In their hunt for yield, European investors are rushing towards the credit market, seeing corporate issuance as the solution to the declining returns on dwindling government supply.
Combined with structural changes driven by the single market, and the resulting increase in supply from European corporates - alongside US companies keen to tap into the new investor base - this demand has driven the credit market to levels exceeding the most optimistic of forecasts.
Last month's record breaking $14.6bn global bond issue for Deutsche Telekom was undeniably a landmark transaction in the credit market. Above all, the size and structure of the deal, offering considerable protection for investors, vividly illustrated the extent to which the market has matured over the past 12-18 months.
The Deutsche Telekom offering, led by Deutsche Bank, Goldman Sachs and Morgan Stanley Dean Witter, had been foreshadowed by others from issuers in the same sector, such as KPN of the Netherlands and Australia's Telstra. But bankers say that the Deutsche Telekom deal was perhaps the first of its kind in the European credit market to provide an almost perfect balance between the hefty borrowing requirements of the issuer and the increasingly sophisticated demands of investors acutely aware of event risk. As one analyst puts it, "over the last 18 months we have moved from what was clearly a sellers' market towards a buyers' market. The Deutsche Telekom deal was important in that it restored the balance of power between sellers and buyers in the European credit market."
It is not difficult to see why, in early 1999 at least, market conditions were so favourable for issuers in the European corporate bond sector. The launch of the single European currency at the start of 1999 unleashed unprecedented levels of demand among institutional investors for products offering a yield pick up over traditional instruments.
The main reason for this demand was the sharp fall in yields available in Europe's government bond markets, which forced even many of the world's most conservative institutional investors to step further down the credit curve than would have been imaginable five years ago. For example, analysts report that central banks starved of triple-A paper are becoming increasingly active players in the credit markets on both sides of the Atlantic.
At the opposite end of the spectrum from central banks, retail investors throughout Europe have also been turning their attention away from government issues and towards the corporate bond market. At Lehman Brothers in London, head of European fixed income sales Glauco Cerri points out that the trend among retail investors - especially in southern Europe - has increasingly been to park their savings with institutional fund managers, rather than to invest directly in government bonds no longer able to deliver double-digit returns.
"At the same time," adds Cerri, "domestic banks have recognised that asset management is a very good source of commission based revenue, and there has therefore been a big push by the banks, through their retail networks, to persuade depositors to switch out of government bonds and into institutionally managed funds."
Additionally, European financial institutions have looked away from their traditional markets to enhance their investment management capabilities. "There has been a tremendous phase of consolidation among institutional fund managers in the US," says Mark Howard, executive director of fixed income research at Lehman Brothers in New York. "But an even more noteworthy trend over the last year or so has been that European institutions have been huge buyers of US money managers that have 20 or 30 years' experience of investing in corporate bonds." As examples, Howard points to the recent acquisition of Pimco by Allianz, the deals that brought together Zurich Insurance with Scudder and with Kemper, and to UBS and Brinson, and UniCredito and Pioneer.
This trend has had an important impact on the European investment management industry. "The competition gates have been flung wide open," says Jim Merli, managing director and co-head of global syndicate at Lehman Brothers in New York. "Fund managers in Europe can no longer expect to operate within their own little insular worlds, but are increasingly aware that if they do not outperform the likes of Scudder and Pimco they will lose assets under management."
Heightened competition among fund managers in countries such as Italy is forcing institutions to travel further down the credit curve in search of enhanced returns, resulting in a striking migration away from government bonds into equities and corporate issues. According to figures published by Credit Suisse First Boston, Italian mutual funds' exposure to domestic bonds plunged from 54% in December 1998 to 31% in April 2000. Although much of this allocation has inevitably been replaced by investment into foreign equities, which rose from 13% of funds' total assets to 32% over the same period, a substantial amount has also been replaced by non-Italian bonds. These accounted for just 11% of the funds' assets at the end of 1997, but had climbed to 21% by April 2000.
Another critical by-product of the launch of the euro has been that institutional investors are much more prepared to look at cross-border opportunities that previously may have been off-limits because of concerns over currency and interest rate exposure. The new currency has created a level playing field across the eurozone that is encouraging investors to allocate assets at a pan-European level, based on a sectoral rather than a geographical approach.
