Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

Primary Credit Analysts: Taron Wade, London (44) 20-7176-3661; taron.wade@standardandpoors.com Yann Le Pallec, Paris (33) 1-4420-6725; yann.lepallec@standardandpoors.com Secondary Contacts: Stefan Best, Frankfurt (49) 69-33-999-154; stefan.best@standardandpoors.com Karlo S Fuchs, Frankfurt (49) 69-33-999-156; karlo.fuchs@standardandpoors.com Rob C Jones, London (44) 20-7176-7041; rob.jones@standardandpoors.com Moritz Kraemer, Frankfurt (49) 69-33-999-249; moritz.kraemer@standardandpoors.com

Table Of Contents
Riskier Borrowers Find It Easier To Tap The Debt Capital Markets Public Agency Issuers Also Benefit From The ECB's Open Market Transactions Issuance From Financial Institutions Is Likely To Remain Muted Although 2013 Has Been Broadly Positive For European Issuers, Risks Remain Related Criteria And Research

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility
It has been a busy start to the month for nonfinancial corporate borrowers, sovereigns, and public agencies issuing debt in the European capital markets. In Standard & Poor's Ratings Services' view, the flurry of activity suggests that borrowers are trying to pre-empt the possibility of the market becoming increasingly volatile over the next few months. Already, fears over the end of quantitative easing in the U.S. and nervousness over geopolitical risks have caused 10-year Treasury yields to rise. (Watch the related CreditMatters TV segment titled "European Issuers Flock To The Capital Markets," dated Sept. 12, 2013.) Many of the big European public agencies are set to sell benchmark bonds this fall, including, for the first time, the European Stability Mechanism, which the EU established in 2012 to provide financial assistance to member states. At the same time, the pipeline of nonfinancial corporate borrowers planning to refinance bank debt with speculative-grade bonds continues to grow. But we believe that issuance from financial institutions will remain muted, because market access for European banks has become more costly. In addition, we consider that investors will be hesitant to buy new issues until they see the results of the upcoming asset quality review by the European Central Bank (ECB) and the European Banking Authority (EBA) stress text next year. Overview The European debt markets may become increasingly volatile over the next few months, as 10-year Treasury yields have started to rise. Borrowers may be trying to pre-empt the potential disturbance a sharp rise would create in the credit markets by issuing debt this month. Lower-rated corporate and public borrowers--including those in Ireland, Italy, Portugal, and Spain--have gained improved access to the capital markets this year. However, issuance on the bank side has been subdued. Nevertheless, borrowers across all markets continue to face credit risks, including an elevated default rate for corporate issuers, ongoing regulatory uncertainty for banks, and possible policy reversals for sovereigns in particular.

Credit risks for all borrowers in the coming months include material downside to the economic recovery in Europe, a large public and private sector debt overhang, and therefore the possibility of larger-scale restructurings.

Riskier Borrowers Find It Easier To Tap The Debt Capital Markets

Lower-rated borrowers, including those located in what is known as the European periphery--Ireland, Italy, Portugal, and Spain--have been able to gain access to market funding at better rates and terms this year. This is partly thanks to the ECB's measures at the end of last year to ease credit conditions through its open market transactions, whereby the

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

ECB purchases government bonds from eurozone members. Nonfinancial corporate issuance has been especially healthy this year, and in the first half of 2013 is 12% ahead of 2012 volumes. The biggest driver of this is refinancing. An uncertain economic outlook has made nonfinancial corporate issuers cautious, prompting them to extend their debt maturities and reduce their reliance on bank funding. At the same time, there has been a dearth of mergers and acquisitions, which goes some way to explaining the lower volumes of investment-grade issuance in the first half of the year. In the year to Aug. 15, 2013, the percentage by volume of issuance from companies Standard & Poor's rates in the 'A' category declined to 34% from 45% from the same period in 2012, while issuance from companies we rate 'B' or 'BB' increased to about 10% from 5% (see chart 1).
Chart 1

The market for new issuance became much more subdued in May this year after Ben Bernanke, Chairman of the Federal Reserve, hinted at a potential end to quantitative easing. Nevertheless, speculative-grade issuance stayed strong over the summer, including notably a number of Italian and Greek companies refinancing bank debt through the bond markets. Anecdotally, it appears to us that disintermediation--which we believe will be a multi-year process--is happening faster in some of the peripheral European countries than in Germany or France, where banks remain more willing to lend. However, many of the highly leveraged companies that aren't tapping the public markets--in many cases legacy leveraged buyouts (LBOs) from the last economic cycle--continue to battle with tight covenants and may

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

need restructuring. This is why the default rate in Europe remains elevated, at 7.5% for the 12 months to the end of June 2013. The default rate had been declining from a peak in 2009, but this year crept back up to above 7% for the first time since the second quarter of 2010. However, even before September had started, nonfinancial corporate investment-grade deals came back, with 8 billion of issuance in the last week of August, and 14 billion in the first week of September, including the first hybrid issuance from an automaker, Volkswagen AG. This strong return of nonfinancial corporate investment-grade issuance could signal fears of increased volatility later this fall. At the same time, we believe that investors will continue to demand higher premiums for the debt of lower-rated issuers than the premiums we saw before Ben Bernanke's comments in May. This is because the market still has fundamental concerns about the pace of economic recovery.

