The capital markets have been a fraught place in recent months. Uncharacteristic volatility in global fixed income and plummeting investor confidence make a tricky backdrop for corporates navigating their funding needs. With few alternatives to the capital markets for large companies wanting to tap long-term, cheap finance across diverse investors and products, shifting geopolitical and economic tectonic plates, coupled with innovation, regulation and increasing sources of private finance, make for new rules of engagement. These include taking advantage of unprecedented cheap finance, tapping new pockets in private markets that also provide routes around regulation – and going green.
Paid to borrow
Historically low sovereign bond yields and attractive spreads have made the cost of borrowing for corporates in the debt capital markets cheaper than ever. At the beginning of the year, global software solutions group Wolters Kluwer launched a €1bn European Commercial Paper programme from which the company drew €150 million at the end of June. The new short-term borrowing facility diversifies the company’s funding sources from its existing long-term bonds, credit facility and private placement programmes, allowing it to tap negative short-term rates so that under this programme the company is actually paid for borrowing money. “There is a lot of money in the market at very attractive pricing,” says George Dessing, Executive Vice President in Wolters Kluwer’s treasury and risk department. “Negative yields make a very special funding environment. Money is for free and I think it will remain so for quite a while.”
Indeed, borrowing conditions seem to be getting even more favourable. In the latest trend, low short-term yields have pushed investors further out on the curve in the hunt for returns, allowing companies to lock-in low borrowing costs for longer. “The deepest pool of investor interest in the euro market has always been around the six to eight-year part of curve,” says Roland Broecheler, Executive Director, Debt Capital Markets at Santander. “Now the deepest pool of investor appetite is around ten to 13 years which is allowing issuers to get much longer-term financing at these record low levels.”
Similarly, investors’ hunt for yield is opening up other areas of finance for companies seeking to borrow, like the hybrid market, notes Broecheler. This part of the debt/capital structure offers issuers equity content and investors better returns and is also popular with issuers since it supports their credit rating. “The hybrid market has been very busy recently,” he explains. “Hybrid issuance comes at a significant premium over senior bonds so offers a way for investors to increase their yield when senior debt is very challenging. It’s also a popular option for companies.”
Nor does nervous investors’ demand for safe-haven fixed income assets, despite low returns, show any sign of tiring. Demand for new European corporate issuance has remained strong even though the entire German bund market dropped below zero in August. “After the whole euro bund curve turned negative, we still saw billions of very well-received new corporate supply across the spectrum from two to 30 years, for highly rated and lower rated companies.” says Broecheler.
Yet today’s low yields do come at a price for issuing companies. Challenging macro data and the risky geopolitical backdrop, particularly the US-China trade war and enduring Brexit chaos, have ushered in unprecedented volatility in recent months. Dovish talk, and actions, from the Federal Reserve and European Central Bank hold the markets steady. But any sign of that support waning unleashes extreme volatility – as witnessed in August. It’s in marked contrast to recent years when rock-solid central bank support countered macro news and made almost every day in the debt capital markets a good one. “If central banks don’t deliver what the markets are expecting the capital markets keep focused on macro data and geopolitics and that means more volatility,” says Broechelers.
Navigating day-to-day, and even intra-day volatility, isn’t easy. Positive morning indicators can turn negative by the afternoon. “Every syndicate update call on a bond deal at the moment involves lengthy consideration of the Trump-China trade war, Brexit headwinds and the risk of recession in Germany,” says James Taylor, a Capital Markets Partner at London-based global law firm Mayer Brown. “It’s never been more challenging to find the right pricing that meets the expectations of corporate borrowers and prospective investors alike within set execution windows. The market on a Monday, can look very different come Tuesday.”
Wolters Kluwer always taps the market well in advance of needing the money to avoid execution risk and trusts its strong investor base will see beyond day-to-day volatility. “You don’t want to be out there on that one nasty day. Don’t go when you need the money, go when you can walk away,” advises Dessing.
