ey - credit markets 2015–16

Credit Markets 2015–16Analysis and opinions on global credit marketsIssue 3

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Credit Markets 2015–16

02 Thank you

04 Foreword

08 Leveraged finance

14 Investment grade

22 Mid-market and corporate

28 Asset-based lending

30 Global credit rating outlook

33 Global interest rate outlook

36 Further insights

Contents

2 Credit Markets 2015–16

Thank you!

Welcome to our third issue of EY Credit Markets and our first including contributions from our wider global EY Capital and Debt Advisory team.

We would like to thank those clients, colleagues, lenders and other market participants who have provided feedback to the team on previous issues of this publication. Your comments have played an important role in guiding the content of this issue, including its global focus.

EY Credit Markets is a publication we are proud of and one that we hope you find of value. Our global partner contact details are included opposite, and we are always pleased to meet, chat and share market views — so please do not hesitate to get in touch.

Overall, 2015 was another strong year for credit markets globally, although there were some regional variances. Global credit markets in 2015 were supported by solid credit fundamentals, continuing support from stimulus measures from

global central banks and a continued acceptance of the new world post the global financial crisis.

2015 was also another important year for our global Capital and Debt Advisory platform. We now have a team of over 90 advisors across the world, with offices in all key markets, including the US, Europe, Australia, the Middle East and China. Globally, we have advised on more than 70 deals with a value of over $25b.

We look forward to working with you in 2016. Best wishes for the New Year.

K.C. Brechnitz Global Head of Capital & Debt Advisory

Chris Lowe Partner, Capital & Debt Advisory

Luke Reeve Partner, Capital & Debt Advisory

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3Credit Markets 2015–16

Meet your global teamChris Lowe [email protected]

Luke Reeve [email protected]

UK

China

Andrew Koo [email protected]

Singapore

Luke Pais [email protected]

Australia

Jason Lowe [email protected]

United Arab Emirates

Hani Bishara [email protected]

US

K.C. Brechnitz [email protected]

Lars Blomfeldt [email protected]

Sweden

Jose María Rossi [email protected]

Spain

Olivier Catonnet [email protected]

France

Britta Becker [email protected]

Jan Henrik Reichenbach [email protected]

Germany

David Zlámal [email protected]

Czech Republic

Yoav Ben-Yeshaya [email protected]

Israel

EY offices

We have a team of over 90 advisors around the world with connectivity to global debt capital pools:

Vincenzo Bruni [email protected]

Italy

Brazil

Viktor Andrade [email protected]

Luiz Campos [email protected]

Gustavo Vilela [email protected]

Canada

Brian Allard [email protected]

Foreword


In recent years, as advisors, we have witnessed the direct and indirect benefits of global quantitative easing (QE) on credit markets. With over US$9t of QE initiatives announced and initiated by central banks globally since 2008, the key question is — where have all these funds gone?

Although it is outside the scope of this foreword to answer this question, we can look at some key trends in financial markets in recent years and draw some conclusions.

In short, since 2008, we have witnessed a rebound in global equity markets, large inflows of capital into higher yielding credit funds, the recapitalization of banks and a significant expansion of central bank balance sheets. These high levels of liquidity, combined with historically low interest rates and low M&A transaction volumes, have driven increasingly competitive behaviors between lenders and investors. Credit terms available to borrowers, are in certain circumstances, better than those they would have received prior to the global financial crisis.

In an artificially low interest rate environment, the phrase “searching for yield” has been used repeatedly by market participants to describe investors’ push into higher return asset classes, such as high-yield bonds. An open question is whether all of these participants are fully aware of the risks that come with this increased return.

Total assets of central banks* *Includes US, UK, EU, Australia and Japan’s central banks

0

2

4

6

8

10

12

US$

t

2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Websites of relevant central banks.

Disintermediation was a central theme of 2015. Globally, we have witnessed the growth in recent years of alternative lenders and non-bank sources of financing. Insurance companies, pension funds and private credit funds have all made moves into direct lending. Products, such as public bonds, unitranche, private placements, mini bonds and Schuldschein are increasing market share in their respective local markets. Disintermediation will increase in 2016 and continue to provide welcome competition to traditional sources of financing such as banks.


“ … since 2008, we have witnessed a rebound in global equity markets …”

“ ... certain sectors, such as oil and gas and metals and mining, are cut off for all but the best credits.”

Global equity markets

0

50

100

150

200

250

Inde

xed

FTSE 100 Index S&P 500 Index

Germany DAX Index (performance) Nikkei 225 Index

Hang Seng Index

Shanghai Stock Exchange Composite Index

ASX Limited

Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15

Source: S&P Capital IQ

Global commodity prices

0

50

100

150

200

250

300

Inde

xed

Crude oil Natural gas Gold Platinum Copper

Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15

Source: S&P Capital IQ


Foreword continued from page 5

However, this is only the start of the disintermediation that is set to come. The financial markets are not immune to the digital revolution that is currently sweeping the world. From taxi companies (Uber) to hotels (Airbnb), traditional business models are facing what many are predicting will be a decade of disruption. Although on at a smaller scale at present, the growth of peer-to-peer lending represents another example of disintermediation in the financial markets. Peer-to-peer lenders have leveraged Big Data, low operating costs, a light regulatory environment and technology, to provide yet another avenue for investors searching for yield. It’s a rapidly expanding model, which commentators are predicting could change the traditional banking industry. While currently focused on consumer credit, an expansion into mortgages, car loans and even larger corporate lending, is not out of the question. From peer-to-peer lenders, to Bitcoin and Blockchain — it will be interesting to see how the contents of Credit Markets changes in the next 12 months.

The emergence of these alternative lenders has been driven by a number of factors: quantitative easing causing a push into higher yielding assets; new digital technologies and a tighter regulatory environment for banks. Over-leveraged global financial banks were

the villains of the last financial crisis. While, globally, banks have de-geared and recapitalized, leverage has grown in darker corners of the financial system that are more difficult for global regulators to track. Against this backdrop, the question for regulators should be — who will be the next villains?

At the time of writing, as we look forward to 2016, there are some headwinds facing global credit markets, including increased regulation, a slowing global economy and falling commodity prices. Default rates increased in 2015 to the highest levels seen since 2009. Against the backdrop of rising interest rates in the US, outflows are being witnessed from loan and bond funds. Wobbles are also being witnessed in emerging markets and certain sectors, such as oil and gas and metals and mining, are cut off for all but the best credits.

Against this backdrop of high levels of liquidity, some local market instability and the mispricing of risk in certain asset classes, 2016 promises to be another interesting year for global credit markets.

Robert Jones Director and Editor of Credit Markets

“ … leverage has grown in darker corners of the financial system that are more difficult for regulators to track.”


Total assets of top 20 non-financial companies

0

1

2

3

4

5

6

2007 2008 2009 2010 2011 2012 2013 2014 2015

US$

t

Source: Forbes 500.

Total credit to non-financial sector from BIS

0

100

200

300

400

500

600

700

2007 2008 2009 2010 2011 2021 2013 2014 YTD Jun 14

YTD Jun 15

US$

t

Source: Bank for International Settlements’ website.

Banks* capital adequacy ratio (average) *Top 20 banks by assets

0

2

4

6

8

10%

12

14

16

18

2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: S&P Capital IQ.


European leveraged finance

European leveraged debt marketsEuropean leveraged debt markets were strong in 2015, although we did not see the volumes of 2014. Terms became more borrower-friendly with increased leverage, lower equity contribution, fewer covenants and less amortization.

Demand has continued to outweigh supply, which has shaped a borrower-friendly environment. Competition for debt assets between banks and non-bank lenders will continue into 2016 with favorable conditions for borrowers, while the increasing pressure for sponsors to deploy their funds will be the underlying dynamic driving buyout transactions and financing volume.

European leveraged loan marketsAt the time of writing, 2015 European leveraged loan issuance is unlikely to catch up with 2014 volumes. European leveraged loan volume for the first nine months of 2015 was €48.9b, which was 25% down on €65.2b in the same period in 2014.

The last two years have seen robust refinancing and dividend recapitalization activity. Financial sponsors have been opportunistically taking advantage of strong credit market conditions as an alternative to exiting investments. However, the opportunities for refinancings and recapitalizations in financial sponsor portfolios decreased in 2015.

