Following the ECB shock, European firms face higher borrowing costs

After the ECB’s surprise pivot toward tighter monetary policy, European companies hoping to fund M&A and capital expenditures on bond markets this year face a sharp increase in borrowing costs and wary buyers. Bond issues are an important source of funding for businesses, and their importance has grown in relation to bank loans in the eurozone, particularly since the financial crisis. Bond yields on investment-grade (IG) European firms have risen by 60 basis points as a result of European Central Bank President Christine Lagarde’s hawkish tone following the bank’s February meeting, which opened the door to rate hikes this year.

Euro credit had been less affected by the January volatility caused by the Federal Reserve’s hawkishness in the United States, with IG bonds delivering less than half the losses in the United States. However, since the ECB, yields have more than doubled to as high as 1.18 percent, the highest since May 2020, according to BofA. Although this is still extremely low, a sudden increase in borrowing costs is significant. If this trend continues, it may have an impact on companies’ ability to invest, slowing economic growth, so central banks are keeping a close eye on credit spreads.

IG spreads rising to 150-175 basis points (bps) from around 110 bps currently would prompt the ECB to take a dovish stance, according to nearly half of investors polled in BofA’s February credit investor survey. Many see a rise in European corporate bond sales this year as a result of a mergers and acquisitions boom and a need for capital investment; JPMorgan, for example, expects a record 645 billion euros of IG issuance. While such moves are insufficient to derail those expectations, Helene Jolly, head of Deutsche Bank’s EMEA IG corporate syndicate, said borrowers and investors were adjusting to “the new normal.”

“Corporates have had to look at the new levels of coupons that are being required due to the rates being paid… and investors have had to think about what does this mean for me, what’s my outlook on rates now, and where do I want to play,” Jolly explained. Sentiment has shifted quickly: according to the BofA survey, only 16% of European credit investors are net long on IG debt, the lowest level since 2019 and down from 27% in December, while corporate debt funds are holding more cash than they have in years.

According to Refinitiv IFR data, companies raised around 9 billion euros in the two weeks following the ECB meeting, which is comparable to volumes raised in the single week preceding the meeting. Several sessions resulted in zero issuance because many companies borrowed cheaply and abundantly during the pandemic, there is no concern about their ability to refinance debt, even for “junk” issuers. According to IFR, only two junk bond issuers have sold bonds since the ECB. The vast majority of issuance came from Cerved, an Italian credit management and data group that raised the majority of its funding through a floating-rate bond. As interest rates rise, these compensate investors.

With the ECB expected to stop buying bonds in September, issuers may have to start selling them soon. Last year, the ECB purchased over 70 billion euros of corporate debt, accounting for roughly 6% of its total purchases during that time period According to BNP Paribas, IG spreads have widened by more than 25 basis points this year, and the additional premium companies pay for new bond sales is already higher than the average since 2015. According to Viktor Hjort, global head of credit strategy at BNP, an upcoming rush for M&A and capex-linked borrowing could widen spreads by another 15 basis points.

“Corporates have a significant need for spending, particularly capex, which is unsustainablely low… so the credit market will have to fund a capex cycle while also dealing with a demand shock,” Hjort explained. According to Refinitiv Datastream, the average coupon on BofA’s index exceeds its yield in the junk market, which is critical for financing leveraged buyouts, so new issuance will cost firms more than the interest on their current debt. Higher yields, however, are not expected to derail borrowing.

According to Shanawaz Bhimji, strategist at ABN AMRO, firms’ total returns from equity this year will exceed the current cost of equity even if net debt costs much more than current rates, so they should continue investing in M&A and capex. Borrowers may opt for shorter-term financing or issue floating-rate notes to reduce funding costs, according to bankers, and such patterns are already emerging on some deals. “Issuers will have to be realistic about the cost of debt,” JPMorgan’s Thompson said.