By Joseph Neu
An improving economic outlook dims prospects that low rates will continue—as if they can—forever. Almost as soon as the Fed reaffirmed its Zero Interest Rate Policy (ZIRP) at its January 24-25 Federal Open Market Committee Meeting, signaling it would last through 2014, there has been a renewed effort to promote the storyline that low rates can’t last. Even Fed Chairman Ben Bernanke was forced to admit recently that if the economy continues to beat expectations, the outlook underlying ZIRP might also change. It’s as if he was also telling treasurers to issue more bonds now before it’s too late to get record low rates. But how many will stop to consider first what they will do with the proceeds and prepare their firms for the day when cheap capital comes to an end?
Party on
On March 2, average yields on investment grade bonds fell to a record low of 3.27 percent, according to the Financial Times, and junk bonds have done pretty well too, averaging 7 percent. This could be the spring of new issues both for blue-chip names that cannot resist a record low on a fresh issuance or lesser credits looking to diversify funding sources away from deleveraging banks.
The continuing party mood in bonds is especially good news for Europe, where bank deleveraging is most accelerated and where corporates tend to be more reliant on bank financing.
Several European issuers have also capitalized on US demand for yield by issuing in dollars. Germany’s Fresenius Medical Care AG, for instance has issued $8.8 billion in USD debt so far this year, more than half of what it issued in all of last year. The recent split issue by another German issuer, Schaeffer, shows the appeal of USD issuers. According to Bloomberg, Schaeffer issued a EUR800mn slice yielding 6.5 percent, while the $600mn piece yielded just 6.1 percent.
This is welcome news for investors too. Yield pick up without adding credit risk is the guiding principle for many these days. Research by Bank of America Merrill Lynch suggests that relative yields on European speculative-grade debt are averaging 222bps more than similar-rated US debt, compared to just a 77bps differential last year.
And USD issuance by European corporates is just the most basic example of the kind of “riskless” arbitrage firms are exploiting as investors of all kinds rethink global asset classes in terms of credit risk. As they do so, however, they must also contemplate, as investors are, what to do when the current central bank-catered party stops.
until it’s roped OFF
If money is free, or nearly so, issuers cannot expect to purchase as much over time with the proceeds of their debt issuance, nor will investors with their meager pick up in gains. And even before inflation kicks in, the ability to make productive use of proceeds will recede.
In a brief article in February of last year, McKinsey’s Richard Dobbs and Michael Spence posited what would happen when the era of cheap capital draws to a close:
Currency rates would get out of whack.
Instead of following fundamentals, they would react to hot-money investors’ moves to find yield.
In response, governments will become ever more restrictive of capital outflows.
Each country will want to keep their own party going as others’ parties start to lull.
In other words, instead of just currency wars we might start to see efforts to find yield or exploit favorable currency trades met with the exploited country seeking to wall off its capital.
Or, as one treasurer summed it up recently, every country in the world might start to look like Venezuela. You might still raise money pretty cheaply, but if you try to deploy it anywhere else they will not let you. You will be forced to keep it there until inflation eventually eats it away.
This sort of scenario is one that all treasurers should contemplate carefully before considering their next issue or investing in their next foreign security. It is all well and good to issue new, cheaper debt to retire more expensive debt or replace bank credit. And it is equally fine to pick up yield as an investor via foreign assets. Just make sure you have a use for the proceeds in that jurisdiction. Preparing for the end of cheap capital will be as much about matching up sources of capital in places where you have real capital needs as it is about chasing basis points.