The financial crisis that began in 2007 has led to significant changes in the structure of the global credit markets and has had important effects on the cost and availability of funding for all major corporates. However, the banking sector and the euro zone market in particular have experienced some of the greatest volatility in borrowing costs and some of the most dramatic changes in structure since then. Furthermore, it appears that certain of the trends witnessed since 2007 are likely to continue in the years ahead.
This article focuses on recent changes within the euro-denominated investment grade credit market, the reasons for these changes, and the opportunities that they offer investors.
As shown in Figure 1, growth in the global investment grade market has been strong across the three major currencies, and despite the fact that U.S. dollar-denominated bonds continue to dominate, euro-denominated bonds also now account for a significant proportion of the market.
We anticipate a continuation of these trends, as well as the following changes in European credit markets in the years ahead:
- The supply of corporate credit is likely to continue to grow strongly and this will create opportunities for investors.
- Euro-denominated issuance is likely to further increase as a proportion of the global total as bank lending is replaced by corporate bond issuance.
- Euro-denominated issuance is likely to become increasingly diversified by issuer, sector and country, creating opportunities for active, experienced managers.
We believe these changes create significant opportunities for the globally minded investor.
Figure 1: Growth of Corporate Credit Markets (Market Value in USD Billions)
Source: Bloomberg. Based on the Bloomberg Barclays Euro Corporate Aggregate, U.S. Corporate Aggregate and Sterling Corporate Aggregate Indices.
A Common Currency but not a Common Credit Market
The advent of the euro in 1999 opened the way for an extremely large, deep and liquid credit market that could potentially challenge the U.S. dollar corporate credit market. Nonetheless, even after 1999, several forces initially held back the development of a single-currency credit market.
Firstly, the very strong loan markets—from 2003 to 2007—allowed corporations that otherwise might have financed themselves in the bond markets to take advantage of cheap bank loans.
Secondly, despite sharing a common currency, the region remained a mix of various different languages, cultures and governments. A Spanish industrial company coming to the credit market for the first time, for example, would require management to embark upon a roadshow across the entire continent, introducing the company to a wide range of investors. Many non-Spanish investors might be unfamiliar with local regulation and tax policy, and therefore require extensive and time-consuming discussion and analysis of the corporate credit, as well as the sovereign and economic backdrop associated with it. As a result, credit investors tended to prefer the perceived safety of local issuers, while the issuers continued to lean on their local banking relationships to raise a high proportion of their funding through loans.
Banking Has also Been very Localized in Europe
Europe’s banking sector has gradually grown up over centuries. Despite the worldwide perception that the “European Banking Sector” is homogeneous across the continent, there have been few cross-border banking deals. At least for retail and corporate banking, each major country’s banking sector remains dominated by old “national champion” banks.
In each country, these banks have built strong, long-term relationships with central and local governments and with local industry. The practical result is that each country’s major banks were integral to their country’s economy and therefore presumed to have the full support of their respective governments. Prior to the financial crisis, they could borrow at extremely low rates of interest in the capital markets and lend on to local companies at relatively attractive interest rates. This is one important reason why Europe’s non-financial corporate sector made less use of capital market funding than comparable U.S. companies did.
The corporate sector in Europe also remains different in composition to that of the U.S. Partly as a result of the fragmentation by country, but also for other cultural and historic reasons, there is a far greater proportion of small- and medium-sized companies and greater family and private ownership in Europe than in the U.S. Hence, a smaller proportion of non-financial European companies are widely known by the investor community. This is another reason why companies in Europe have tended to rely on local banks for funding rather than to tap the capital markets directly.
How the Financial Crisis Disrupted the Model
With Europe’s governments having injected tens of billions of euros into their banks to prop them up in 2008—providing a clear demonstration of their support—government debt levels across the euro zone rose markedly. When the European Sovereign crisis began to emerge in 2009, it was clear that certain governments’ high-debt levels relative to GDP were primarily the result of having supported their banking sectors. Governments’ costs of borrowing rose across the euro zone—particularly in the periphery nations.
