In part, the divergent strategies reflect the differences in domestic rate levels but also the starkly different mandates applied to corporate treasuries on each side of the pond.
By the start of this month, issuance volume of investment-grade fixed-rate bonds in the US was 160% of 2014 volume over the same period, according to Dealogic. A similar trend has emerged this year for floating-rate debt, although the volumes are much less.
Investment-grade issuance by European corporates through May, on the other hand, was only 89% of 2014 volume for fixed-rate debt and 69% for floating-rate debt, despite benchmark rates hovering close to zero. Their floating rate issuance, at US$21.8bn through early June, fell just a few billion dollars short of US floating-rate issuance, although between 2010 and 2014 it was well above. European companies’ US$160.8bn in investment-grade issuance through June 4 was just over half of US issuers’, at US$315.4bn, although the two regions’ volumes had tracked much more closely in previous years.
Corporate issuance of high-yield, fixed-rate bonds by US issuers through June 4 has also picked up, at 125% of 2014’s level, while issuance of high-yield, floating-rate debt – a tiny fraction of fixed-rate – plummeted. European companies’ issuance of fixed-rate, high-yield debt was 72.7% of last year’s volume and less than half of US issuance. Their issuance of high-yield, floating rate debt through June 4 was only 40.6% of the previous year’s for the same period, although at a mere US$3.7bn it was still more than twice issuance by US companies.
In short, America’s multinationals are continuing their bond issuance splurge – far outpacing European companies, which have already had ample time to bulk up on funding at historically low costs.
Mandate from the Board
“European corporate activity has slowed in recent weeks,” reports Frazer Ross, managing director of Deutsche Bank’s global risk syndicate desk that focuses on corporate issuers. “They’ve seen rates in this zero to 1% range for close to a year, so even though rates got very close to zero, the current low rate environment has been around for some time,”
He adds that many European companies are given parameters by their boards in terms of what debt durations and mixes of floating- and fixed-rate debt to aim for. A European proclivity for floating-rate exposure – even though European rates have nowhere to go but up – likely explains the higher portion of debt that is swapped to floating-rate. Ross says the more recent uptick in floating-rate notes issued by European companies is the result of their more competitive pricing compared to fixed-rate bonds in the two-to-three-year part of the yield curve.
“We had a recent mandate from a client who wanted to do seven- or eight-year fixed-rate bonds, and they ended up with floating, because that’s what their board said they had to do,” Ross adds.
Much of the issuance in Europe – Ross estimates up to two-thirds – has been by US corporates seeking to take advantage of such low rates; behemoths including AT&T and Coca Cola. US companies have mostly increased their issuance of fixed-rate debt since 2010, while issuance of floating-rate debt peaked in 2013 and has since declined. Those numbers, however, are somewhat deceiving, since at least some of those investment-grade companies are swapping their fixed-rate debt to floating-rate.
“We’ve seen activity and dialogue pick up on swapping fixed to floating, and we’ve actually executed a few recently, after not having done so in quite a while,” says Damien Matthews, a managing director at Morgan Stanley who focuses on corporate-interest rates and foreign-exchange (FX) risk management.
Yields on the 10-year Treasury tightened significantly in 2014, from as high as 3% at the start to closer to 2% by year-end, and rates plunged below 1.5% in January. They trended up in April and May, reaching as high as 2.28% in the middle of May, when corporate interest in swapping to floating was perked by the steepening yield curve.
Rates trended as low as 2.14% toward the end of May, then jumped in early June to reach 2.31% June 4. If the 10-year rate continues to increase and the yield-curve steepen, Matthews says, he would anticipate more corporates swapping their fixed-rate exposure to floating rate.
Logic behind the Swap
At first glance, swapping to floating-rate in a rising rate environment, instead of holding on to historically-low fixed rates for an extended period, appears counterintuitive. However, in recent years US corporates, taking advantage of such low rates, have focused on building up their fixed-rate exposure. It varies by company and industry, but most US corporates want to retain some floating-rate exposure as a hedge. The flat yield curve until recently, however, has made swapping to floating-rate unattractive, given the swap issuer essentially receives the fixed-rate and pays the floating-rate.
