in the corresponding period a year ago, whereas the proportion with a maturity profile of greater than 10 years fell to 18% from 32%. Meanwhile, the maturity profile among continental European borrowers remained broadly unchanged from the profile recorded in the same period a year ago, with 27% of new issues maturing in one to three years, 40% in three to seven years, 12% in seven to 10 years, and 21% with maturity of greater than 10 years.
The proportion of floating rate notes in total new issues has increased substantially-both among financial and nonfinancial entities-in the current year, reflecting investors’ relative unwillingness to lock in return at the low end of an anticipated rising trajectory in interest rates. In the first half of 2004, the proportion of floating rate notes rose to 56% of total issues compared with 42% in the corresponding period a year earlier and 36% in 2002. This rising proportion also implies that the refinancing imperative will continue in the coming months, albeit at a much slower pace than in 2003.
The new issues market in Europe continued to be dominated by entities at the highest end of the ratings spectrum (see Chart 4). Issuers at the ‘AAA’ and ‘AA’ rating categories increased their share of total rated new issuance. The share of ‘AAA’ rated issues has been rising steadily since 2001, and totaled 26% in the year to date. This is in large part attributable to the issuance by government-supported German banks, as well as the government-supported debt programs issued by Network Rail Ltd. Issues in the ‘AA’ rating category (inclusive of issues rated ‘AA+’, ‘AA’, and ‘AA-‘) also increased their share to 33% in the latest year to date, compared with 24% in the same period a year earlier. In the aggregate, issues rated investment grade (‘BBB-‘ or higher) accounted for 96% of total rated new bond issuance, with speculative grade issues (‘BB+’ or lower) accounting for the remaining 4%, which, though small, represents an increase in share compared to the two previous years.