European credit markets show first signs of revival
Following the worst first half in many years for European credit markets, there are tentative signs of recovery with the euro-aggregate index rising 4% in July, its best month ever.
The improvement reversed a similar-sized loss in June, which punctuated a 13% drop in the first six months of 2022 for supposedly safe investment-grade bonds. Predictably the summer season means that there are only a handful of new corporate bonds being sold, but there are signs that activity will accelerate as the second half of the year progresses, in contrast to the record 33 days of zero issuance so far this year.
Rising interest rates coupled with a sustained widening of credit spreads of corporate bonds over government benchmarks have produced difficult market conditions for all companies outside of the highly liquid well-known names. Even these must be attractively priced to succeed, as the premium that issuers have to offer over existing debt increased substantially from the boom period of 2020 and 2021.
The prolonged era of negative yields that even some highly rated companies enjoyed is now over and the landscape for fixed income is very different, with the European Central Bank (ECB) ending sub-zero rates and winding down its quantitative easing (QE).
Several deals last week show that household names with an attractive credit spread are being enthusiastically received by investors despite the summer lull. Sweden’s Volvo sold €500 million of five-year notes (see next story below) while French multinational Cie. de Saint-Gobain SA brought a three-part €1.5 billion deal, including a sustainability-linked 10-year. Scottish energy company SSE PLC sold a €650 million-euro seven-year green deal that saw an order book nine times the issued security. Green-linked bonds accounted for 23% of total issuance this year, down from 27% in 2021, but conditions are not comparable.
The Covid-19 pandemic heavily impacted primary debt markets when it hit in March 2020, with the resulting massive fiscal and monetary stimulus creating a surge in debt raising, with commensurate investor demand to match. So there is currently much less pressure for funding, but the vacuum is temporary, and while underlying yields and credit spreads are certainly more elevated than at the start of 2022, the new normal has to start somewhere. A fairer comparison, it’would be to assess this year’s total with 2019 and earlier.
Corporate treasurers must factor in two elements when deciding whether to borrow in the bond market. First, underlying market interest rates: The benchmark German 10-year bund yield started this year at minus 11 basis points but soared to 1.77%. With yields now around 1%, it is considerably less scary to test where new funding levels might reasonably be.
The second element is the yield premium that riskier companies have to offer above governments, which has also subsided. The iTraxx five-year euro investment grade credit default swap index, which was less than 50 basis points in early January, peaked at 127 basis points in mid-July, but has fallen back close to 90 basis points, meaning that the cost of raising funds for mainstream companies has typically reduced by over 100 basis points in the past month.
However, as we head towards winter Europe’s energy crisis is expected to intensify, and there are also potentially market-moving Italian parliamentary elections due on 25 September. Additionally, the ECB’s second-quarter bank lending survey showed loan credit standards tightened considerably for consumers, especially on residential mortgages. Access for wholesale bank funding also deteriorated which will be a key concern for the ECB should it deteriorate further.
September will provide an important test of investor appetite, particularly whether the freezing of QE has been fully priced in. The ECB, which sits on €344 billion of investment grade corporate debt, reinvests maturing bonds into the market at the rate of over €2 billion monthly and about a quarter of that has been invested into primary deals.
Nonetheless, the overall buying impact is significantly diminished, as the ECB is no longer adding about €5 billion monthly of new purchases. However, investors should welcome the absence of the biggest buyer crowding out much of the available liquidity float in European investment grade.
Analysts believes that provided market volatility remains subdued, the second half of 2022 should be substantially more active for corporate debt supply. While borrowing costs are highly unlikely to once more become as cheap as in 2021, the recent market calming has made yields bearable for companies, while sufficiently attractive for investors to once more test the water.
Volvo dives into Europe’s sluggish corporate bond market
Swedish carmaker Volvo AB believes that Europe’s seized up market for new corporate-bond issues is still open, provided the returns are high enough to attract investors.
