The resurgence of the corporate bond market is providing companies a unique opportunity to rethink their capital strategies.
The corporate bond market has been booming of late. With issuance rocketing upwards and yields at historic lows, nimble companies have been able to dip into a deep pool of remarkably low-cost capital. But look beyond the short-term fluctuations of the market, and a deeper change is underway.
The corporate bond is fast replacing bank finance as the funding source of choice. Already, the bond markets have replaced bank credit as the main provider of net new debt for UK businesses, according to the Bank of England.
The imperative for companies is to understand how the immediate appeal of bonds and the structural move in favor of bond finance affect their capital raising and optimization strategies. When rivals are locking down their medium-term funding needs at remarkably low cost, now is not the time to be stuck on the sidelines.
Will the pool dry up?
The absolute yield on investment-grade corporate bonds fell to 3.55% in October, the lowest since at least 1986. The total cost of finance is down too, and global corporate bond issuance is running at or near record highs. It's tempting to think that these favorable conditions are here to stay, so the decision on whether to access the market can be deferred. But hesitation could prove a costly mistake.
It is true, up to a point, that the drivers behind low-cost bonds are likely to be with us for a while. Bond market conditions are favorable for two reasons. Western governments and central banks have been injecting cash into their moribund economies via quantitative easing, hoping to accelerate a recovery. The figures involved are huge.
The US alone has provided $2.3t of new money. Such action forces down the cost of bond finance, and while economic recovery in the developed world remains fragile, the possibility of further quantitative easing should not be ruled out.
Governments have also shored up banks by providing almost unlimited liquidity support. Commitments under the UK financial sector bailout, for example, total £846b in share purchases, loan guarantees and insurance cover. No doubt policymakers would like to withdraw such support as soon as possible. But that's probably not an option in the near term.
Nevertheless, while bond market conditions are likely to remain favorable for some time, they may not remain quite as appealing as they are now. There are clouds on the horizon. Chief among them is the risk that the Eurozone's sovereign debt crisis will spread or that inflationary concerns will grip investors.
To date there's been a clear correlation between bond yields and the development of the Eurozone's difficulties. With the bailouts of Greece in May and Ireland in November we saw yields on investment-grade Euro bonds rise significantly. Further contagion would likely push yields even higher.
Investment-grade Euro bond yield
Source: Bank of America Merrill Lynch
Three capital trends
Given these market conditions, we expect to see an increasing number of companies acting to optimize their capital strategy while they can. There are three trends to watch:
- More companies will raise bond finance to execute share buy-backs, replacing equity finance with lower-cost debt. Indeed, the volume of US share buy-backs in the first half of 2010 jumped 139% to $133.9b, according to Morgan Stanley.
- The scales will tip in favor of increased M&A activity, as companies seek to buy additional capacity and sell non-core businesses. There hasn't been a noticeable uptick in deals yet, which is understandable — the cost of funding is only one of the factors that should drive an M&A decision. Nonetheless, the availability of lower-cost finance will make its presence felt at some point.
- More companies will use bonds to fund organic investment and refinance their existing liabilities, as they try to be as lean and profitable as possible.
Who is left out?
The pool of low-cost bond finance is not available to all companies. While yields are low even for those with below AAA credit ratings, smaller companies — and especially those in out-of-favor sectors — remain heavily reliant on bank debt. In the UK, for example, bank loans still account for 76% of corporate debt finance.
Bank lending to such companies is less available and more expensive than it used to be. In the US, for example, rates on commercial and industrial loans of less than $100,000 climbed half a percentage point to 8.95% by August 2010. Moreover, US banks cut their lending in this category by 11.3%, according to the Federal Reserve.
Companies in this bracket face a different challenge. They need to look beyond bank debt to alternative sources of funding, such as the private placement market. A growing number are doing this already.
But overall, current market conditions mean companies have a unique opportunity to optimize their medium-term financing needs. And they should not wait. A company's ability to raise capital quickly and effectively is integral to its growth potential.
Those that are slow to secure new financing or to refinance existing debt may find that it becomes increasingly difficult or expensive for them to do so.
The bond is back: make the most of it while it lasts.