Wednesday, September 05, 2012

Corporate Bond Issuances in Europe’s Economic Periphery Face Challenges

Bloomberg: Santander Defies Spain Woes to Sell First Bonds Since March
FT: Peripheral Corporates Eye Bond Sale Window
MarketWatch: Cash-rich Mull Spanish, Italian Corporate Bonds
Reuters: Bond Comeback No Easy Feat for Spanish Corporates
Reuters: DBRS Downgrades Spanish Banks After Sovereign Rating Cut
WSJ: Beware a Corporate-Bond Reversal

Some corporations headquartered in Europe’s economic periphery, which includes Spain and Italy, have experienced difficulties issuing corporate bonds since the first quarter of this year. Other peripheral companies have recently been able to issue corporate bonds, but at much higher interest rates than in the past. Corporations typically issue interest-bearing bonds (bonds that periodically pay interest) to investors in exchange for money. They use this money to refinance existing debt, fund operations, or invest in growth. However, uncertainty surrounding the European sovereign debt crisis has limited investors’ demand for these types of bonds throughout much of 2012.

Investors’ hesitation is due in part to the increased likelihood of downgrades in sovereign debt credit ratings. Countries, like Italy and Spain, issue debt to investors and private credit rating agencies, such as Moody’s and DBRS, publish ratings assessing the investment quality (risk) of that debt. They also rate the debt issued by private companies. A rating agency might downgrade a country’s debt to “junk” status (the lowest grade) if it believes a country will default on its debt (be unable to repay debt or make interest payments). This downgrade will negatively impact the ratings for corporate debt issued in that country. This is because rating agencies often link the debt rating of a company to the debt rating of the country where it is headquartered.  For example, DBRS recently downgraded Spain’s debt to an “A (low)” rating due to its poor economic outlook. As a result of this downgrade, DBRS automatically downgraded several Spanish banks to an “A” rating, one notch above Spain.

Due to their higher risk of default, junk bonds must pay a higher interest rate to investors than investment grade (non-junk) bonds. A downgrade to junk status is problematic for corporate bonds because many investment fund managers are prohibited by fund prospectuses (legal agreements with investors) from investing fund resources in more risky assets, such as junk bonds, despite their higher interest rates. These fund managers must instead focus on less risky and more liquid, or easily tradable, investment grade bonds. According to Bank of America Merrill Lynch, there are approximately €200 billion of investment grade corporate bonds traded in Italy and Spain. If these countries are downgraded to junk status, there would likely be too few investment funds willing and able to invest in junk bonds to absorb this amount of downgraded corporate debt.

Thankfully, many companies in peripheral countries have plenty of cash on hand to operate in the near term without issuing new bonds. However, if investors remain mostly unwilling to purchase new corporate bonds due to the risk of sovereign downgrades in the coming months, it could cause several problems. First, peripheral companies will eventually need to issue new bonds to successfully refinance existing debt. Second, credit rating agencies worry companies without the ability to issue new bonds could run out of money to pay off existing debt and fund future operations. Thus, in order to keep strong debt ratings, credit rating agencies require companies to prove they still have the ability to issue new debt to bond investors. Finally, if companies in Europe’s periphery have trouble issuing new bonds, or can only issue bonds at relatively high interest rates, it could make them less competitive in the long term. These companies would have higher overall interest costs and less ability to expand and grow than companies headquartered in Europe’s economic core—e.g., Germany.

Although they are in the periphery, some Italian and Spanish corporations have recently benefitted from increased investor demand for their bonds. Spurred on by the European Central Bank president Mario Draghi’s remarks that he would do “whatever it takes” to support the euro, some investors are turning to corporate bonds issued by large, financially stable corporations in peripheral countries to put their growing cash holdings to work. For example, Italian bank UniCredit SpA issued €750 million in bonds on August 14. In Spain, Banco Santander SA raised €2 billion from the sale of bonds on August 21. These were the first transactions of their kind since the first quarter of 2012 in either country. Throughout the rest of 2012, analysts expect corporations in Europe’s periphery to issue as much as €10 billion worth of bonds.

Despite the recent increase in investor demand, even financially strong peripheral companies are paying significantly higher interest rates on debt today than they were one year ago. This also is primarily due to the risk of sovereign downgrades in the near future. For example, many investors and analysts fear Italy or Spain could be downgraded to junk status as early as this month. The fear of a sovereign downgrade for Spain is one of the reasons investors demanded Banco Santander pay them an interest rate on the bonds it issued in August that was 1.4 percentage points higher than on bonds the bank issued in March. Given these high interest rates, it is unclear if other financially strong companies in Europe’s periphery, including Spain’s Telefonica, will take advantage of the increase in investor demand and issue bonds in the near future, or wait for more favorable market conditions to return.

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