Public Agency Issuers Also Benefit From The ECB's Open Market Transactions
Public agencies on the European periphery also gained popularity with investors in 2013, particularly investors looking for diversification from sovereign debt. The ECB's open market transactions appear to have successfully reduced risk premiums and borrowing costs in government markets. Ireland, Italy, Portugal, and Spain have all placed bonds this year, with Ireland taking steps to return to regular monthly auctions before year-end. Although we see a solid pipeline of benchmark bonds scheduled for this fall, public debt issuance is generally frontloaded during the calendar year. Consequently, the fact that this issuance doesn't yet match that in the first half of 2012 indicates to us that volumes will be lower for the full year (see chart 2). Similar to nonfinancial corporate issuers, public agency issuers may try to issue early in the fall due to the potential end to U.S. quantitative easing and the increasing political uncertainty.

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

Chart 2

One credit risk we see for sovereigns is that their relative ease of access to the capital markets could lead them to conclude prematurely that the region's troubles have passed. This could result in the fragile agreements among European policymakers unraveling and the shelving or watering down of previously agreed actions. Governments' correction of budgetary imbalances still has years to run in several eurozone countries. If investors doubt the strength of the governments' commitments to these corrective measures, governments may find themselves forced to intensify austerity again, with all the social risks that would entail. For more information on European sovereign borrowing this year, see "European Sovereign Borrowing Looks Set To Decrease Modestly In 2013, While The Debt Stock Peaks At An All-Time High," published April 18, 2013, on RatingsDirect.

Issuance From Financial Institutions Is Likely To Remain Muted

For banks, 2012 was the first year that the amount of maturing unsecured debt exceeded the amount of new issuance in Europe (see chart 3). According to our research, in the first half of 2013, unsecured new debt issuance was only about one-third of total new volumes in 2012.

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

Chart 3

Market access for banks in Europe has become more difficult and costly over the past few years, and we see disparities between the core of Europe and the periphery. The average cost of unsecured debt for Italian and Spanish banks has steadily increased, and using Dealogic data, we've computed that it's now up to 300 basis points higher than German and French banks' unsecured debt costs in 2013. To close this funding gap, banks are attracting more deposits, slowing loan growth, increasing their use of private placements, and deleveraging to reduce their funding needs. There are many factors that indicate to us that bank debt issuance will remain muted over the next few quarters. We believe deleveraging will continue on the periphery of Europe, which is consistent with what we are seeing on the nonfinancial corporate side. Furthermore, several European banks are struggling with the new capital and leverage ratios as part of Basel III. And in terms of demand, investors are keen to get the results from the upcoming ECB asset quality review and the EBA stress test next year before investing in new transactions from the banks. We still see material downside risks to the economic recovery in Europe, and because of the public and private sector debt overhang, there's also a risk of larger-scale restructurings. For banks, the changing nature of government support to avoid future bail-outs with taxpayers' money is contributing to the higher cost of, and reduced access to, unsecured debt. Ring fencing--or separating the trading activities of large European banks from their deposit-taking businesses--could have similar implications, because it makes investors uncertain about which entity they are lending

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

to in the long run. So overall, we foresee that bank issuance will remain at about the same, or possibly lower, levels over the next nine to 12 months. For more details on funding conditions for financial issuers, see "Despite Relatively Calmer Markets, Systemic And Specific Funding Risks For Banks Have Not Gone Away," published July 18, 2013. Regulation could also impair insurers' ability to contribute to economic growth, including their appetite for investing. Proposals for insurance regulation reform under Solvency II may lower sales of long-term life insurance policies, reducing insurers' appetite to invest in matching long-term debt instruments. In our view, insurance companies are concerned that the proposed capital requirements under Solvency II are not economically justified compared with other investment classes. The uncertainty about these proposals explains the delays in the implementation of Solvency II to 2016 at the earliest. For more information, see "Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains," published July 31, 2013. Furthermore, there has been a large drop in covered bonds issuance this year, for similar reasons to the drop in unsecured debt (see chart 4). However, we could see a slight uptick in the rest of the year because net negative issuance suggests that investors are sitting on cash. Nevertheless, we don't expect issuance of covered bonds this year to reach 2012 levels. So far, we've only seen about 45% of last year's volumes, and therefore they might reach only two-thirds of 2012 issuance by the end of this year.
Chart 4

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Inside Credit: European Corporate, Sovereign, And Public Agency Issuance Surges In September, Ahead Of Potential Volatility

Although 2013 Has Been Broadly Positive For European Issuers, Risks Remain
Both nonfinancial corporate and public borrowers have benefited from improved access to the European debt capital markets over the past year, particularly lower-rated borrowers and issuers located in the European periphery. Issuance from banks, meanwhile, has been subdued. Despite the easier access for some European borrowers, borrowers across all markets still face credit risks. The default rate for nonfinancial corporate issuers is still above 7%, due to legacy LBOs, while banks face ongoing regulatory uncertainty. At the same time, we believe that sovereigns' relative ease of access to the capital markets could contribute to complacency about the strength of an economic recovery and consequently, to policy reversals. And while we anticipate that the capital markets will remain busy at the beginning of the fall, this could be due to increasing nervousness about the potential end to global quantitative easing, as well as geopolitical risks.

Related Criteria And Research

Europe's Insurers Welcome EIOPA's Assessment On Long-Term Guarantees, But Solvency II Uncertainty Remains, July 31, 2013 Despite Relatively Calmer Markets, Systemic And Specific Funding Risks For Banks Have Not Gone Away, July 18, 2013 Inside Credit: Q&A: Tracking The Evolution Of The European Leveraged Finance Market Post Crisis, July 18, 2013 Sovereign And Bank Downgrades Are Weighing On Covered Bond Ratings, July 18, 2013 Inside Credit: As The Pace Of Dividend Recaps Accelerates In Europe, Transactions Remain Selective, May 30, 2013 European Sovereign Borrowing Looks Set To Decrease Modestly In 2013, While The Debt Stock Peaks At An All-Time High, April 18, 2013
Additional Contact: Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com

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