2015 leveraged loan volume driven by M&A was also down on 2014. This was skewed by some larger transactions in 2014, masking an underlying trend of increasing M&A activity. Overall, 2015 trends point to a more stable level of M&A activity to support financing volumes. This is likely to continue to be one of the primary drivers of activity in 2016.

In contrast to the moderate supply of financing transactions, there is significant liquidity in the European leveraged loan market driven by:

Leveraged finance ► Banks: after a period of considerable deleveraging,

European banks are actively seeking to deploy capital to drive top-line growth.

► Alternative lenders: there has been a significant increase in the number of alternative lending funds operating in Europe. This reduced reliance on bank lending is more in line with the US market structure. EY estimates that the number of European alternative lenders has grown by over 50% in the last two years, although this growth is slowing.

► Collateralized loan obligation (CLO): despite increased regulation, the European CLO market is re-emerging, driven by investors “searching for yield” in Europe’s low interest rate environment. CLO issuance for 2015 is expected to exceed €15 billion, which would be a post-crisis record, and is set to continue into 2016 — providing yet another pool of liquidity.

As a result of these high levels of liquidity and strong competition, there has been momentum from financial sponsors to push toward covenant-lite or loose packages. At the time of writing, the average number of covenants per transaction in the European leveraged loan market had decreased from 2.5 in 2014 to 1.6 in 2015. The trend for covenant-lite or loose transactions is expected to continue into 2016, filtering down into the European mid-market.

Leveraged loan volume

0

100

200

300

400

500

600

700

800

2007 2008 2009 2010 2011 2012 2013 2014 YTD Oct 14

YTD Oct 15

US$

b

Europe US

Source: LCD S&P.


High yield volume

0

50

100

150

200

250

300

350

400

450

2007 2008 2009 2010 2011 2012 2013 2014 YTDOct 14

YTDOct 15

US$

b

Europe US

Source: LCD S&P.

European high-yield bond marketIn 2013 and 2014, the European high-yield market firmly established itself as an alternative source of financing for leveraged transactions. As at the end of September 2015, year to date volume was €56.1b, down 17% compared with €67.7b for the same period in 2014.

High-yield appetite was impacted by market volatility reducing investors’ risk appetite. The Greek debt crisis, a slowing global economy and falling commodity prices all contributed to investor concerns.

Activity in 2015 was dominated by M&A related issuance, both financial sponsor led buyouts and corporate acquisitions. At the time of writing, year to date M&A related volume of €21.1b was ahead of the full-year high of €12.8b in 2014.

The increasing trend to access the high-yield markets for acquisition financing, has been driven by competitive pricing, higher leverage and increased flexibility. Specific benefits being increased flexibility for issuers to manage cash and fewer restrictions on making acquisitions, investments, distributions and disposals.

In 2016, we expect to see an uptick in activity in the European high-yield market, driven by an increase in M&A volume and increasing liquidity.

“ ... the average number of covenants per transaction has decreased from 2.5 in 2014 to 1.6 in 2015.”

continued on page 10


Average number of covenants per transaction

3.52 3.71 3.64 3.66 3.65 3.56

3.00

2.50

1.59

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 LTMSep 15

Source: LCD S&P.

European leveraged finance continued from page 9

European alternative lendersThe European alternative lending market has experienced significant growth in recent years. It now represents the primary alternative source of financing in the mid-market space for transactions with an enterprise value of circa GB£25m to circa GB£500m.

After significant growth in the number of new funds in recent years, 2015 witnessed a slowdown. However, alternative lenders have continued to gain market share from traditional banks, offering borrowers increased flexibility, leverage and minimal or no amortization.

Strong competition in the market has led to pricing pressure on these alternative lenders, bringing the pricing closer, in many cases, to that of bank debt. This has particularly been seen in the recent growth of bifurcated unitranche transactions. Here, the unitranche is underwritten by two (or more) lenders, and divided into two tranches, a senior tranche at or below typical bank leveraged pricing, and a subordinated tranche (typically provided by an alternative lender).

“ EY estimates that the number of European alternative lenders has grown by over 50% in the last two years.”



Given the large amount of undeployed capital, there will be significant activity in 2016 from alternative lenders within the European leveraged finance market. The mid-market will continue to be the focus segment, containing a sustainable volume of financing targets and less competition from the high-yield market. However, alternative lenders have recently begun pushing upward in size range toward traditional high-yield territory. For deals of €150m and above, the market is rich in liquidity, with banks, alternative lenders and high-yield investors all competing for the same deals, and driving terms.

European leveraged finance by:

Greg Moreton Director

Mark Tsang Assistant Director

US leveraged finance

US leveraged loan marketAt the time of writing, year-to-date US leveraged loan volumes were down 24% from the same period in 2014, and were on pace for the lowest annual total since 2011. Loan volume has slowed as a result of regulators’ attempts to rein in leveraged multiples. Both new-issue and secondary spreads trended upward throughout most of 2015 in light of mixed market conditions — US Federal Reserve uncertainty on raising rates, pressure on metal and mining and oil and gas borrowers and a moderate technical environment. Default rates remained at the low end of the historical range at circa 1.2%, although certain sectors (e.g., energy, metals, mining, commodities) experienced challenges and weak liquidity. Despite these headwinds, leverage multiples remained near historical highs with structures and credit protections loosening.

Combining the increased regulatory environment with an overall mixed technical environment, the following trends were observed throughout 2015:

► M&A volume remained relatively strong compared with opportunistic (recapitalization and refinancing) transactions. M&A activity was supported by a friendly deal environment including robust valuations, continued access to debt financing, record cash balances for corporates and continued need for top-line growth.

► While corporate M&A drove loan volumes in 2015, leveraged buy out (LBO) activity slowed as private equity shunned historically high valuations. Private equity firms continued to exploit any market windows strong enough to support opportunistic transactions.

► As a result of the decline in LBO and dividend recap volume, private equity backed issuers’ share of leveraged loan volume slipped below 50% for the first time since 2011.

► Pro rata proportion of overall volume is at a six-year high, accounting for circa 40% compared with 29% over the same period in 2014. Corporates demonstrated a propensity to gravitate toward the lower cost pro rata option, despite financial maintenance covenants and higher loan amortization.

Going forward, higher-leveraged LBO and recapitalization activity will continue to be hampered by the stringency of US leverage lending guidelines. However, technical conditions should improve given the modest level of maturities in 2016 and the continued strength in CLO formation, perhaps offset by new supply coming from a strong M&A market. Regarding the default rate, modest economic growth, which is supporting cash flow, along with limited maturity and covenant pressures, suggest a below average default rate environment in 2016. This will be offset somewhat by higher than average defaults in the metals and mining and oil and gas sectors as those sectors work through the ripples of continued low oil prices.

“ In line with the broader leveraged loan environment, US mid-market new-issue loan volume was down circa 25% compared with 2014.”


US leveraged loan volume

0

100

200

300

400

500

600

700

2007 2008 2009 2010 2011 2012 2013 2014 YTDSep 2015

Volu

me

US$

b

Pro rata Institutional

Source: LCD S&P.

US mid-market leveraged loansIn line with the broader leveraged loan environment, US mid-market new-issue loan volume was down circa 25% compared with 2014. Contrary to the broader leveraged finance markets, financing for LBOs in the mid-market accounted for nearly 60% of total volume in 2015. The mid-market remains more

fundamentally driven with investors focused on credit quality, requiring pricing premiums and structural enhancements relative to larger leveraged loans. Demand for loans is more idiosyncratic with larger and less-storied credits receiving the best execution. The mid-market is still anchored by a strong investor base that includes buy-and-hold traditional investors, business development companies and regional banks. Finance companies continued to drive mid-market deal flow and gained market share at the expense of traditional regional banks, which have been hampered by leveraged lending guidelines. Looking ahead, the pipeline remains strong, led by corporate M&A and refinancing activity.

US high-yield bondsAt the time of writing, new-issue US high yield volume was down approximately 10% year on year. Volatility across the broad capital markets, energy and commodity sector pressures, renewed global growth concerns and uncertainty around rate increases weighed on the US high yield market. These issues combined gave investors pause about investing in the asset class, causing yields and spreads to reach levels not seen since 2011. Additionally, secondary spreads widened due to the persistent supply and demand imbalance in the energy and coal sectors, which comprises circa 15% of the total outstanding paper in the

US leveraged finance continued from page 11


high-yield market. Otherwise, spread degradation is largely issuer-specific and centered around acquisition events.