Nor should companies let today’s cheap money tempt them away from their funding strategies. At Wolters Kluwer, borrowing has three main objectives: either to finance investment in the business; including selective value-add bolt-on acquisitions – expensive in the current climate, maintain optimal leverage or shareholder renumeration. The company increased its dividend to shareholders by 15% in 2018 and plans an up to €250m share buyback in 2019. “We only go to the market according to our strategic plan. This decides the size, timing and currency we tap. It’s great that we can get out money at attractive rates, but it always needs to be allocated effectively.”
European companies wanting to tap a different part of the capital structure via listing will face just as challenging macro conditions. It’s one explanation for the low European issuance of recent years. While the US IPO market has soared thanks to US equities’ rally luring companies to list, in Europe dramatic outflows from European equity funds have impacted the IPO market. Recent research from Bank of America Merrill Lynch found 64 weeks of equity outflows out of the last 66 weeks. Brexit has also taken a toll, with investors withdrawing US$4.2bn from UK equity funds since late May, according to data provider EPFR. The number of UK IPOs fell 44% in the first half of 2019 compared with the same period last year, says EY.
“Corporates tend to list in their local market. But European macro, as evidenced by continued equity outflows, has been a headwind,” says Andrew Briscoe, head of EMEA syndicate at Bank of America Merrill Lynch. “Sellers who are unable to achieve desired valuations may choose to stay private for longer.”
Moreover, European companies grown impatient with lacklustre European equity markets, are increasingly tapping private capital. “We are also seeing more companies, particularly in the tech sector, getting attractive terms from private capital,” says Briscoe. Indicative of the trend is long-term investors like pension funds beefing up their private equity allocations in recent years, he says. “Traditional public market investors have wisened up to this and restructured so they can participate in capital raising in the private markets,” he says. Asset owners now place an estimated 14% of their assets in private markets (mostly private equity and real estate), up from virtually nothing a couple of decades ago, according to Willis Towers Watson.
Briscoe reassures that like all cycles, IPO doldrums won’t last for ever. “Europe has struggled for attention from US investors as a result of poorer macro, but at some stage the valuation disparity will compel them to re-engage, and we have begun to see this change.” In one encouraging sign of the tide turning, merger and acquisition financing is increasingly in demand which can feed into the IPO calendar, he says.
In fact, treasury should start to prepare. As soon as the European equity market returns to health, he advises issuers to go for it. It helps to have first mover advantage and there is only so much dry powder to go around – however good the company. IPOs also tend to succeed – or struggle – in sync, so one poorly received IPO can drag down the next. “In many ways IPOs are an asset class. Although IPO companies may be in different sectors and geographies, interest in IPOs does get influenced by performance of other listings,” says Briscoe.
It’s not just macro factors that make the capital markets challenging. Treasurers face structural barriers to entry too, like the challenge European corporates face issuing dollar debt because of different regulations and disclosure documentation. Whereas euro and sterling issuance involves similar processes, issuing in dollars is complex and burdensome.
Given that Wolters Kluwer derives more than 60% of its revenue from the US, dollar debt makes sense as a natural hedge. But the company has never issued in dollars, and currently accesses its dollar finance needs via a multi-currency credit facility instead. “Dollar financing comes with real challenges. We would have to study a new legal roadmap with potential governance and compliance restrictions,” says Dessing.
It’s not a burning frustration because euro financing is cheaper than dollars. Today the bond market prices a ten-year euro benchmark issuance with negative interest rates versus the US where corporates are still paying around 1.5%. That’s only the market or mid swap rate, so without the credit spreads. “It’s still cheaper for us to borrow in euros,” says Dessing. Any decision to issue in dollars would also need careful analysis of how much dollar issuance the company needs, its requirement for an internal or natural hedge, and how often it wants to tap the market. “It also means multiple dollar issuance over the number of years of the issue. We are already tapping the euro market and there is a question mark as to whether we have sufficient liquidity needs to have dollar debt issuance too.”