Bankers say that two important technical changes are likely to drive increased demand for credit products over the coming years.
The first of these will be the growing use of indices more oriented towards corporate bonds than historically popular benchmarks dominated by government bonds. One of the anomalies of European fixed income investment is that a number of funds continue to benchmark their performance against domestic government indices. While this was a rational approach in the pre-euro era - as long as credits represented no more than a tiny proportion of an investor's total assets - it is becoming considerably less rational as more and more assets are being channelled into corporate bonds.
"In the context of the eurozone, we believe it makes little sense to use domestic indices," says David Munves, executive director of European corporate bond strategy at Lehman Brothers in London. "It is like having fund managers based in California using California-only indices when they can and do invest freely in bonds issued by companies located anywhere in the US. So those domestic indices should continue to decline in importance."
Traditional benchmarks may be a misleading guide to performance. "If you measure yourself against a government benchmark and buy a lot of corporate bonds, you expose yourself to an immense amount of tracking error risk," says Howard at Lehman Brothers. "In the US, consultants and plan sponsors have demanded that fixed income investors avoid this sort of risk. Increasingly I believe that the same pattern will evolve in Europe."
The second technical change that should promote increased investment in credits, say bankers, will be the new BIS framework for risk weightings. When introduced, this should cut the risk weightings of higher rated corporate bonds from 100% to 50% - which in turn should encourage a shift in banks' portfolio allocations towards the credit market.
Dovetailing with the dramatic increase in demand for corporate bonds has been an equally spectacular rise in supply - again driven by a variety of influences.
One of these has been the progressive reduction in the supply of government bonds in nearly all the leading capital markets - with the exception of Japan. This means that corporates are no longer crowded out of the market.
Government supply has fallen rapidly in the US and Europe. Between 1994 and 1999, according to figures published by Merrill Lynch, US government securities fell from 65% of the total US fixed income market to 53%, and the share of government debt in euroland fell from 54% in 1996 to 45% in 1999. The consensus among market analysts is that this trend will continue over the short to medium term. For example, according to projections made by JP Morgan, net debt issuance among the six largest governments in euroland will fall from Eu99bn in 1999 to Eu51bn in 2000, and to just Eu21bn in 2001.
This reduction in government supply is paving the way for issuance from corporate borrowers from either side of the Atlantic, but Europe has had the complementary impetus of the single currency. At Lehman Brothers in London, head of European debt capital markets Marco Figus is convinced that since January 1999 the euro has been the most important driver of increased corporate supply in Europe.
"We have had a credit market in Europe ever since 1961, when Autostrade launched the first corporate Eurobond," he says. "But the problem with the credit market before the introduction of the euro was that it was driven primarily by geographical divisions.
That meant that regardless of how strong individual companies were, they were always going to be capped by the credit ratings of the country in which they were based.
"ENI, for example, has always been a very strong credit, but because it was capped by Italian sovereign ratings it would have ended up having to pay more in the capital markets than French companies such as EdF or Total. Or take the example of Greece's Alpha Credit Bank, which is a highly profitable company with a return on equity of 32%. If it had been based anywhere else in Europe, it would have been rated at least as a strong single-A, if not as a double-A, but because of its location it was capped by Greece's triple-B rating."
Another element which will increasingly drive issuance in the credit market, say many analysts, will be a continued reduction in the availability of bank finance, which for most continental European companies has historically been the principal source of funding. "Banks are still shrinking the size of their balance sheets and restructuring of the European banking industry remains an important theme," says Emmanuel Weyd, head of credit research at JP Morgan in London.
"That will continue to reduce the capacity of banks to lend funds to the corporate sector, which in turn will support issuance in the corporate bond market."
While there is broad agreement among analysts that the European market for bank finance will continue to shrink, there is also a consensus that the speed with which it does so will vary from market to market.