► Higher rated credits have been less volatile and continue to receive broader market access, accounting for over 50% of 2015 year-to-date volume.

► Consistent with 2014, refinancing accounted for nearly 50% of 2015 year-to-date volume.

► M&A supply, including acquisitions, mergers and spinoffs, at the time of writing, represented roughly 36% of total issuance, slightly outpacing the 29% for all of 2014.

► Challenging market conditions limited issuers pursuing more aggressive structures including drive-by issuances, holdco financings and PIK toggle notes.

At the time of writing, full-year 2015 issuance volume was forecast to drop nearly 20% from 2014, the lowest since 2012. Investor concerns center on global economic slowness, a US Federal Reserve intent on raising interest rates, continued low commodity prices, and default rates ticking higher. Going forward, expected higher interest rates will pressure cash flow, and bankers expect opportunistic issuers to enter the market ahead of any potential interest rate increase.

US high-yield volume

0

50

100

150

200

250

300

350

400

2007 2008 2009 2010 2011 2012 2013 2014 YTDSep 2015

US$

b

Secured Unsecured Subordinated

Source: LCD S&P.

US leveraged finance by:

Todd Ulrich Director

Australian leveraged and acquisition finance2015 witnessed steady Australian leveraged finance deal flow, consisting of a mix of new deals and refinance transactions. Bank appetite to support leveraged buyouts was steady over 2015 (albeit still below pre-global financial crisis levels), with interest particularly for deals with reputable sponsors and strong underlying businesses.

Sponsors (both private equity and corporates) successfully tapped offshore markets to capitalize on strong liquidity and healthy risk appetite for Australian deals, particularly the US Term Loan B market.

Australia was a major driver of M&A activity in the Asia-Pacific region over the first three quarters of 2015, contributing over 40% of regional M&A loan volume during the this nine month period. On a deal count basis, Australia closed 25 syndicated transactions — over twice as many as the second best market, Hong Kong.

The Australian resources sector was also a strong contributor to the M&A market in 2015 with a number of notable transactions.

The pipeline for 2016 looks promising. Borrowers are expected to benefit from new sources of capital as Australia’s private equity and venture capital markets are set to get bigger, with new sources of funding, such as crowdfunding and visa schemes, targeting offshore investors. The additional liquidity is expected to add to the existing investor pool dominated by Australian pension and superannuation funds.

Allocations to private equity investments are already on the upswing globally as sovereign wealth funds increase their allocations to the asset class, with Asian funds contributing a significant portion of that capital. Additionally, Australia’s significant investment visa scheme could contribute meaningfully with around AUS$500m expected to be raised. Investors are required to invest at least AUS$5m in different asset classes for at least four years. A minimum 10% of that capital needs to be invested in venture capital.

Australian leveraged finance by:

Jason Lowe Partner


European investment grade market2015 was a great year for European investment grade corporate borrowers. Investment grade debt markets benefited from high levels of liquidity, yielding near record low “all-in” interest rates. The impacts of QE measures across Europe were plain to see. Certain sectors did not benefit from these strong market conditions, notably oil and gas, mining and metals, and retail.

The bank market started the year with a finale of sorts; that of the end of the recent wave of amend and extend (A&E) transactions. At the start of the year, we witnessed the final A&E deals for 2011-13 transactions. With many corporates benefiting from substantially reduced pricing and extended maturities, the impact of QE, an improving economic outlook and a distinct lack of mainstream M&A activity was there for all to see. For some companies, the temptation to complete an A&E transaction was trumped by a desire to keep bank relationship powder dry for potential future M&A transactions.

Investment gradeIn hindsight, the sheer number of A&E deals completed in 2014 and early 2015 was a clear signal of the lack of appetite by company boards for M&A. In the UK, M&A volumes undershot expectations.

2015 was also the year that credit spreads in the bank market increasingly reflected the cost of securing lead relationships and, in particular, ancillary business. At the year’s low point (March-April), even lower investment grade companies could secure five-year loan commitments with opening margins as tight as 50 to 60 basis points.

Combined with sustained low LIBOR rates, after-tax debt costs fell to levels that could be rounded down to near zero for many larger European borrowers. In theory, cheap funding and improving economic sentiment should have helped fuel an increase in M&A. However, macroeconomic volatility quickly dampened the enthusiasm of all but the largest names. For banks’ loans teams holding out for lucrative event-driven “bridge” financing, 2015 was a year that comprehensively disappointed.

Global M&A volumes

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 YTDSep 2015

US$

t

Source: Dealogic.

“ 2015 was a great year for European investment grade borrowers.”



“ … the impact of QE accelerated in 2015, as a wall of capital flooded both the private and public debt markets.”

European capital marketsIn the European bond markets, the impact of QE accelerated in 2015, as a wall of capital flooded both the private and public debt markets. European investors had some demand catered for during the first half of the year by a large number of US corporates issuing in the Eurobond market; principally due to favorable cross-currency pricing conditions. The sterling market was heavily under-supplied — a problem further exacerbated by a number of UK companies issuing in the US private placement market and US and European public markets (again due to favorable cross-currency pricing). Compounded by a lack of M&A, demand for investment grade credit fell well short of supply, ensuring coupons remained at or close to historic lows throughout the year.

As primary issuance flows slowed over the summer, macroeconomic volatility further impacted M&A. A flurry of unexpectedly weak economic data quickly dampened new issue pipelines, compounded further by a notable absence of M&A transactions. Even for the few jumbo M&A transactions announced after the summer, lengthy shareholder processes and regulatory clearances ensured debt investors were left waiting patiently for deals to complete. For the companies concerned, prolonged transaction timetables only served to increase the risks of adverse market conditions eroding the economic rationale underpinning initial deal announcements. The risk of deal collapse remains acute heading into 2016, and flexibility on financing structures is at the forefront of many companies’ minds.

NAIC-1 US private placement spreads (bps)

500

150100

200250300350400450500

Spre

ad to

US

Trea

sury

(bps

)

10-year high 10-year low

Oct

11

Jan1

2

Apr

12

Jul 1

2

Oct

12

Jul 1

3

Jan

13

Apr

13

Oct

13

Jan

14

Apr

14

Jul 1

4

Oct

14

Jan

15

Apr

15

Jul 1

5

Oct

15

Source: Private Placement Monitor.

NAIC-2 US private placement spreads (bps)

500

150100

200250300350400450500

Spre

ad to

US

Trea

sury

(bps

)

10-year high 10-year low

Oct

11

Jan1

2

Apr

12

Jul 1

2

Oct

12

Jul 1

3

Jan

13

Apr

13

Oct

13

Jan

14

Apr

14

Jul 1

4

Oct

14

Jan

15

Apr

15

Jul 1

5

Oct

15

Source: Private Placement Monitor.

European investment grade outlookOn the back of a slow second half of 2015, European investment grade bank and capital markets teams are set to start 2016 with ground to make up. With increasing uncertainty on both political and economic fronts, companies venturing into the market will do so cautiously. “Optionality” remains the byword for financing strategies; where consideration of multiple markets will become ever more relevant. The combination of pricing, terms, quantum and flexibility will likely ensure banks continue to compete hard with alternative capital pools, particularly for lower investment grade credits. Sustained competition between debt markets and high levels of liquidity will keep credit spreads at or near historic lows, at least until a combination of M&A demand, macroeconomic factors or corporate earnings results prove the stronger upward force.

For prospective borrowers, this remains an attractive proposition; that of access to debt capital for investments at post-tax costs significantly below the cost of equity. Finding transactions that present compelling rationale for shareholders will remain challenging, but trading conditions in certain sectors will present opportunities in 2016.

EY’s 2015 Capital Confidence Barometer highlighted the significant proportion of companies (60%+) expecting to pursue acquisitions actively in 2016. From a financing standpoint, it will be a question of getting the mix right and ensuring value for


money for shareholders, while retaining optionality during a deal and sufficient flexibility after completion. Throw into the mix considerations around hedging strategies, credit ratings, evolving tax legislation and the deliverability of transaction synergies, and companies have much to contemplate prior consummating a transaction. The prospective EU exit vote could see many UK corporates put M&A plans on hold, barring the most favorable opportunistic deals.