The group surprised the market last week by issuing a five-year note that drew orders for six times the deal size
Volvo Treasury AB, the manufacturer’s financing arm and one of Sweden’s biggest corporate-bond issuers, attracted more than €3 billion (US$3 billion) of bids for a €500 million note- a coverage ratio of six times, according to an inside source. The demand allowed Volvo to slash the spread offered to buyers at a time when sales of corporate debt in Europe are plunging and markets are recovering from the steep bond selloffs since the start of 2022.
The bonds will price at a spread of 53 basis points above midswaps, well below its opening target of about 85 basis points. The revised pricing is about nine basis points above Volvo Treasury’s outstanding debt curve, according to data compiled by Bloomberg.
The deal provides a test of a market where European businesses have been hesitant to borrow, as rising interest rates from central banks worldwide and resurgent inflation fuel concerns about a steep drop in economic growth. That resulted in one of the slowest markets for new bond issues in Europe in years, with sales by nonfinancial corporations down about 40% from 2021.
Bloomberg reports that the Volvo sale is the first from a European firm outside the finance industry since 2 August and comes after a global rally pushed a gauge of corporate default risk to the lowest in more than two months.
Volvo Treasury’s sale is the borrower’s third foray into Europe’s publicly syndicated debt market this year. A 2025 maturity euro note priced by Volvo Treasury in May has tightened about 20 basis points since it was issued.
India’s PM Modi promises digital revolution
India’s prime minister Narendra Modi has promised that his country’s digitisation initiatives will transform education, health care, and agriculture, as it expands the optical fibre network and gears up for the nationwide launch of 5G services.
Speaking at celebrations to mark the 75th anniversary of India’s independence, Modi said “Today we are all set to enter the 5g era. We are ensuring that optical fibre reaches every village until the last mile...The dream of Digital India be attained through rural India,” he said, listing his government’s plans for the programme.
Launched in 2015, the Digital India initiative aims to expand India’s digital economy through inclusion and empowerment. The Ministry of Electronics & IT has set up common services centres (CSCs) to deliver citizen-centric services. Modi said it had also created over 400,000 local entrepreneurs. While almost 60% of India's rural population have yet to start actively using the internet, the overall number of active Internet users across the country is expected to rise by 45% over the next three years, reaching 900 million by 2025
As of June 2022, a total of 531,203 CSCs were operational across the country, of which 420,198 CSCs were operational at ‘gram-panchayat’ or village level and equipped with broadband connections under the BharatNet scheme to deliver last-mile connectivity.
However, according to recent media reports CSCs had stopped operating and maintaining BharatNet’s fibre optic cables and equipment in June, due to the company’s overdue payments According to a recent report by IAMAI-Kantar, internet usage is growing in villages but understanding the technology remains a challenge.
While stressing the growth of start-ups and the innovation ecosystem, Modi said the people behind these companies come from smaller cities and villages and that India is an “aspirational society” where changes were being powered by a collective spirit.
The prime minister also praised India’s world leadership in real-time digital payments, where it accounts for nearly 40% of all transactions, helped by the Unified Payment Interface (UPI) and India’s fintech sector.
ESMA urges caution on new foreign clearing house rules
One of the most senior officials responsible for the regulation of foreign clearing houses in the European Union has warned that mooted EU policy could “worsen the status quo” by driving swaps clearing further away from European supervision.
The European Commission is pushing ahead with new legislative proposals designed to accelerate the post-Brexit shift of derivatives clearing – especially euro-denominated interest rate swaps – from the UK into EU central counterparties (CCPs) such as Eurex. But Klaus Löber, chair of the European Securities and Markets Authority (ESMA) says the policy risks backfiring as euro swaps trading may simply move away from CCPs that face the toughest EU scrutiny.
After Brexit, the EU said it would not allow EU market participants to clear euro derivatives in London after June 2025, citing a need to end its heavy reliance on that market in the same way the bloc is cutting dependency on Russian energy.
Brussels is reported to be working on a law for later this year with “incentives” to move euro clearing from the London Stock Exchange (LSE), which dominates euro clearing, to Eurex Clearing in Frankfurt, using a likely mix of mandatory and voluntary measures.
However, Eurex’s chief executive Erik Mueller has also stressed that relocating euro clearing from London to the EU must be “market-led” rather than mandatory, and believes the shift is already well underway. Speaking at the IDX derivatives industry conference in June, Mueller, Chief Executive of said market participants want competition and Eurex now accounts for €27 trillion euros (US$27.4 trillion) in euro swaps contracts, a 20% market share.