As an example, take the differing views on the evolving structure of the Italian banking industry, and its potential impact on the corporate bond market in the country. At Lehman Brothers in London, executive director of fixed income syndicate Lorenzo Frontini points out that a period of rapid consolidation in the Italian banking sector is eroding close relationships between regional savings banks and local industry, which in turn is pushing up costs for borrowers in the loan market.
"Three or four years ago, Italian corporates would typically be shown loans by their local bankers at, say, Libor plus 20bp, when in the bond market they would have had to pay Libor plus 70bp," says Frontini. "Quite naturally, they would ask why they should pay 50bp more in the bond market. Today, when we are pitching bonds to new corporate borrowers, the capital market proposal is very much more in line with bank pricing. The loan may now be at Libor plus 50bp with the bond at Libor plus 60bp."
That still leaves the loan option cheaper than the capital market alternative, but, as Frontini says, CFOs of Italian companies are becoming increasingly alive to the ancillary benefits of the fixed income market. "Bonds are becoming much more competitive with loans," he says, "and CFOs who handle their companies' finances responsibly are recognising that the bond market is much more flexible and does not come with the restrictive covenants you usually see in the loans market. They are also recognising the value of diversifying their funding sources by accessing the capital market."
Others are not so sure that - even in a swiftly changing market like Italy - the loan market is losing its attraction quite as fast as this prognosis suggests. "Europe is still dominated by family owned companies - the Berlusconis, the Agnellis and the Quandts of this world - who have enjoyed close relationships with their bankers for 100 years or more," says one sceptic. "Of course if those bank lines dry up, or if commercial banks start getting very tough in terms of loan covenants, then there will be pressure to change. But I see no evidence that this is yet happening. As long as the domestic banks continue to knock on the doors of companies like Benetton throwing money at them at ridiculously cheap levels, what is going to force European CFOs to change their attitudes towards bank finance?"
Away from markets such as Italy, analysts say that highly liquid, state supported lenders, such as the Landesbanks, will continue to hinder the development of the European corporate bond market. One reason why an active market for Mittelstand credits has failed to materialise, say analysts, is that Landesbanks continue to fund them at below market rates.
Be that as it may, there is no question that the powerful cocktail of fast growing demand for corporate bonds and companies' hunger for increased debt finance led to a surge in issuance in 1999, especially in Europe. As analysts at Dresdner Kleinwort Benson commented in the bank's review of activity in the corporate market last year: "The establishment of the new euro bond market in 1999 has resulted in swift and dramatic market developments. These exceeded even the most optimistic scenarios with regard to the depth and breadth of both supply and demand of corporate bond new issuance."
According to Dresdner's figures, more than 400 corporate issuers raised over Eu154bn in 1999, compared with just Eu39bn in legacy currencies in 1998. Corporates accounted for 34% of all new euro denominated bond issues in 1999, compared with 18% in all legacy currencies in 1998.
Further underlining the impressive growth in the corporate market in Europe in 1999 was the rise in the average size of transactions, from Eu230m in legacy currencies in 1998 to Eu380m in 1999.
Unlike its high yield equivalent, the high grade corporate bond market in Europe is relatively well diversified. Although telecoms issuers accounted for the largest individual share of new issuance in 1999, accounting for 22% of volumes, and will clearly do the same in 2000, the sector's dominance of the high yield market was far greater, with telecoms and media companies accounting for more than 60% of issuance. Other sectors that were well represented in the high grade corporate market in 1999 included industrials (13%), utilities (10%), autos (9%), oil and gas (8%), retailing (4%), media (3%), and food and drink (2%).
It has not just been the industrial diversification of the euro denominated market that has impressed since the start of 1999. From an early stage, the depth of demand for credit in euros also proved that the market would be a fertile source of capital for non-European borrowers.
In January 1999, Xerox and Gillette established a template for other US issuers when each launched debut deals in the European currency. While borrowers such as these were clearly suitable candidates for issuance in euros, enjoying good ratings and strong name recognition, further diversification came in April 1999 when BBB+/Baa2
Enron became the first triple-B rated US corporate to tap the euro market, with a Eu400m deal via BNP Paribas and Lehman Brothers. Since then, a steady flow of other euro denominated offerings from US corporates has attested to European institutions' desire for geographical diversification.