European investment grade by:

Michael McCartney Director

Giles Barling Director

,

US investment grade market2015 proved to be an active year for US investment grade credit markets. At the time of writing, year-to-date 2015 new-issue volume for US investment grade bonds was 34% ahead of comparable 2014 levels and on pace to be the highest ever. Issuers were keen to lock in historically low rates for longer durations ahead of an anticipated rise in rates. Average tenor on new-issue bonds came in at its longest since 2008 at 10 years and nine months. Overall, fundamentals in the US corporate bond market were favorable (excluding energy and metals and mining) with many consumer-related sectors benefitting from a pick-up in US economic growth.

Use of proceeds was dominated by corporate purposes (often share repurchases or dividends), followed by refinancing and M&A. With organic growth difficult to achieve in the current environment, corporates have been seeking acquisitions with attractive synergy opportunities to drive future earnings growth. Expanding valuations are leading to elevated M&A multiples and, not surprisingly, higher average financing sizes — the highest level on record.

“ Going forward, the supply outlook is strong, although a sudden and sharp rise in long-term rates could hamper issuance.”

European investment grade continued from page 15


Supporting the volume increases were attractive yields for issuers driven by low treasury rates. While yields were low, investment grade spreads have recently widened to the highest levels in nearly three years. Consistent with historical trends, fixed rate issuance made up nearly 95% of total issuance. Additionally, BBB issuance remained the most prolific rating category, accounting for approximately 50% of volume. From a sector perspective, financials accounted for 37% of total volume followed closely by industrials at 36%.

Going forward, the supply outlook is strong, although a sudden and sharp rise in long-term rates could hamper issuance. Should a low rate environment prevail, event-driven financing is anticipated to be heavy. Financial institutions are expected to be large users of the capital markets as additional holding company debt issuance will be necessary to address higher capital reserve requirements.

US investment grade loan issuance

0

100

200

300

400

500

600

700

800

0

100

200

300

400

500

600

700

800

2007 2008 2009 2010 2011 2012 2013 2014 YTD Sep 15

Vol

ume

of d

eals

US$

b

Num

ber

of d

eals

Volume (number of deals) Volume (US$b)

Source: Bloomberg.

Monthly US M&A volume (US$b)

Jan 20070

10050

150200250300350400

Volu

me

US$

b

Jan 2009

Jan 2008

Jan 2010

Jan 2011

Jan 2012

Jan 2015

Jan 2014

Jan 2013

Source: Bloomberg.

US investment grade by:

Todd Ulrich Director

Australian investment grade and corporate marketOver the last three years, Australian corporates have benefited from borrower-friendly and liquid credit market conditions. Many have achieved significant margin savings and greater flexibility in their refinancing transactions. Others have successfully tapped into a wide range of emerging debt capital markets and funding solutions, both domestically and increasingly offshore. The market is dominated by the main four domestic banks that made up 60% of syndicated loan market share for the first three quarters of 2015. However, strong competition is guaranteed in the investment grade lending space from the largest Japanese banks, who also sit among the top 10 in the Australian league tables.

Although it is an opportune time to refinance or seek new funding from the Australian bank market, market participants question how long conditions will remain favorable. Headwinds are on the horizon with global regulatory moves in the banking market. In Australia this has been highlighted by the Government and the Australian Prudential Regulation Authority’s response to the Financial System Inquiry, highlighting a longer term trend for increased bank capital levels and compliance requirements. In light of this, each of Australia’s four largest lenders has recently increased its mortgage rates to protect profits and cover the costs of tougher capital requirements.

In exploring the domestic market outlook for the future, it is helpful to consider activity in the European and US credit markets and how this might flow through. These markets have experienced a material shift in sources of funding for corporate borrowers. The US has seen banks’ share of the primary loans market declining from 54% to 16% in the last 10 years, while Europe has experienced a shift of 76% down to 54% over the same period.

The availability of a wider range of capital options, from investment grade bond placements through to sub-investment grade and high yield, has provided increased flexibility. With global banks retreating due to a reduced capacity to lend and increased capital requirements, capital markets have advanced to fill that void and have provided competitive funding alternatives.

However, the trends in the US and European markets are yet to flow fully through to the Australian market, with banks share of primary corporate lending at around 89% in 2015. Despite this, we believe that change is in the air, with growth of the local private debt or placement market evident (estimated by EY to be over US$30b in value in 2015). This alternative corporate debt market continues to grow with new financiers and investors emerging on a regular basis and a growing awareness by borrowers.

One of the key reasons we expect this global dynamic to impact the Australian market is the approach to credit risk management within the regulated banking environment. With increased



regulation and oversight, the Australian banks will increasingly need to adopt a “cookie cutter” approach. The resultant zero loss and minimal risk philosophy that is emerging will impact how the banks approach existing and potential new borrowers in the Australian market. Banks are expected to focus on a narrower band of low risk borrowers on more consistent terms, in turn seeing the only competing lever as price. This opens up a window of opportunity for these emerging lenders to provide an alternative and more flexible view of credit risk and increase their share of Australian corporate borrowings.

Investment grade loan market activity in Australia dropped by 24% to US$54.5b for the first nine months of 2015, compared with the US$71.23b during the same period in 2014. Specifically, in Australia, a weaker commodities market and a lack of appetite for opportunistic project and infrastructure developments weighed on volumes.

Australian volumes were supported by increased M&A activity in the corporate sector, providing relief to loan bankers as business confidence improved. Despite the encouraging level of M&A activity, refinancing activity continues to dominate total Australian loan volumes. Borrowers took advantage of robust market liquidity and low interest rates to obtain improvements in their pricing and terms (including covenants). Debt repayment accounted for 59% of the country’s total loan volume in the first three quarters of 2015, with A&E transactions accounting for approximately 25% of this refinancing volume.

Whether we are at the bottom of the pricing curve remains to be seen, with upward pressure on price (driven by increased regulatory concerns), currently being offset by significant downward pressure, driven by low deal flow and increased competition. Recent Australian refinance transactions completed by EY suggest there are still significant pricing benefits to be achieved by quality investment grade borrowers who can provide banks with a meaningful level of ancillary fee income. This is especially true for large blue-chip borrowers who are achieving extremely favorable terms and conditions from large banking syndicates seeking to avoid balance sheet run-off.

Australian investment grade by:

Jason Lowe Partner

“ With increased regulation and oversight, the Australian banks will increasingly need to adopt a ‘cookie cutter’ approach.”

Australian investment grade continued from page 17


Brazilian investment grade and corporate marketThe Brazilian economy faced difficult times during 2015. The commodities crisis, a slowdown in Chinese economic growth and the troubled political environment in Brazil contributed to a slowdown in the economy.

The impacts of these factors are reflected in the 2015 GDP forecast, which, at the time of writing, showed an estimated decrease in GDP of 3.0% year on year (according to the Brazilian Central Bank), with 2016 GDP forecast to decrease by 1.4%.

In addition to this, by early September 2015, the devaluation of the Brazilian real (BRL) against the US dollar (US$) reached its highest level in history (more than BRL 4.00/1 US$). Foreign investments fell, mainly after Brazil’s credit rating was downgraded. Moreover, many of the largest Brazilian companies had their credit ratings reviewed or downgraded too.

All of these factors resulted in increased provisions and a lowering of credit availability compared with previous years.

Forecast debt market conditions in South America are considered to be slightly better for 2016 than they were for 2015, even though Brazil may face some of the same difficulties as last year.

Brazilian investment grade by:

Gustavo Vilela Partner

Middle East and North Africa (MENA)A modest recovery is expected to continue in MENA despite a slump in oil prices, ongoing regional conflicts and lingering uncertainty of the post-Arab Spring transitions.

2015 has been a year defined by two key themes in MENA, spanning the volatile oil price and ongoing conflicts in Iraq, Libya, Yemen and Syria, leading to somewhat reduced overall confidence and the beginning of tighter liquidity in the banking market. Despite both of these themes the World Bank forecasts that growth in the oil-exporting countries will remain steady at 2.7% in 2015 with limited inflation. Growth in developing MENA countries, over the same time, is expected to be about 2.3%.

The low oil price, which has dropped by more than half since the start of 2014, is now widely expected to remain depressed into the medium term following a fall of more than 50% since the start of 2014, with Brent crude trading below US$50 at the time of writing. The low price has caused large oil revenue losses for the region’s oil exporters, which has led to growing fiscal deficits. Richer oil exporters are expected to use accumulated financial buffers and available financing to cushion some of the impact on growth, but reductions in government spending has started to demonstrate a knock-on effect for private companies in the region.

