Corporate bonds in demand
With the end of the summer holidays, an unusually high number of corporate and financial bonds have been issued in the European market recently, including 35 corporate bonds with a combined volume of €24 billion in the past week alone. Companies are taking advantage of the fact that the capital markets are currently able to absorb a high volume of new issues. Despite interest rates being at record low levels, investors are not holding back and order books were oversubscribed three times over on average last week.
Inflows into European investment-grade bonds have risen by around 8 per cent in the year to date. But why are corporate bonds in the investment-grade segment currently so popular? There were virtually no primary market issues during the summer break, which means the need to invest is that much greater now. Many investors have high levels of cash waiting to be invested. It is no longer worthwhile purchasing German government bonds, for example, as they are only offering negative yields in all maturity segments. By contrast, yields on European corporate bonds are still in positive territory for the most part. There is also the prospect of a new asset purchase programme from the European Central Bank (ECB). The markets anticipate that, at its next regular meeting in September, the ECB will sign off on an interest-rate cut and a new bond-buying programme (quantitative easing). This new programme would likely extend to corporate paper. These prospects mean that many investors are willing to add credit risk to their portfolio. Institutional investors, in particular, have to invest their money where they can still achieve a positive return. It is therefore unsurprising that demand for recent corporate bond issues was so strong.
Funding via the bond markets becoming increasingly popular with European companies
This is not the only reason for the growth of the European credit market. Overall, there are significant differences in how US and European companies fund themselves. US companies have a long tradition of obtaining finance through the capital markets. In the US, the investment banks predominantly act as advisors and service providers for bond issues. The banks place the bonds that they issue with a broad range of investors in the capital markets. They also carry out the market making, but do not take the credit risk onto their own books. In doing so, the investment banks mainly earn fees for the provision of advice and services. This highly profitable business has no impact on their balance sheets.
By contrast, companies in continental Europe traditionally obtain finance in the form of bank loans. The commercial banks generate earnings from the maturity transformation between their customers’ low-interest deposits and the higher interest income from longer-dated company loans. The loans are recognised on the banks’ balance sheets and thus directly affect their capital requirements and risk requirements. In the current period of low interest rates, however, maturity transformation is not working as well as it did in the past because the loans extended now only generate small returns. Consequently, the margins between the banks’ lending business and their deposit-taking business have narrowed sharply.
In the current capital market environment, European commercial banks are at a disadvantage with their traditional banking business. Given the prospect of an imminent relaunch of the ECB’s bond-buying programme, which could extend to corporate bonds, many companies prefer to issue bonds at the currently very favourable conditions. The trend towards ever greater substitution of bank loans for corporate bonds is therefore likely to continue for the time being. This is problematic for the purely commercial banks, as they are missing out on business opportunities. The ECB’s quantitative easing will therefore heighten the profitability challenges faced by many European banks.
Trend for corporate bond issues set to continue in Europe
The prospect of a new ECB purchase programme being launched for European corporate bonds means that demand for such paper will be sustained. But a fresh supply of new corporate bonds is also ensured, because companies want to obtain funding at the current historically low interest rates. Despite the low yields and as long as investors keep an eye on the usual risks, we believe that investment-grade corporate bonds still offer opportunities in this market environment. This is subject to the proviso, however, that the ECB actually delivers by signing off on a new purchase programme for corporate bonds.
Unless otherwise noted, all information and illustrations are as at 30 August 2019