Demand from European institutions for US credits has provided a fertile source of competitive finance for US issuers. "US borrowers are increasingly looking to the European market as an alternative source of finance," says Allen Cutler, managing director of debt capital markets for industrial issuers at Lehman Brothers in New York.
"US companies with European businesses are taking the opportunity to capture lower yields in the euro market through issues that do not have to be swapped back into dollars," he says, "and I expect the process to continue. US borrowers are comparing their costs of funding in euros versus dollars on an absolute coupon basis, and are seeing that they can pick up between 100bp and 150bp in savings in the euro market."
At the same time, bankers say that US borrowers are finding no more than a very limited bid for US dollar denominated credit among European institutions eager to build up portfolios in their new domestic currency. Even in the case of a magical name such as Wal-Mart, the world's largest retailer, demand among European accounts has been muted.
In August 1999, the company issued an inaugural $5.75bn global bond via Lehman Brothers, divided into two, five and 10 year tranches, which attracted total orders of more than $10bn, but very few in Europe. "We probably sold about 10% of the Wal-Mart deal in Europe," says Cutler, "and during the roadshow we continually heard that if we had been offering euros there would have been a much more enthusiastic reception for a credit that European investors are very comfortable with."
The geographical diversification of the euro sector has not been restricted to European and US corporates. In March 1999, Hutchison Whampoa became the first Asian corporate to access the market, with a Eu500m seven year bond via Deutsche Bank and HSBC. The same month also saw the first euro denominated transaction for a Japanese borrower, a Eu750m deal for AA/Aa1 Tokyo Electric Power led by IBJ, Paribas and WestLB.
Away from the market for corporate bonds, European institutions' appetite for enhanced yield has fuelled an expansion of the asset backed market. As analysts at Dresdner Kleinwort Benson noted in May: "More and more investors in continental Europe are turning to the ABS market, becoming more sophisticated and comfortable with the product. Asset backed securities are advancing as a very attractive asset class within the credit spread sector. This is reflected in spread levels, which have tightened since the beginning of the year when most other sectors widened."
Although Europe has been home to the most dramatic explosion of corporate issuance in recent years, the trend towards rapidly expanding corporate bond markets is a global one - even in those few markets where government supply is increasing. Japan, where the government bond market rose from ¥230tr in 1990 to ¥417tr at the end of 1999, provides the most vivid example of this. Outstandings in Japan's corporate sector rose from ¥31.6tr, or 8.2% of the bond market, in 1992, to ¥59tr (10.1%) at the end of 1999. Over the same period, the share of outstandings from financial issuers declined from ¥78.5tr (more than 20% of the market) to ¥56.7tr (less than 10%).
Elsewhere in the Asia Pacific region, corporate issuance in Australian dollars jumped from A$76.9bn at the end of 1998 to A$108.3bn by the end of 1999, from 28.6% of the total market to almost 36%. "The most notable development in Australian dollar debt is happening in the corporate sector of the domestic market," said an analyst at Merrill Lynch in a report on the global bond market.
But as impressive as growth has been in the corporate bond markets of Europe and several APR economies, their volumes are dwarfed by those in the world's largest and most liquid for corporate issuance: the US. According to figures published by Lehman Brothers, net corporate new issuance in the US market expanded from $96.9bn in 1996 to $232bn in 1999.
Nevertheless, looking to the longer term, analysts are convinced that there will be powerful growth in the European corporate bond market for many years to come. This will be driven in part by shifting demographic patterns in Europe. A report on private pensions in the eurozone published by Barclays Capital in February 2000 highlighted the impact that these trends will have on the corporate credit market in Europe over the medium term.
"Although it is likely that pension savers in the eurozone will have an overwhelming demand for equities, the growth in demand for financial assets will support fixed income markets as well," forecast Barclays' analysts. "This process should provide significant scope for the euro denominated private bond market to develop, particularly in the likely absence of sufficient growth in government debt.
"Even against the background of aggressive equity market reweighting, these developments alone are likely to prompt the euro credit market to grow by around 50% in the next 10 years. Other factors, such as M&A activity, suggest that this growth could be more rapid."