We expect further diversification of funding for several reasons.
- Limitations on bank capital and low bank return on equity
Basel 4 measures, which require banks to hold more expensive capital and more low-yielding, high-quality liquid assets, alongside broadly flattened yield curves, are lowering banks’ return on equity. Banks have therefore been forced to become increasingly selective in their lending decisions. This has resulted in a pick-up in loan market pricing and reductions in tenor over 2020, making bank debt relatively less attractive than in recent years.
- Loan covenants are becoming stricter
Corporate treasury teams have spent lots of time managing their bank groups in 2020, with covenant waivers and documentation amendments not uncommon. Less restrictive documentation may be possible outside the bank market, and this will have strong appeal. Even in the high-yield space, and particularly for “fallen angels” (previously investment-grade corporates that have fallen to high-yield status), we expect covenant-light capital markets to be considered attractive even if they are more expensive than more heavily covenanted structures.
- Pandemic diversification lessons
Early in the pandemic, we saw corporates try to identify all possible sources of liquidity. For many, accessing the Bank of England’s CCFF or similar schemes elsewhere marked their first foray into the capital markets. Many corporates that previously did not consider commercial paper or the wider public capital markets as a funding option have established programmes that will remain alternatives to drawing down revolving credit facilities (RCFs). Similarly, corporates set up new legal entities in other jurisdictions to access other capital markets.
“By mid-December 2020, around £15 billion of CCFF drawings currently outstanding will become due in 2021”
By mid-December2020, around £15 billion of CCFF drawings currently outstanding will become due in 2021. Of course, capital markets will not absorb all refinancing – surplus cash and other deleveraging strategies will play their part. However, we expect corporates considering their refinancing needs in 2021 and beyond to think about pre-funding in the capital markets, or at least pre-hedging – given curve steepening risks and currently favourable funding conditions. Indeed, as inflation becomes a key consideration next year, corporates experiencing longer-term effects from the pandemic may suffer both wider credit spreads (due to a lower credit rating) and the risk of higher debt funding costs.
While credit spreads can be managed through an improving credit position (via debt reduction, asset disposals, hybrid and equity capital, and strategic initiatives), the risk of rates rising can be mitigated through opportunistic pre-funding. Capital markets and the macroeconomic backdrop remain supportive, and early 2021 should provide a window of opportunity to pre-fund upcoming needs.
There’s also ever-growing demand for green bonds as investors seek to lend to companies contributing to the United Nations Sustainable Development Goals. This is covered in an article by our colleague Arthur Krebbers, but the key point is the growing pricing benefit for green borrowing relative to non-green debt, and the ‘halo effect’ this can have – where the cost of all debt for the same borrower is reduced.