To counter growing fiscal deficits, government borrowing has begun to grow and liquidity in domestic MENA markets has begun to tighten and rates have also begun to rise. This could be compounded in the short term by a potential US Federal Reserve interest rate hike, which will add an additional monetary squeeze for the dollar pegged local currencies at the same time as the cut in spending and will weigh further on growth.

According to Kuwait’s Markaz, the central banks of Kuwait, Bahrain, Qatar and Oman raised almost US$29b in local debt issuance in the first half of 2015, and in the second half of the year Saudi Arabia has already raised US$15b in local bond issuance in a new debt program that could reach US$27b by the end of 2015.

Delaying infrastructure projects, such as the Riyadh underground, and enforcing a spending squeeze across government departments has brought a slowdown in the private sector, which



has combined with large cash withdrawals and market signals to local banks and investment companies that deposits for both 2015 and 2016 will be much reduced to tighten liquidity. Colloquial evidence suggests that some Abu Dhabi financial institutions closed their loan books to new business for the year as early as November.

For those countries already in conflict, including Iraq, Libya, Yemen, and Syria, economic prospects are tough. At the time of writing, 15 million people have fled their homes, many to countries such as Jordan, Lebanon, Djibouti and Tunisia, giving rise to the biggest refugee crisis since World War II. Mounting security issues have forced some countries undergoing political transitions, such as Egypt, Tunisia, Morocco and Jordan, to address security concerns over growth-promoting policies.

In a real sign of the reduced confidence and liquidity in the region, a large bank unexpectedly failed to close a bond in October. This softening in the historically liquid debt markets has been matched by a slowdown in the equity markets where, despite colloquial evidence of a strong pipeline of issuers coming to market, the number of initial public offerings has declined by 42% year on year to 11 issues, raising 27% less money than in the same period in 2014.

2016 outlook2016 is expected to see a continuation of the themes seen in 2015, with much of the regions fortunes resting on developments in the oil price and how existing regional conflicts play out.

Following the nuclear deal signed in July 2015 and the potential lifting of sanctions, Iran’s economic prospects should improve, and indeed economic growth is forecast to rise to an estimated 5.8% in 2016, in line with an expected increase in their oil exports. The reintegration of Iran into the world economy will further boost oil supply, and much needed inflowing investment is likely to follow. Iranian international investment is also expected to become easier, with Iranian funds predicted to begin trickling into the Middle East once again.

If the oil price remains depressed into 2016, as expected, regional economies will be forced to further curtail spending, which will impact growth and liquidity in the banking market, much of which is provided by government deposits and injections.

With the dramatic change in the fortunes of regional trade surpluses the market has begun to speculate on the strength of commitments to regional dollar pegs.

The pipeline of equity issuers is expected to remain on hold in the first half of 2016, and will only pick up after the region digests the impact of lower oil prices over the medium term.

MENA investment grade by:

Hani Bishara Partner

Ben Parton Senior Executive

MENA investment grade continued from page 19


“ A modest recovery is expected to continue in MENA despite a slump in oil prices, ongoing regional conflicts and lingering uncertainty of the post-Arab Spring transitions.”


European mid-market and corporate lending

UK market overview2015 saw a number of new alternative lenders entering the market. After a number of years with limited choice in the mid-market, there is now a diverse range of alternative lenders and lending products available to borrowers. The USP for these alternative lenders continues to be their ability to provide more flexibility in a debt structure than traditional high street banks, and this trend has continued in 2015. This flexibility can come in the guise of limited or no amortization, looser financial covenants or longer tenors.

As well as being able to offer increased flexibility and targeting smaller mid-market deals, another theme we have witnessed during the year is that of alternative lenders seeking to be more creative. Some alternative lenders have increased the range of debt products in which they are willing to invest, with many now marketing themselves as able to offer everything from senior debt to equity. In response, banks are also becoming more creative for fear of being pushed out of the market.

The unitranche product continued to be popular in 2015, being used for a range of transactions from leveraged buy-outs to dividend recapitalizations. Over the course of the last 12 months, we have continued to see a downward trend of pricing. A continued scarcity of high-quality deals in the mid-market coupled with high levels of liquidity, has led to increased competition between alternative lenders and banks. We have also seen, over the course of the year, a number of funds shifting downward on pricing and offering debt on a stretched senior basis, encroaching on traditional bank territory.

Mid-market and corporate lending


Consequently, lower levels of amortization from banks is also becoming more popular in the UK mid-market, with larger proportions of non-amortizing Term B loan forming part of the structure.

The terms in the lower mid-market are not as favorable but, in 2015, we have seen banks and debt funds increasingly dropping down into the lower mid-market in search of deal flow, resulting in an improvement in liquidity and an increase in leverage multiples. Debt funds are also applying unitranche debt structures to increasingly small transactions, further evidence of the significant levels of liquidity flowing around the UK mid-market at present.

On-going competition to put funds to work among lenders in 2016 is expected to continue driving aggressive behavior, with lower fees, fewer covenants and lower margins.

The mid-market is seeing covenant-lite and covenant-loose structures becoming more prevalent as funders look to compete, mirroring the large-cap space. Very noticeably we’re seeing the average number of covenants decrease and larger baskets for acquisitions and disposals.

Going into 2016, we expect to see continued increased levels of non-amortizing Term Loan B participation, lower pricing and higher leverage. Regulation, however, will be the biggest burden for the banks as they struggle to commit to long-term non-amortizing debt. A number of new debt funds continue to be launched and vie for deals, albeit the pace of growth is slowing. Although the core of the alternative lender market is focused on large sponsor-backed M&A deals, the resurgence in the mid-market is expected to continue. We have seen a greater number of funds with appetite to consider sub-GB£10m EBITDA transactions with an increasing willingness to look outside of London and the South East. Furthermore, as M&A in the mid-market gains momentum, the need for capital will grow.

UK market overview by:

Colm Treston Assistant Director

French market overviewIn 2015, the trend toward further banking disintermediation gathered momentum in France. According to data published by the Banque de France, the growth rate of disintermediated financing (such as bonds or private placements) in France grew by 7.9% over the 12-month period to August 2015, compared with 3.9% for bank financing over the same period. At €427b, disintermediated financing, at the time of writing, represented 33.3% of total financing.

The bulk of these alternative financings consists of public bonds issued by large investment grade corporates. However, the shift from bank debt to public bonds or private debt has been particularly visible in the French mid-market, with borrowers turning to the high-yield or euro private placement markets to diversify and increase their funding sources.

This move may appear surprising when liquidity in the bank market is also very strong. French banks have clearly shifted their agenda from deleveraging to growing revenues now that liquidity concerns have been eased. The rates offered by banks remain attractive, but they still remain cautious to limit their exposure

“ On-going competition to put funds to work among lenders in 2016 is expected to continue driving aggressive behavior, with lower fees, fewer covenants and lower margins.”



to cyclical companies and still have a preference for amortizing debt. As a result, in spite of the higher cost of funding, many CFOs of mid-market companies see the benefits of non-bank financing. Although these alternative financing solutions can be more expensive, they can offer borrowers longer maturities without amortization.

In 2016, we expect that the trend of disintermediation will keep progressing on the back of continued European QE, but with acceleration for smaller mid-market companies.

The development of non-bank financing for mid-market corporates in France was initially boosted by a state-sponsored initiative through the NOVO investment vehicles launched in 2013 with loans of €20-30 million. This framework has recently been duplicated for smaller companies as NOVI; this time, targeted investment is in the €5-15 million range. Both target entrepreneurs and family-run businesses and are not eligible for financial sponsor-led projects.

Alongside these state-driven initiatives, there have been a number of private debt funds recently launched in France as a result of the changes in legislation. This has allowed insurance groups to invest in direct lending and offer more flexibility in terms of format.

French market overview by:

Olivier Catonnet Partner

German market overviewDespite the fact that German corporates are increasingly using alternative funding elements such as bonds, m-bonds or private placements, traditional bank lending maintains its predominant position in the German market. This is especially true for the mid-market, where local banks such as savings banks (Sparkassen) and cooperative banks (Genossenschaftsbanken) are historically very active financing partners.

On the back of the evolving alternative financing market, combined with ongoing quantitative easing by the European Central Bank (ECB) and moderate demand for loans among corporates, banks are facing a highly competitive environment. This is especially true

for the German mid-market, which continues to attract foreign funding sources in addition to the various mid-market initiatives launched by local competitors.

