EU Banks Boost

Good Morning,

The European Central Bank is bailing out the region’s bond market and, in doing so, boosting beleaguered banks.

The ECB’s announcement last week to increase corporate bond buying to 80 billion euros per month triggered a rush of companies stampeding to lenders and looking to finance deals. Anheuser-Busch InBev followed up on a $46 billion bond deal by issuing more than 13 billion euros of debt to European investors this week, a boost for banks in Europe that worked on the deal. Deutsche Telekom also priced a 4.5 billion-euro deal.

Getting a flood of corporate bond issuances to close out a first quarter when banks globally came under fire for the quality of their energy loans has the potential to reverse an ugly trend before earnings are reported.

“The banks are poised for some rebound,” said Julien Jarmoszko, senior investment manager at S&P Global Market Intelligence. “The European banks are a lot stronger than they used to be.”

Right now, the euro-denominated bond market is as frothy as it’s ever been. More than $38 billion in investment-grade deals were done so far this week, according to Dealogic. With one day to go, the all-time high of $44 billion in issuances, from mid-2008, is well within striking distance (Dealogic’s data tracks back to 1995). Further, jumbo transactions have fueled this rise in issuances. There have been only 25 euro-denominated bond issuances this week, compared to 72 deals in 2008 when the record was set.

While the bond market has turned around in Europe, banks are still waiting for a rebound in their share prices.

Similar to U.S. banks, which saw shares hammered in trading to begin 2016, EU bank stocks plummeted to begin the year. The iShares MSCI Europe Financials ETF, which invests in banks including Allianz, HSBC, UBS and Lloyd’s Banking Group, has fallen more than 17 percent over the last 12 months and nearly 9 percent so far in 2016, but it factors in a rebound more than a month ago as global markets and bank stocks bounced back from the worst of investor fears.

EU banks themselves rushed to make issuances after news of the central bank’s plans broke. UBS raised fresh contingent convertible bonds earlier this week, considered the riskiest class of bank debt, and banks including Deutsche Bank and the Royal Bank of Scotland also reportedly sought to sell bonds.

MCF Consultants see other silver linings for European banks, as well.

Despite dour news for investment banking divisions — American banks’ share of European investment banking revenue recently hit a high not seen since 2000 — EU banks can take solace in that they have increasingly elbowed U.S. banks away from deal financing.

This year, European banks’ wallet share for leveraged lending grew to 80 percent of the market as of last Friday, according to Dealogic. That is compared to a piddling 11 percent of wallet share for leveraged lending for U.S. banks. It’s the greatest disparity in this category since 2008, when EU banks dominated a whopping 86 percent of the leveraged lending market, the highest amount Dealogic recorded since 1995.

The same goes for investment-grade deals in Europe: As of Thursday, Europe banks accounted for 73 percent of the wallet share of investment-grade deals, representing a high not seen since 2011.

But U.S. banks haven’t been totally left out by the ECB’s surprise stimulus.

“More buying of U.S. bonds by European investors following the ECB’s easing announced last week should support demand for [investment-grade] paper going forward,” BofA Merrill Lynch Global Research analysts wrote this week.

As always,

Stay away from the rocks.

The Lighthouse Keeper keeps watch with MCF Consultants.

Foreign Bonds – What , Why How .

Good Morning,

Today’s spotlight falls on Foreign Bonds and an insight in to how the set up works.

When a sovereign government needs to borrow to fund its operations, there’s a distinct advantage to issuing debt in its own currency. Namely, if it has trouble repaying bonds when they mature, the treasury can simply print more money. Problem solved, right?

As it turns out, there are limits to this approach. When governments rely on an increased money supply to pay off debt, an approach known as seigniorage, the currency is no longer worth as much. If bondholders earn 5% interest on a bond, but the currency’s value is 10% lower as a result of inflation, they have actually lost money in real terms.

When investors worry about inflation and, therefore, demand high interest rates, countries might have to issue debt in a foreign currency. This is a particularly common strategy for emerging and developing markets around the world. Often, these governments will choose to denominate bonds in more stable, marketable currencies. It’s typically easier to sell debt this way, as investors no longer fear that devaluation will erode their earnings.