“As the curve is starting to go the other way and steepen, you’re starting to get better entry points,” says Matthews. “If the 10-year should increase to 3%, I’d expect to see a lot of [fixed-to-floating swap] activity.”
The market for floating-rate bonds in the US is smaller and less liquid compared to its fixed-rate counterpart, at US$39bn in 2014 against US$477bn in fixed-rate.
“We’ve spoken to some of the large issuers in the industrial sector, who say they’re going to issue whatever investors want and then swap to floating or not, depending on the companies funding structure,” says Lance Pan, director of research at Capital Advisors Group.
Volumes in the US clearly illustrate investors’ preference for buying fixed-rate debt. That may shift if rates continue to rise- volume through June 4 for investment-grade, floating-rate bonds already makes up 110% of 2014 volume over the same period. Pan adds that two-year floating-rate paper that resets every three months pays a premium compared to paper refinanced every three months, giving investors a double whammy of benefits.
From an investor perspective, Pan says, floating-rate debt “should be a part of a core strategy regardless of where rates are going, and especially in a rising rate environment.”
Another way for corporates to increase their floating-rate exposure is to increase their commercial paper programmes. However that route is only open to corporates with high credit ratings, and concerns remain about refinancing the short-term funding should the capital markets lock up – as they did in the first part of 2009.
Matthews says another factor prompting US corporates to swap to floating – besides their view on rates – is that floaters provide a natural offset for a part of their business; for example, significant cash trapped overseas and placed in very short-term investments. “It more properly balances your asset-liability mix.”
Swaps for non-investment grade companies, on the other hand, can be prohibitively expensive. In addition, those companies typically have little excess cash but plenty of floating-rate bank debt, prompting them to hold on to any fixed-rate exposure they accrue.
“Because they’re more leveraged and less able to tolerate swings in their interest-rate costs, non-investment grade companies want more fixed, so they’re more likely to do floating-to-fixed rate swaps,” says Matthews. If the yield curve continues to steepen “we may see more activity in the US swap space going in both directions, but from two different client sectors.”
Sitting on Cash
European companies, despite generally favouring more floating-rate exposure, have been holding on to their fixed-rate debt and trying to extend it as far out as investors permit.
“If people are able to finance longer and cheaper, and on easier conditions than they ever thought they’d be able to, why wouldn’t they?” asks John Grout, the London-based Association of Corporate Treasurers’ (ACT) policy and technical director, adding that the risk of rates falling further is very low.
Another aspect, he says, is that many of Europe’s big companies, like their US counterparts, are sitting on significant cash as they want it on hand for opportunities and acquisitions, and because they don’t trust the banks and capital markets to be open for lending the day they need the capital. Companies with significant cash and debt can effectively fund maturing debt. When the markets are open and debt can be refinanced, they can keep the cash on hand; when they are closed and refinancing is impossible, the cash can be used to pay down debt.
“It changes somewhat a company’s view on rates,” says Grout. “It’s now more interested in managing the spread between the borrowing costs and the return on cash than the cost of the debt.”
The slowdown in issuance by European corporates against their US peers, Grout says, is likely because European companies tend to be less proactive, with board members setting long-term policies and treasurers seeking to fulfil them, rather than taking positions on where rates are headed.
Ross agrees that European corporates are less likely to swap to more floating-rate exposure if the yield curve steepens. “It’s not as fluid as that in Europe,” he says. “Boards put policies in place for a number of years, and whether rates move from 0.5% to 1%, it tends not to change much from a treasury perspective.”
Why the difference? Grout, who previously held treasury positions at three U.K. companies, noted that fewer corporate treasurers in Europe are ex-bankers. “Most corporates measure their cost of capital in percentage points, perhaps to one decimal place, whereas bankers look at margins in fractions of a basis point,” he says. “So it’s a different appreciation of risk.
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