Since 2010, margins have been continually decreasing. These circumstances led to an excessive supply of liquidity for corporates with very favorable terms and conditions, especially for investment grade and corporate borrowers.

Corporates tend to make use of the favorable situation by refinancing or amending and extending loans at an early stage, or by securing today’s terms and conditions for future years. We see, for example, banks offering loans with a 5+1+1 option for corporate borrowers, indicating a further incentive for corporates to opt for an early refinancing of outstanding commitments.

A noteworthy feature of the German market is the revival of the Schuldschein. The Schuldschein is a fixed or floating rate instrument, typically with a bullet repayment, and ranges in size from circa €10m to €500m. It is offered with maturities between 2 and 10 years. Schuldschein instruments are not marked-to-market, meaning the securities are not revalued as market conditions change and there is no legal requirement to produce a sales prospectus for Schuldschein issuances.

Although the overall volume is small by comparison with traditional bank funding or bond issuances, it nevertheless is an instrument that German corporates increasingly make use of.

In terms of volume, the latest bank lending survey from German banks indicates that net loan demand is relatively flat. If it were not for the favorable lending conditions, demand would be expected to decrease, as investment grade corporates often exhibit high cash balances, strong cash generation and relatively low investment activities.

The market does not expect this situation to change significantly in the near future. Banks will face even more competition from the ongoing market penetration by debt funds that are pushing into the German market.

On the sub-investment grade side, we see a similar trend with banks competing for mandates in the large-, mid- and small-cap segments. Although most of the mid-market deals are executed on a club deal basis, there is a the general willingness to underwrite deals, even up to 100%, as was the market standard before the financial crisis. Whereas 2013 and 2014 were characterized by a wave of refinancing and amend and extend transactions, 2015 was dominated by a larger number of small-cap deals.

French market overview continued from page 23



Alternative lenders that have entered the German market from 2012 onward have now become a key element in the buyout market, in particular for smaller deals. However, senior bank debt continues to compete with unitranche financings in the structuring phase of a transaction. As for the investment grade segment, the stiff competition has put structures, prices and terms under pressure. Whereas in 2012 and 2013, an amortizing loan piece was standard for buyout transactions and all-bullet financing was widely accepted for large-cap transaction, Term Loan B-only structures have now also found their way into the small- and mid-cap segment.

Another key feature of the German leveraged finance market is the erosion of financial protection, which affects both the mid-market segment as well as large-cap deals. Large-cap deals with covenant-lite features are increasingly accepted in the market. Even for small- and mid-cap deals one can see less covenant protection compared with 2013 and 2014, with numerous deals carrying only two maintenance covenants and sometimes only one.

German market overview by:

Jan Henrik Reichenbach Partner

Markus Handke Assistant Director

Italian market overviewFollowing two record years for corporate issues, 2014 showed a sharp decline in public issue volumes (down 40% from 2013) and the consolidation of a new asset class (in Italy) represented by small (<€150m) euro-denominated and privately placed notes issued by non-listed mid-caps. This source of debt funding exceeded €1.8b of the total amount issued and represents the first step toward a reduced reliance from SMEs on traditional bank funding.

2015 has been a year of consolidation:

► With the benefit of increased liquidity, local commercial banks have remained keen to lend. Increased competition has squeezed the banks’ margins with average spreads for loans with 5+ year maturities declining around 90 bps versus the same period in 2014.

► Debt capital markets are still dominated by public issues (amounts greater than €150m) which, in 2015, represented about 90% of total volume (of which about 12% is attributable to high-yield issues). Private placement and so called mini-bond (PP with an issue amount below €50m) are coming together to gain a 10% share, which is about four times the volume they had in 2013. In terms of number of issues, European private placements and mini-bonds represent about 65% of the market, with mini-bonds increasing their share.

Italian mid-corporates (which are usually unable to tap the Eurobond market due to the minimum issue size typically required) have more regularly attracted interest from international credit funds, not only for speculative grade issues but also for long-term senior debt funding. In Italy, a new generation of credit funds has arisen for the specific investment in mini-bonds.

Bond redemptions by Italian issuers in 2016 and 2017 are expected to exceed €15b (vs. €10b of total redemptions in 2014), sustaining the primary bond market.

Issuers in the utility and public services industry are still expected to provide the majority of the corporate bond supply, due to the concentration trend triggered by changes in the relevant regulations (e.g., gas distribution).

“ In Italy, a new generation of credit funds has arisen for the specific investment in mini-bonds.”

Italian market overview continued from page 25


The recovery of the European economy has reached Italy, albeit slightly later than some other European countries. M&A activity is expected to increase, in turn raising the volume of acquisition financing transactions. Players in the industrial sector with high revenue exposure to foreign markets should help drive this trend. Improved economic conditions and increased penetration of international sophisticated credit funds could also sustain, to some extent, structural innovation and leveraged finance transactions.

Italian market overview by:

Vincenzo Bruni Partner

Australian mid-market and corporate lendingThe benefits of increased liquidity within Australian capital markets have generally not extended to the mid-market segment. Credit availability to Australian mid-market companies has decreased, amid softening market conditions, lower credit risk appetite and increased capital requirements.

As a result, bank financing has generally been directed to larger, investment-grade enterprises in preference to mid-market corporates. We are seeing capital constraints being experienced by mid-market enterprises, particularly higher-growth entrepreneurial businesses and those exposed to cyclical sectors (i.e., agriculture, resources, mining services, property development, construction and homebuilding).

Against this backdrop, an active and growing alternative debt financing market has emerged to fill the void left by the banks, spurred by the low interest rate environment and the absence of capital adequacy requirements on alternative lenders. Alternative lenders with direct debt mandates, such as credit funds, superannuation funds, insurance companies and mezzanine funds, have increased their participation rates in Australia. These lenders are able to offer debt financing on more flexible terms and longer tenors to borrowers, compared with commercial Australian banks.

Australian mid-market by:

Jason Lowe Partner

Chinese mid-market and corporate lendingAccording to statistics covering the first three quarters of 2015 provided by the People’s Bank of China, aggregate financing to the real economy reported double digit growth on an annual basis. Renminbi-denominated loans and the net financing of corporate bonds increased by RMB8.99t and RMB1.80t, to RMB97.06t and RMB14.41t respectively. In the past few decades, bank loans have been the dominant means of financing in China for its real economy. In 2015 financing through bank loans slowed down in the first half of the year but picked up again in the third quarter following market volatility. While bank loan issuance was turbulent, bond issuance accelerated throughout the year and became the fastest growing segment.

In the onshore bond market, by October 2015, a total amount of RMB7.79t had been issued according to ChinaBond, predominantly in government bonds and policy bank bonds. Corporations that previously issued bonds denominated in foreign currencies in the offshore market have returned to the onshore market given the relatively lower financing costs and uncertain foreign exchange outlook.


“ China has developed its bond market from nonexistence in the 1980s to the world’s third largest today.”

2015 has seen major diversification in the bond market, as exchangeable bonds, short-term corporate bonds for securities companies and M&A private placement bonds debuted in the exchange bond market. In 2015, the Chinese Government carried out a debt restructuring program, swapping over RMB1t of maturing local government debt for long-term municipal bonds, in turn deepening and broadening the investor base for municipal bonds. A growing municipal and corporate bond market is expected to relieve the systematic risk of the economy and the burden on the banking sector, and help diversify funding resources across all enterprises.

In line with financial reforms and internationalization of the renminbi, China allowed overseas investors wider access to its bond market in 2015. Certain foreign central banks, sovereign-wealth funds, and other international financial institutions now have open access to the interbank market where the vast majority of government and corporate bonds are traded.

Although many market participants have raised concerns that the Chinese bond market is overheated, the size of the Chinese bond market compared with GDP is still relatively small. Under moderately easy monetary policies and financial reforms aimed at innovation and internationalization, China is expected to continue to see its bond market broaden and diversify.

Nearly every analyst cut expectations on Chinese economic growth for the years ahead in the third quarter of 2015, after manufacturing Purchasing Managers Index (PMI) hit a six-year low. Although the sluggish manufacturing sector and GDP figures concern many bankers and asset managers, there is much room for development in the Chinese capital market as the Chinese economy enters a new steady growth phase of around 6–7% annually.