“The trend is clear,” Mueller told conference delegates, adding that the “pie” will grow to swell volumes further.“We will keep pushing for a market-led solution that would be the best outcome for everyone.”
ESG’s role in FX analysed
Environmental, social and governance (ESG) challenges have become a dominant theme in global financial markets, according to Dutch financial services multinational ING Group. Yet in the context of foreign exchange, the points of contact with ESG are still very much evolving.
In a newly published white paper, ESG in FX: The current state of play, ING’s team of Chris Turner, Antoine Bouvet and Jaems Wilson consider, where ESG has found a footing in FX, where it can grow, and the roles to be played by both the public and private sectors
“Financial market derivative products linked to ESG continue to evolve and as in other asset classes, those in the FX space typically involve two counterparties agreeing on ESG key performance indicators (KPIs),” the team notes.
“Should the client meet those KPIs (usually assessed annually by an independent third party such as an auditor) then the client would either secure a cheaper hedging cost on, for example, a strip of FX forwards or in some cases a cash rebate depending on the amount of FX hedging business done in a year – the latter effectively a loyalty scheme contingent on ESG goals being met.
“A further scheme being looked at by some participants is the integration of ESG metrics into FX counter-party considerations. Those metrics could generate reductions for fee-linked products (e.g. FX algorithms) or indeed affect the pricing of a counterparty’s access to FX liquidity. This could see banks offering FX pricing incentives to clients with better ESG ratings and equally clients allocating business to banks based on the banks’ own ESG ratings.
“Constraints to the further growth in some of these initiatives could be the lack of homogeneity in the KPI metrics, where each client requires their own specific ESG targets. Greater take-up in these products could require some move towards standardisation of ESG benchmarks, although the regulation of benchmarks in derivatives remains a minefield.
“Another challenge in the FX space is that the industry works on fine margins, meaning that the scope for rebates and the financial incentives to meet ESG targets may not be as large as in some other asset classes or products.
The paper concludes that several touch points exist between ESG and the FX industry. However, while progress has been made, a move to the next level probably requires an even greater push towards green assets in the public sector. The team recommends tracking developments at the Network for Greening the Financial System, which has written on the topic.
“Equally, the financial incentives have to be present in the private sector,” the authors add. “The good news is that the FX industry is heading in this direction and the challenge will be how regulators can support this progress too. Expect a lot more transparency on this subject with the introduction of the European Commission’s Sustainable Finance Disclosures Regulation (SFDR), which comes into force at the start of 2023.”
Scotiabank, BNP Paribas launch Latin America structured products
Canada’s Scotiabank has launched through its Mexican unit Quanto peso (MXN)-denominated structured notes linked to MSCI Food Revolution and Ageing Society Indexes. The offerings mark the first-ever launch in Latin America of structured products linked to custom MSCI indexes, bringing innovation and diversification into the Mexican market.
The structured solution, commercialised by French bank BNP Paribas, provides an investment approach that seeks to identify long term, structural trends that could drive stock performance in a rapidly changing world.
The structured notes are based on two MSCI custom thematic indexes designed to represent the performance of various broad investment themes. The two indexes are the MSCI USA IMI Ageing Society Select Index, which includes companies catering to the health, recreation and lifestyle needs of older populations, and the MSCI USA IMI Food Revolution Select Index, which includes companies associated with new products and services focused on improving the way food is produced and consumed.
BNP Paribas customised the indexes with a target volatility mechanism “that will dynamically adjust the level of equity exposure depending on market volatility. With growing client appetite towards volatility control strategies, BNP Paribas and Scotiabank are providing these Quantitative Investment Strategies in Mexico.”
The structured notes will be issued at three years, offering a leveraged exposure on the performance of the indexes at maturity. According to a Scotiabank release: “The innovative investment solution will provide exposure to US companies that are leaders in serving senior populations through healthcare, financial services and other industries, as well as companies tackling sustainable and responsible farming, food technology and zoonotic disease migration.”
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