Mark Lewellen, head of European corporate origination at Barclays Capital

China has had an inflationary spike, Australia is raising rates and more are expected to follow suit. This has prompted a flood of bond issuance from businesses and governments ahead of fears about rising rates. When more central banks signal that they are in a neutral and tightening mode, what will this do to the debt capital market? Writer Joanne Hart

January 2010 started with a bang. New decade, new era, new mood. Bond issuance was buoyant, spreads continued to tighten and everyone believed the end of the downturn was nigh. However, barely four weeks into the new year, the atmosphere in the markets began to sour. It started in the Balkans.

On January 25, Greece launched its €8bn five-year bond, attracting more than €20bn of orders. The issue was priced at a spread of 350 basis points (bps), considered high but fair. But within a few days of launch, the spread had widened substantially and by early February there were fears of an imminent crisis.

Even as it became clear that Greece was too big to fail and stronger members of the eurozone would have to help out if necessary, market sentiment remained on high alert. Within the EU, Greece is not the only eurozone sovereign saddled with huge amounts of debt and a faltering economy - Spain, Portugal and Italy are also suffering and are likely to continue in that vein for several years. Adding grist to the mill, Moody's said the US's AAA rating was not sacrosanct - if the US failed to handle its budget deficit appropriately, its rating would suffer.

Investors were relatively unfazed by Moody's threat, but the juxtaposition of its statement and the situation across southern Europe highlights the key issue in the credit markets for 2010 and beyond: the enormous and pressing need for capital.

Hurdles ahead

"Prospects in 2010 are not good. The elephant in the room is southern Europe and its sovereign debt schedule. Then there is the question of Germany's manufacturing industry and even in the US there are fears that recovery will take longer than originally thought. All in all, markets are finely poised right now," says one senior banker.

Doom and gloom prevailed early in 2009 as well, following on from a desperate fourth quarter in 2008. During the first few weeks of last year, markets were almost exclusively the preserve of highly rated sovereigns, supranationals and government-guaranteed financial institutions. But the mood soon changed and 2009 turned into a bumper year, particularly for sovereigns and corporates. They needed capital and investors had plenty to offer. Interest rates were low so borrowing costs were reasonable for issuers and institutions were incentivised to look for yield so they were keen to snap up bonds with a spread over money market rates.

This year, however, the mood is slightly different. Last year, credit spreads were effectively priced to perfection. Now the gloss is coming off. The change of sentiment is particularly acute with regard to sovereigns and banks.

"The market is driven by a significant amount of refinancing from financials and new financing for the public sector. There is a wall of financing coming over the next two years," says Roger Thomson, European head of debt capital markets at HSBC.

Supply and demand

Credit markets are not dissimilar from any other markets. A glut of supply on the sell-side affects buyers' appetite and the price they are willing to pay. So, if a mountain of issuance is expected, the cost to issuers will rise.

"Investors will be able to demand - and receive - good spread levels," says Paul Reynolds, head of Middle East debt and equity advisory at Rothschild.

The situation for financial institutions is undoubtedly challenging. They face a withdrawal of government guarantees and government funding, a dormant securitisation market and an increase in capital requirements from the regulators.

"There is simply too much supply. This is likely to create a real pressure on spreads as the market focuses on the maturity mountain," says David Lyon, managing director of the financial institutions group at Barclays Capital.

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Paul Reynolds, head of Middle East debt and equity advisory at Rothschild

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Diane Vazza, head of global fixed-income research at Standard & Poor's

Growing concerns

The difficult environment is exacerbated by concerns over inflation and interest rates. "The outlook for inflation is bearish. Interest rates will almost certainly have to rise in the UK and Euroland, but the question is when? Policy-makers, politicians and borrowers would like that moment to be put off for as long as possible. Regulators and central bankers want to pre-empt inflationary pressures without strangling recovery. It is not an easy situation," says Mr Reynolds.

The situation is not easy for issuers or investors. Despite recent jitters, spreads have narrowed substantially since the financial crisis erupted, hence the surge in issuance during the second half of 2009. In February, spreads began to widen, but they were still far lower than they were 15 to 18 months ago.

"Since their record highs in December 2008, investment-grade spreads have tightened in the range of their five-year moving average of 197bps," says Diane Vazza, head of global fixed-income research at Standard & Poor's.

Unsurprisingly, therefore, most issuers - be they sovereign, quasi-sovereign, financial or even corporate - want to access capital now, while interest rates are low and spread levels are reasonable. Investors, however, are of a different mindset. Many would prefer to wait and see how the year progresses, knowing that if interest rates rise, yields will almost certainly follow suit while any signs of inflationary pressures will impact the price of existing paper.

"Investors are uncertain about the future so many are thinking: let's wait because we will probably be able to buy better later," says Mr Lyon.

Standard & Poor's chief European economist Jean-Michel Six sums it up neatly: "In 2009, demand exceeded supply. In 2010 and 2011, the equation will reverse, leading to increased volatility and rising rates."

Volatility has many consequences, not least a mismatch of expectations between buyer and seller. In the equity markets, large initial public offerings for Travelport and clothing chain New Look were very publicly postponed in mid-February. In the debt markets too, a couple of issues were quietly pulled. "There was almost certainly a disagreement between the issuers and the lead managers," says one senior banker.