2015 saw equity market volatility, with RMB24t of the bubble being deflated between June and July, and forcing a series of central government interventions. 2015 also witnessed rapid growth in the bond market as well as interest rate liberalization reforms. The Chinese Government took measures to protect and stabilize its equity market and develop its bond market as part of its longer-term financial reform.

Renminbi-denominated loans used to take up over 90% of aggregate financing to the real economy, whereas this figure was reduced to 67.2% by the end of Q3 2015, according to the People’s Bank of China. To support the enormous amounts of capital needed for its continuing infrastructure development, diversify the risk in its banking system, and establish a multilevel capital market, China has developed its bond market from nonexistence in the 1980s to the world’s third largest today, after the US and Japan. To stimulate capital raising for high-growth start-ups, offer a greater share of financing activity to the private sector, and encourage entrepreneurship, China has created the GEB (Growth Enterprise Board), over the counter (OTC) market, and numerous local equities exchange centers. Change in market structure is further evidenced by the much greater role of direct financing such as bond issuance, which will likely continue in 2016.

2015 saw the nonperforming loan rate of commercial banks, according to the China Banking Regulatory Commission, increase to 1.5% at the end of Q2 2015. We also saw the first default by a state-owned enterprise on the bond market. As risks develop in the fast growing credit market, regulators continue to introduce policies to shift debts away from commercial bank balance sheets, broaden the investor base, improve liquidity, and facilitate corporate debt restructuring and local government debt swaps. Entering 2016, the Chinese economy will face challenges brought by over-capacity and credit risks, but prior experience will help the market and regulators to correct mistakes and deal with extreme market conditions. We see the Chinese capital markets, especially sectors that offer direct financing, becoming more active and efficient for domestic financiers, and more attractive to global financial institutions.

Chinese mid-market by:

Andrew Koo Partner


Committed terms have now extended to those of term loans and traditional funding facilities, with five-year facilities now common. This has presented opportunities to borrowers in that they have been able to take advantage of the low margins currently on offer, and lock in these attractive rates for longer. Facilities provided are more flexible and can be utilized via an Revolving Credit Facility (RCF). We also note that the breadth and structure of the available collateral has been extended following the global financial crisis and the retrenchment of traditional banks. These increases in appetite are seen in the 90-95% advance rates, increasing property loan-to-value (LTV) and recurring revenue funding. Intellectual property and cash flow funding are back alongside debtors, stock and plant and machinery.

In addition, a new trend has emerged in the European ABL space this year that combines traditional asset-based lending alongside debt instruments to increase overall lending capacity, commonly via a debt fund or unitranche debt. This form of lending structure has been in place in the US for some time now, and like many financing products that originate in the US, looks to be making its way across the Atlantic.

The benefit of this relatively new ABL or unitranche structure is that it provides the opportunity to stretch leverage with a single financier, typically for a one-off transaction, such as an acquisition, buyout or dividend, as opposed to traditional ABL used to fund working capital only. From a lenders perspective, this combination enables them to offer an innovative structure and access to a wider range of deals where an ABL or unitranche

Asset-based lendingUK asset-based lendingAsset-based lending (ABL) is a form of financing whereby lenders advance funds against a percentage of the underlying value of the borrower’s assets. The UK ABL market stood at GB£41b in terms of agreed facilities as at June 2015, representing an almost 10% increase compared with the same period in 2014. This statistic illustrates how the ABL market, despite being well established, continues to grow and develop, and is no longer the preserve of small or turnaround and under pressure businesses. According to statistics from the Asset Based Finance Association (ABFA), ABL-based advances across all businesses have grown consistently for the past 10 years. It’s clear that both borrowers and lenders are now fully comfortable with the benefits of ABL as an effective financial instrument.

From a borrower’s perspective, the advantages are clear. The fact that lenders are advancing against liquid assets with readily attributable value means that their credit risk is ultimately smaller, and with this will often come lower interest margins and non-utilization fees. Pricing has remained with the borrower in 2015, partly driven by the low interest rate environment, but also due to an increase in competition in the ABL space. What may have been a relatively niche product just a small time ago is now common place, with the vast majority of domestic banks offering ABL-based solutions in competition with well-established ABL specialists and debt funds.

Key aspects of this change include the length of facilities offered via the market.

structure is more appropriate than a cash flow lend. As funders become increasingly comfortable with this offering, we expect this debt product to be a key area of growth in the ABL space in 2016.

In terms of sector, ABL continues to be an appropriate fit for financing working capital in the manufacturing, distribution and services industries. Together, these sectors made up 84% of ABL customers as at June 2015, according to ABFA data. The service sector was the largest, with 13,125 ABL clients, closely followed by manufacturing with 12,832. We are also seeing an increasing willingness to lend to sectors not traditionally associated with ABL. The technology industry is one such example, with lenders starting to advance funds against “softer” securities, such as intellectual property, finance companies and construction.

The growth in recent years of the ABL market has showed no signs of slowing. Both total funding available and total facilities agreed increased in the six months to June 2015. This is a trend we expect to see continue into 2016. This growth has been driven by a combination of increased corporate understanding of ABL products, coupled with an increase in the flexibility and lending structures offered by the growing number of ABL providers.

The key question as we move into 2016, is how the mainstream banking parties in the ABL market respond to the increased competition and favorable conditions for borrowers. If the initial indication is anything to go by, it looks like this could be through new product offerings that combine ABL with more traditional debt products, resulting in more nuanced ABL products coming to the fore.


US asset-based lendingUS asset-based lending volume dipped in 2015, down approximately 11% over the same period in 2014. Seen as an attractive form of relatively inexpensive debt with limited covenants since the credit crisis, asset-based loans have become a popular tool for private equity firms.

Combining an asset-based loan with high-yield bonds creates a maintenance free covenant package. However, private equity, LBOs and high yield volume have trailed off in 2015. Despite supply

“ The key question as we move into 2016 is how the mainstream banking parties in the ABL market respond to the increased competition and favorable conditions for borrowers.“

being down in 2015, banks remain eager to deploy capital and spreads remain attractive for issuers. Market activity continues to be driven by refinancing volume, as issuers seek to take advantage of the attractive interest rate environment with new issue drawn and undrawn pricing continuing its downward trend since the global financial crisis.

With banks strong loan books and continued deposit growth, conditions in the US asset-based lending market are expected to remain favorable for issuers as demand is anticipated to exceed supply in 2016.

By:

Ben Wildsmith Director


By:

Anton Krawchenko Director

Francesco Cauli Assistant Director

Mathieu Scemama Senior Executive

Global credit rating outlook

Falling back in 20152014 continued a positive trend of lower corporate defaults in the US and emerging markets. However, 2015 witnessed a sharp correction, with the highest default tally since the disastrous record set in 2009. As at September 2015, Standard & Poor’s (S&P) recorded 79 defaults globally, second only to the 198 recorded in 2009.

For European issuers, the news is consistently negative, with both 2014 and 2015 seeing a higher number of defaults than during and after the global financial crisis. However, these defaults are heavily affected by Greek and financial sector defaults.

Global corporate defaults by region (2004 to 2015 year to date*) *As at 23 September 2015

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20150

25

50

75

100

125

150

175

200

US Europe Other developed region Emerging markets

Source: “Global Corporate Default Tally Rises To Highest Level Since 2009,” S&P, 24 September 2015.

We are very far from a turning point in global corporate credit quality (in which defaults consistently fall and ratings upgrades outpace downgrades). Rather, we expect to see overall net downgrades going into 2016, with corporate defaults remaining above the average of the past five years.


Emerging market issuers comprise a higher portion of the 2015 default tally, at double the average in the previous years.

Conversely, the proportion of US defaults decreased to less than 60% in 2015, against over 75% in the last 10 years. These figures reflect the current economic environment, with the US expected to be the first developed nation to normalize its interest rates. The emerging markets’ outlook has materially weakened on the back of recessions in Russia and Brazil and overall softness. Nevertheless, both S&P and Moody’s expect US speculative grade defaults to increase in 2016.

The trend in 2014 was positive, but this has reversed in 2015For the first year since 2007, S&P recorded more rating upgrades than downgrades in 2014. But this positive trend is likely to be short-lived.

Long-term trend in upgrades versus downgrades

-30

-25

-20

-15

-10

-5

0

5

10

15

20

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014

%

Upgrades (% all issuers) Downgrades (% all issuers)

Net downgrades and upgrades (% all issuers)

Source: “2014 Annual European Corporate default Study and rating Transitions,” S&P, 19 May 2015.