“Original Sin”
However, the inability to control the money supply is a double-edged sword for the investor. While it offers protection against inflation, it also limits the government’s options to repay in the event of a financial crisis.

Borrowing in a foreign currency also exposes them to exchange rate risk. If their local currency drops in value, paying down international debt becomes considerably more expensive. Economists refer to these inherent challenges as “original sin.”

These risks came to light in the 1980s and 1990s, when several developing economies experienced a weakening of their local currency and had trouble servicing their foreign-denominated debt. At the time, most emerging countries pegged their currency to the U.S. dollar. Since then, many have transitioned to a floating exchange rate to help mitigate their risk. The theory, MCF Consultants believe is that a decline in the local currency will make the nation’s exports more attractive and therefore stimulate growth.

Today, the near-zero interest rates that many developed countries are actually offering has heightened demand for foreign-currency bonds. In fact, a number of governments have issued such debt for the first time in recent years because of the relatively low cost of borrowing. Angola, Mongolia, Namibia and Zambia have all introduced foreign-denominated bonds with significant success.

The potential pitfalls of original sin put pressure on government leaders to reign in their deficits. If the government isn’t able to increase revenues or lower its level of spending over time, there’s always a risk that it could default. However, building the political will to implement these painful measures can be challenging.

Countries often attempt to postpone serious belt-tightening by simply rolling over their debt – that is, issuing new bonds to replace those that reach maturity. But if investors begin to lack confidence in its management of finances, they’re likely to look for other investment opportunities or demand higher yields.

Measuring Risk
For these reasons, government bonds – and particularly those issued in a foreign currency – tend to draw a high level of scrutiny from investors. After all, with no international bankruptcy court where creditors can claim assets, they have little recourse if the country defaults. Frequently, they will try to avoid this outcome by offering to renegotiate the terms of the loan. Even then, they’ll likely take a hit.

Of course, there are compelling reasons for a country to make good on its obligations. Failure to pay bondholders can ruin its credit rating, making it extremely difficult to borrow in the future. Naturally, countries have an incentive to build a strong reputation for creditworthiness so they can borrow at lower rates. And if its own citizens hold much of the national debt, defaulting can make government leaders vulnerable at election time.

Yet defaulting on government debt is not an altogether uncommon occurrence. Argentina proved unable to pay its debt beginning in 2001 and took several years to regain its financial footing. Venezuela, Ecuador and Jamaica are among several countries that also defaulted – albeit for shorter periods of time – in recent years.

Pinpointing signs of an impending default is no easy task. Investors frequently use debt-to-GDP ratios, which look at a country’s borrowing level relative to the size of its economy. While outstanding debt is certainly an important piece of data, economists have debated its usefulness in the absence of other factors. For example, Mexico and Brazil defaulted in the 1980s when their debt represented 50% of GDP. By contrast, Japan has kept its financial commitments despite carrying a roughly 200% debt level in recent years.

Consequently, evaluating a variety of factors is important. This is precisely what credit rating agencies such as Moody’s and Standard & Poor’s do when they grade the debt of sovereign governments around the globe. In addition to looking at the country’s total debt burden, they also assess its economic growth prospects, political risks and other factors. Governments with a higher rating are typically able to market their debt at a lower interest rate. Some economists also suggest looking at a nation’s debt-to-exports ratio, as selling abroad provides a natural hedge against exchange rate risk.

In Conclusion
Sovereign debt represents roughly 40% of all bonds worldwide, so it’s an important part of many portfolios. However, it’s important to understand the potential risks before deciding to buy, particularly when notes are issued in a currency that the government can’t control.

For investors seeing very little return on debt from developed countries, there’s often a temptation to seek higher returns elsewhere. Emerging nations that are new to the international bond markets can be particularly enticing.

While emerging markets as a whole carry less debt than in years past, some economists are concerned about the inconsistent track record from this part of the world. Looking at a variety of risk factors – and paying attention to what multiple credit rating agencies say – can be a worthwhile exercise.

Stay away from the rocks.

The Lighthouse Keeper keeps watch with MCF Consultants.