Debt Capital Markets – A Review of the Big Picture
Jonathan Price looks at how big picture financial trends have impacted markets globally
It is hard to have much sympathy for bankers. Cossetted by high salaries and by pensions that most of us can only dream about, they seem insulated from the real world where people struggle to make ends meet and live in fear of the call from the debt collector. In boom times, such as the period 2001-2007, bankers often succumb to hubris, believing themselves to be super-human merely by virtue of the large sums of money they have made.
A well known example of this phenomenon was Jean-Marie Messier, CEO of Vivendi SA which started out as a boring French water utility, but under Messier’s leadership ballooned into a media empire. Messier was not shy about trumpeting his achievements, boasting in his autobiography, “Don’t ask a CEO to be modest. The costume does not fit him. Strong ego, not to say an outsized one is more becoming…”[i]
Nemesis, the goddess of retribution, waits for such people, and the bankers of Europe have had two doses of punishment from her. First, the Global Financial Crisis of 2008/2009, triggered by the collapse of Lehman Brothers, but caused by the Collateralised Loan Obligation (CLO) market; followed swiftly by the Eurozone crisis of 2011/2012.
The impact of these crises can be seen by looking at some big picture numbers. Total global financial assets, which in 1980 represented 120% of global GDP, had by 2007, the peak year, risen to 355% of GDP, equivalent to US$206 trillion according to McKinsey Global Institute. In 2008 total financial assets fell to $189 trillion and have since recovered to $225 trillion by the end of Q2 2012. The annual rate of growth since 2008 has been around 2% p.a. compared to the rate of growth prior to 2007 of nearer 8% p.a. Relative to GDP, total financial assets have fallen 43% since 2007 or 54%, McKinsey calculates, if government debt is excluded.
The ratio of financial assets to GDP is a measurement of the depth of the world’s financial system, so we can say that the world is a lot shallower today than it was in 2007. This may not be an entirely bad thing if we consider a little further what caused the depth to increase in the first place. McKinsey estimates that fully 37% of the increase in the depth was caused by financial institutions borrowing to fund their growing asset base. By 2007 the bond issues by financial institutions were five times as big as those by non-financial institutions. Borrowing by households and non-financial corporations amounted to only a quarter of the increase in financial assets, an astonishingly low number if one considers that the whole point of having a capital market is to allocate capital for productive uses.
The period since 2007 has also seen a sharp reduction in cross border capital flows, particularly in Europe, where for obvious reasons, banks have become nervous about lending to other EU countries. The prospect of an exit by one or other country from the EU and the consequent forced conversion of assets from Euros to a re-created national currency is the stuff of nightmares for banks and institutional investors.
The fall in cross border capital flows consists of a drop in flows from advanced countries to developing countries. The picture for flows between developing countries is different. The level of what is sometimes referred to as South-South capital flows has been increasing, as has South to North investment by developing countries in mature economies, as typified by Chinese purchases of US Treasury bonds or Tata’s purchase of Jaguar LandRover.
How have these big picture trends affected borrowers and lenders at ground level? The reluctance of banks to lend to corporates, particularly small and medium sized companies, is well documented and this has driven borrowers to find alternative sources of capital. Those companies that are large enough to do so, have turned to the corporate bond market to raise capital, often even if they had no immediate need for funds. Finance directors prefer to tap the market when it is open and keep a pile of cash for a rainy day or as a war chest for acquisitions. Small companies are increasing turning to the burgeoning peer to peer and crowd funding website such as www.fundingcircle.com.
Companies that have a debt rating find it much easier to issue corporate bonds than unrated companies, and it is interesting to note that, whereas some years ago the minimum acceptable rating for a corporate issuer in Europe was BBB, these days BB and B rated companies find a market for their bonds. In fact the strong desire for yield from institutional investors allowed Euro 21.4 billion of high yield bonds to be issued in the first quarter of 2013. The market also responded positively to several new issues of CLOs and to four issues with PIK toggles, where interest can be paid by issuing new notes, rather than in cash at the option of the borrower. European companies have also been borrowing actively in the US capital market where liquidity is greater and the covenants in the terms and conditions can be less onerous.
Are these developments a sign of a return to the bad old days of boom and bust? It is foolish to make predictions about such matters, but one can be re-assured to a certain extent by the fact that the most active issuers of bonds today are non-financial institutions, so the debt capital markets are at least for the time being, performing the function that they were created to do.
[i] Gaughan, P.A. (2011) Mergers, Acquisitions and Corporate Restructurings, Wiley, New York p171
Jonathan Price is an Associate Lecturer at LSBF
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Jonathan Price, Associate Lecturer at LSBF, holds degrees in Law (from Cambridge University) and EU Law (from the Université Libre de Bruxelles).
After being called to the bar in 1981, he studied Accounting & Finance and practised as an investment banker for 25 years. In 2011, he was appointed a Chartered Fellow of the Chartered Institute for Securities & Investment.