Nevertheless, it would be a nice option to have.
Post-financial crisis regulation like Market Abuse Regulation (MAR) and the Transparency Directive is also a headache for companies tapping the European debt market. It is starting to trigger new patterns in corporate issuance as some companies move some of their funding needs from European regulated markets to other products and jurisdictions. Growth in unlisted private placements is a key example, evident in Germany’s Schuldschein market, a hidden corner of borrowing that doesn’t tap bank loans or bonds, and which has tripled in recent years.
These instruments don’t require a prospectus or costly documents prepared by lawyers because there is no listing requirement, explains Mayer Brown’s Taylor. “Corporate treasurers who have issued benchmark bonds on regulated markets are now deciding that instead of doing repeat deals on listed markets, issuing alternative products such as a Schuldschein saves on costs and offers real liquidity.”
In another trend, European corporates are also tapping the US private placement market. Not only is the regulation simpler, it offers alternative maturities allowing companies to slice and dice their issuance in line with their own, and investor base needs. “A US$500m issue could be divided into, for example, five different tranches with different tenors and pricing,” says Broecheler. This market also allows delayed drawdown for corporates, meaning they can lock in cheap borrowing for money they won’t have to draw for up to two years. “This is impossible in the public bond market but has now become a staple diet for many European corporates,” he says.
Elsewhere, Europe’s listed high-yield market is increasingly migrating from EEA regulated markets to locations outside Europe’s regulatory reach. For example, the Guernsey-based International Stock Exchange, or TISE, has now become the market of choice for new issuers of high-yield bonds, says Taylor. “Issuers are listing their high-yield bonds away from EEA regulated markets, with consent of the investor base, because they are not subject to the same regulation.”
According to TISE’s website, its high-yield bond issuers include a mix of public and private European and US companies, some of which are the most internationally recognised brands or global leaders in their industries. “The listings have included both new issuances and migrations from EU exchanges as issuers and their advisers are attracted by our robust and proportionate rules for listing HYBs,” it says.
Regulation is also crimping growth in other important corners of Europe’s capital market. Deepening and integrating regional markets in accordance with the EU’s Capital Markets Union (CMU) initiative has stalled, most notably around efforts to draw retail investors into the bond market to help finance SMEs.
EU regulation around prescriptive bond prospectuses and the need for additional marketing materials are to blame, says Taylor. “This kind of regulation is difficult and complicated for SME issuers to understand. Regulation is actually moving in the opposite direction of where the CMU wants to go,” he says, observing that similar challenges befell London’s Order book for Retail Bonds (ORB) market which tried to open up the bond market to retail investors in 2012. “The disclosure requirements and prospectus companies needed to list was prescriptive, burdensome and costly for issuers.”
Ebb and Flow
New streams of finance are testimony to the constant innovation and competition of the capital markets. If one source wains, new sources quickly appear. For food and catering group Compass, the arrival of green bonds and their growing pricing advantages over browner siblings encapsulates that innovation. “The money is starting to talk,” says Deputy Treasurer Ben Walters. “Pretty much every time we talk to a bank about raising finance, this is on the agenda. Investors want to invest in sustainability and there isn’t enough supply.”
The company doesn’t have a date for a green debut yet, but is actively exploring the best approach, looking particularly at which parts of its business it could audit and report sustainability milestones. Issuance focused on water usage or food waste are possible areas Walker enthuses, noting that green issuance is a much bigger undertaking than traditional capital market issuance. “It’s not just treasury involved. The whole company, from corporate social responsibility teams to investor relations and the individual parts of the business that are tracking and auditing sustainability, need to be on board.”
European companies’ dependence on bank financing has fallen during the past decade but remains almost twice as high as in the US, according the ECB. Challenges and barriers remain, none more so than today’s whippy markets. But for established and thriving companies, the capital markets is still the easiest way of raising money. “We see good demand in all but the toughest markets,” concludes Walters. “The capital markets still give us the most competitive pricing out there.”