With investors realizing that governments’ willingness and ability to support their banks was far lower than before, senior bank spreads (the additional yield paid over risk-free interest rates) moved wide of industrial spreads. As seen in Figure 2, prior to 2007, investment grade industrial company spreads were consistently higher than the spreads for senior bank debt. From 2007, the cost of senior funding for Europe’s banks rose to levels that were roughly in line with the cost at which similarly rated non-financial corporates could raise funds in the credit market. In the years that followed, the cost of borrowing for Europe’s banks rose above the level for non-financial corporates. Despite a narrowing of the difference since 2011, they remain at similar relative levels today.
Figure 2: Barclays Euro Aggregate Corporate Option Adjusted Spread (Basis Points)
Source: Barclays POINT, Bloomberg.
This clearly has significant ramifications for the economics of the banking sector’s business model: If it now costs more for banks to fund themselves in wholesale markets than they can receive for lending to similarly rated corporate customers, then unless they can charge other fees or gain other benefits from the relationship, they will reduce lending.
Compounding that, regulatory changes being enacted—led by the Basel III accord—have significantly increased the amount of capital that banks must hold, as well as constraining them from a liquidity perspective. Bank funding now needs to have a longer average term and banks need to hold far more in liquid assets, earning a minimal return, than before the crisis. The result is that, everything else being equal, banks now need to charge significantly more to lend to corporate borrowers than previously in order to earn an acceptable economic return on the higher levels of capital that they now have to employ.
The Shift from Bank Lending is Changing the Euro Corporate Bond Market
The resulting shift away from corporations borrowing from banks toward borrowing in the capital markets is starting to drive both increasing euro credit market issuance and a change in the mix of issuance over the past few years.
The most immediate changes have been an increase in the number of entities issuing euro-denominated bonds, particularly since Mario Draghi’s confidence-boosting promise to do “whatever it takes” to preserve the integrity of the single currency in 2013, and a decline in the dominance of financial-sector issuers (figure 3). While financials still account for 41% of the market, as opposed to 32% of the U.S. dollar market, that represents a fall of 18 percentage points since the financial crisis peak, and a full 30 percentage points since 2000. The decline has been much less precipitous in the U.S.
Figure 3. The Changing Size and Industry Mix of the Euro Corporate Bond Market
The number of issuers has been rising…
Source: Barclays POINT, Bloomberg. Based on the Bloomberg Barclays Euro Corporate Aggregate Index.
… while the dominance of banks has been declining
Source: Barclays POINT, Bloomberg. Based on the Bloomberg Barclays Euro Corporate Aggregate and U.S. Corporate Aggregate Indices.
The euro universe has also become more diverse by country, while retaining a high level of quality, as indicated by credit rating sectors (figure 4). Interestingly, following significant ‘reverse Yankee’ issuance—euro bonds from U.S.-based entities—the U.S. is now firmly among the top countries alongside France, Germany and the U.K. The rest remains dominated by AAA/AA countries, with the peripheral euro zone accounting for little more than 11% in total. Only around half of the universe is rated in the BBB categories, with the rest rated A or above.
Figure 4. The Euro Corporate Bond Market by Country and Credit Rating
Source: Barclays POINT, Bloomberg. Based on the Bloomberg Barclays Euro Corporate Aggregate Index.
Conclusion: Euro Credit—Larger, Higher Quality and More Diversified
The advent of the euro in 1999 paved the way for an alternative to the U.S. dollar-denominated market. However, the particular structure of the European banking and corporate sectors held back the growth of the euro credit market over the following few years. It took the financial crisis and the subsequent regulation of the banking sector to change that structure; corporate funding costs declined relative to the rising cost of funding for banks, incentivizing more and more companies to turn to the bond markets for capital.
We think it is likely that the next few years will see the non-financial sectors within the Euro Corporate Aggregate Index increase significantly, both in absolute terms and as a share of the index. That would mean the mix by sector gradually converging with that of the U.S. dollar market. With the mix by country and rating already looking strong, this development should present a multitude of opportunities for European investors, and for those taking a global approach to corporate bond investing.