In another instance of friction, one of the most conservatively run banks in Europe issued a five-year bond of less than €2bn. The paper was placed with more than 200 institutions. Optimists might interpret this as a sign of intense demand. More percipient observers concluded that lead managers had to bring in as many investors as they could because each was prepared to take only a small allocation.

"In 2009 there was almost a feeding frenzy. Bonds were massively over-subscribed, almost regardless of rating. This year, there is much more evidence of stock-picking. Certain credits are in favour. Others are not," says Martin Egan, global head of primary markets at BNP Paribas.

Some of the credits most in favour can be found, perhaps ironically, in the corporate sector. Although these have traditionally been viewed as higher-risk than public sector or financials, events of the past two years have changed the dynamic.

Sovereign debt

Sovereigns and financials are now hugely indebted. Investment-grade companies seem rather robust by comparison.

"The sovereign sector has been volatile, with spreads coming under pressure. Investors continue to see well-rated corporate bonds as a safe haven," says Mark Lewellen, head of European corporate origination at Barclays Capital. "Investors are looking for safe assets, so there is considerable demand for A and AA credits, as well as well-known names across the rating spectrum," he adds.

Investors are also doing far more of their own leg work, choosing to analyse and investigate issuers themselves rather than rely on credit rating agencies' assessments.

"Issuers have to work harder and processes take much longer than before the crisis. They have to make a good investment case and they have to treat investors and prospective investors well," says Mr Reynolds.

"For first-time issuers, a lot more work is required and the execution process, from announcement to pricing, takes longer. Asset managers have to get approval before investing, so whereas bond issues used to be tied up in a matter of days before the crisis, now it takes one or two weeks," says Mr Egan.

New environment

In the heady days of 2006 and early 2007, approval processes were far less prevalent and both issuers and lead managers became used to an environment in which the seller was king. Now that the balance has shifted, issuers are having to court investors rather more.

"Debt IR [investor relations] creates real value these days. Issuers should not underestimate the time and resource needed to sell their credit. A couple of years ago, investors were just asked: do you want to be in or not? Now, issuers are spending time with investors, delivering presentations, going on roadshows and preparing the necessary due-diligence reports," says Mr Reynolds.

There is a clear logic behind all this activity. Once, not so long ago, issuers from across the spectrum could source capital directly from the banking market. So in Europe, about 80% of issuers' capital requirements were satisfied by the banking market and just 20% by the bond markets. Now the ratio is shifting.

"Bank lending is constrained by regulatory and capital pressure. Borrowers want flexibility so they will use whatever markets are open to them. Traditionally, the US has had much more of a bond culture than Europe, but the trend is changing. Many European companies are accessing the bond markets for the first time. In the US, about 80% of financing is done in the bond markets. We are a long way from there, but we are moving in that direction," says Mr Egan.

Many companies are also looking for ratings for the first time, aware of the need to diversify away from bank debt and satisfy institutional investors that they are an interesting and rewarding credit.

"The key trend is the diversification away from bank debt. Companies want to mitigate against the risk of relying on a few banking relationships," says Mr Lewellen.

For many companies, it is not just a question of wanting to diversify - there is a pressing need for them to do so. Bank capital is in short supply and likely to remain so for several years, which means that few issuers can simply refinance bank debt when it falls due.

"In the non-sovereign sector, issuers can't just hope for the best as bank loans come to maturity. They want to put liquidity risk behind them. They want to reassure creditors and shareholders that they have sufficient capital behind them and they are not that concerned about cost," says Mr Reynolds.

"In the past, issuers were very concerned about spreads. Now they just want to know where they can get money. Risk management is far more [at the] front of [people's] minds than cost management," he adds.

The thesis makes sense. Corporates tend to issue debt once or twice a year, so paying a few extra basis points to secure medium- or long-term financing is relatively painless, particularly when underlying interest rates are so low. Many of the stronger corporate credits are also hoping to snap up weaker competitors over the coming months.

"In a world where there are significant numbers of distressed credits, the opportunities should be plentiful. But companies need to be prepared, or their financing or opportunity costs could be very material," says Mr Reynolds.

"Companies are looking to raise money for corporate finance, be it capital expenditure or even merger and acquisition activity. They are not going to source all their capital in the bond markets versus the bank markets, but the pendulum will be a lot more finely balanced than in the past," says Giles Hutson, co-head of European fixed income at Morgan Stanley.

Need for capital

Corporates may be willing to pay a little more for credit. For sovereigns and financials, however, the dynamics are different. Their need for capital is far more intense and their status in the market is far more significant. Most market participants believe the more highly rated issuers in this space will still be able to access funds. Lower-rated issuers may find the markets less forgiving. On the sovereign front, there is a widespread expectation that southern European credits will find the going tough this year and moving into 2011. Northern European sovereigns may have a slightly easier time, but even for them investor appetite is expected to remain moderate and attitudes will be questioning.

As one banker says: "People were buying indiscriminately last year. But this year will be different. There will be some beneficiaries, but there will also be some who suffer. The days of 'I lend, I bang chest, I do bond' are well and truly in the past."

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