Macro challenges in 2015 include low commodities prices, tepid growth in most developed markets, comparatively slower growth in China, stock market volatility, and the Greek crisis. Those problems triggered negative impacts for issuers exposed to commodities and emerging markets, resulting in a surge in downgrades.

US speculative gradeAt the end of October 2015, S&P had recorded 299 rating downgrades among US speculative grade companies since the beginning of 2015, an increase from 193 over the same period in 2014. Around 30% of these were from the oil and gas sector, with the metals and mining sector also impacted. Other sectors are also starting to see potential issues materializing. For example, in the automobile sector there are concerns over demand growth in emerging markets and the aftermath of the Volkswagen scandal.

As at the end of October 2015, the share of US speculative grade companies with a negative bias from S&P (either a negative outlook or a credit watch negative) stood at 17%, against 6% for those with a positive bias. We expect this proportion to be broadly consistent for ratings across the board.

Muted global growth outlook, with risk to the downgradeWhile China remains one of the engines of global growth, its growth rate is expected to decrease, potentially leading to a hard landing.

Other emerging markets have suffered more worrying developments, with both Russia and Brazil expected to remain in recession in 2016. Oil economies are also expected to continue to suffer, potentially impacting a swathe of corporate issuers in those markets affected by lower business and consumer demand.

Moody’s GDP growth forecasts

-6

-4

-2

0

2

4

6

8

10

Brazil China India Russia UK US Eurozone

%

2014A 2015F 2016F

Source: Moody’s, “Global Macro Outlook 2015–16,” 28 August 2015.

Developed markets have fared better, notably with the US and the UK recording positive growth, however, forecasts continue to be revised downward, pushing the prospects of monetary easing farther down the road.

We expect the rating trend to match the global trend, with emerging market weaknesses and the global uncertain outlook to limit positive rating movements.


This rollercoaster ride shows clearly the volatility in swap rates throughout 2015; significant swings in rates were experienced by risk managers and traders alike in the first quarter of 2015. This was driven by the Greek crisis and subsequent elections followed by the anticipation of the ECB finally instigating its wholesale asset purchases in the form of QE. This volatility never really left as markets lurched from the Chinese equity rollercoaster, data points indicating to slowing global growth, and in the UK a vote on Scottish independence and a general election.

With such a volatile rate environment, what else can hedgers do to make a more informed decision?

When we advise clients on their hedging strategies we will always compare the current LIBOR forward curve with an average of a sample of economist forecasts to see if the market is pricing close to where economists believe rates should be. The LIBOR forward curve should never be taken as the only predictor of where LIBOR will fix in the future. We’re not trying to beat the market, after all that’s not what hedging is about, but comparing both curves gives our clients more context for their hedging decisions.

Comparison of LIBOR forecasts versus economists’ forecasts

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Rat

e (%

)

Economists Market view

Dec 2015

Oct 2016

Mar 2017

May 2016

Aug 2017

Jan 2018

June 2018

Nov 2018

Feb 2

020

Jul 2020

Dec 2020

Sept 2

019

Apr 2019

Source: Bloomberg.

Who would be a rates strategist in this market?This time last year we commented on how the interest rate markets had wrong-footed so many forecasters. Gilt yields and swap rates were to rise steadily throughout 2014, and the UK and US would be the first of the G7 nations to raise their benchmark interest rates from today’s historic lows.

What happened to swap rates during the year?At the start of 2014, many forecasters suggested the 10-year gilt would end the year at 2.80%, while it actually closed at 1.75%. At the start of 2015, many commentators predicted that medium-term swap rates and gilt yields would end the year roughly where they started, and they are thus far proving to be right. The 10-year gilt is currently yielding 1.88% … but that doesn’t quite tell the full story as you can see from the graph below.

5yr GBP swap rate

Jan 2015

1.0

1.21.3

1.1

1.41.51.61.71.81.9

%

Mar 2015

Apr 2015

Feb 2

015

May 2015

Jun 2015

Jul 2015

Aug 2015

Nov 2015

Oct 2015

Sep 2015

Source: Bloomberg.

Global interest rate outlook



In the middle of 2015, the LIBOR forward curve was pricing materially higher interest rates than most economists forecasts. As concerns grew over economic growth, with Chinese and UK data also pointing to slowing growth, LIBOR forward rates fell and were slightly below the economists’ forecasts. This example shows the benefits of looking beyond just the LIBOR forward curve when making decisions on the most appropriate hedging product. Simply, the market (i.e., the LIBOR forward curve) always exaggerates a move higher or lower in rates, while economists and forecasters look beyond short-term market influences.

Following November’s “Super Thursday,” it looks as if a UK rate hike could be some time away, and much has been written on this subject. The EY Item is forecasting the first rate rise in the UK in the autumn of 2016.

How have borrowers hedged their exposures this year?With so much uncertainty over the interest rate outlook, what has been very apparent to us is that at the start of the year our clients were more inclined to buy caps to keep that optionality. It was a good decision, backed up by EY’s analysis on the cost of carry of entering into a fixed rate swap versus the purchase cost of an option. With so many macro events and the resultant swings in rates, market volatility started rising, while swap rates fell, pushing up the cost of interest rate options relative to swaps.

Interestingly, we also saw banks competing more aggressively on swap credit margins, with credit and capital spreads easily back in single figures for good-quality credits. Therefore, many more clients moved to hedging with forward starting swaps to benefit from a flatter yield curve, which made the forward start less expensive and avoided the relatively more expensive option premium.

10yr–2yr GBP swap rate

Nov 2015

0.5

0.70.6

0.80.91.01.11.21.3

Difference in 10yr swap rate and 2yr swap rate

%

Feb 2

015

May 2015

Aug 2015

Nov 2015

Source: Bloomberg.

Although this strategy may not suit everyone, the thorough analysis we provide gives our clients a significantly more informed view to make that decision. A bank’s swap desk will often argue that a hedger is indifferent to transacting a vanilla swap today versus a forward start swap with a higher rate. This is true when compared with the LIBOR forward curve from which it’s priced, but using the same LIBOR forward curve to discount back what you’ve priced on a forward basis is always going to give you the same answer. That’s why it’s key to consider the reduction in the cost of carry to make a more informed decision.

We see the UK rates staying low next year, but volatility won’t go away … Looking forward to 2016, the majority of forecasters are seeing a slowing of GDP and low inflation in the UK, so the “lower for longer” theme should continue. Nonetheless, this doesn’t mean that swap rates will be any less volatile than in 2015, and careful analysis will be needed for clients to create the right hedging solution.

Global interest rate outlook continued from page 33

Credit Markets 2015–16 35

… and the divergence in global rates will continueAlthough euro rates spiked after the disappointment of much less monetary easing than forecast (hoped?) by the ECB, the market then decided that this would force the ECB to cut discount rates further and increase the quantity of asset purchases with many commentators looking for a further €40 billion a month. Euro rates then traded lower while, conversely, a US rates hike seemed certain for December; the first increase in US rate in nine years. This divergence in monetary policy is illustrated below in the path of two year euro and US dollar swap rates.

2y euro and 2y US$ swap rates

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

Jan 15Feb 15

Mar 15Apr 15

May 15Jun 15

Jul 15Aug 15

Sep 15Oct 15

Nov 15Dec 15

%

2 yr US$ swap rate 2 yr euro swap rate

Source: Bloomberg.

With the current slump in commodity prices and oil at a seven- year low, slowing demand from China and a stronger US dollar hurting emerging market economies, we don’t see any narrowing in the spread between European and US dollar monetary policy, with the UK stuck somewhere in between the two.

It’s not the first rate rise, it’s the secondWe’re intrigued to see the global impact of the US Federal Reserve’s rate rise, which will further strengthen the US dollar against emerging markets and hurt US exporters. Remember that in 2011 the ECB raised rates twice, only to reverse as the economy stalled. Our worry would be that a rapid tightening of US monetary policy may actually drag US growth lower and further delay the global recovery. Hopefully the US Federal Reserve will pause to assess the impact of a rate hike before continuing with its policy.

By:

Stewart Mackinlay Executive Director

Rhona Herbert Assistant Director

“ Looking forward to 2016, the majority of forecasters are seeing a slowing of GDP and low inflation in the UK, so the ‘lower for longer’ theme should continue.“


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About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

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