Credit Markets 2016 17 - EY - United StatesFIL… · Contents Credit Markets 2016–17 02 Thank you 04 Foreword 08 Leveraged finance 13 Investment grade 19 Mid-market round-up 22

Credit Markets 2016–17Analysis and opinions on global credit marketsIssue 4

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Cont

ents

Credit Markets 2016–17

02 Thank you

04 Foreword

08 Leveraged finance

13 Investment grade

19 Mid-market round-up

22 Asset-based lending

23 Global credit rating outlook

25 Global interest rate outlook

28 Further insights

2 Credit Markets 2016–17

Welcome to our fourth issue of EY Credit Markets. 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.

EY Credit Markets is a publication we are proud of, and one that we hope you find of value. EY 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.

2016 was a year dominated by global political events. It was also another strong year for credit markets worldwide. Global credit markets traded through periods of political uncertainty, supported by solid credit fundamentals, continuing support from stimulus measures from global central banks and an ongoing acceptance of the new world post the global financial crisis.

Likewise, 2016 was another important year for our global Capital and Debt Advisory platform. We now have a team of over 100 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 US$25b.

We look forward to working with you this year and wish you all the best for the remainder of 2017.

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

Chris Lowe Partner, Capital & Debt Advisory

Luke Reeve Partner, Capital & Debt Advisory

Chris Lowe

Luke Reeve

K.C. Brechnitz

Than

k yo

u!

3Credit Markets 2016–17

Meet your global team

EY offices

We now have teams of over 100 advisors in EY member firms across the world with connectivity to global debt capital pools:

France

Olivier Catonnet [email protected]

Czech Republic

David Zlámal [email protected]

Spain

Jose María Rossi [email protected]

Israel

Yoav Ben-Yeshaya [email protected]

Italy

Vincenzo Bruni [email protected]

Australia

Jason Lowe [email protected]

China

Andrew Koo [email protected]

Canada

Brian Allard [email protected]

Brazil

Gustavo Vilela [email protected]

Singapore

Luke Pais [email protected]

United Arab Emirates

Hani Bishara [email protected]

US

K.C. Brechnitz [email protected]

Germany

Britta Becker [email protected]

Jan Henrik Reichenbach [email protected]

UK

Chris Lowe [email protected]

Luke Reeve [email protected]

Sweden

Lars Blomfeldt [email protected]


The crash of the US stock market and subsequent depression did not immediately sweep the world in a wave of economic decline. The US suffered sharp declines in manufacturing output and employment, but globally, other industrial countries also experienced difficulties. One outcome was a large decline in world trade. This was exacerbated by a round of tax increases on imported goods (tariffs) instituted by many nations turning inward through trying to bolster low growth in their own economies. As a result, international tensions and labour-related issues began rising globally. Financial and political events began cascading, with one crisis leading to another. A large European bank collapsed and concerns grew over the possible weak financial condition of other European banks. The rush of crowds of depositors all at once further weakened banks across the world.

New and struggling governments, heavily burdened by debts, raised international concern. With their economies struggling, people lost faith in their elected governments. Economic crisis continued to spread to other European nations. Other countries responded with major budget cuts and finally changes in

19

29

Wall Street Crash of 1929 and Great Depression 1929–1939

19

73

Secondary UK banking crisis 1973–1975

19

95

20

14

Dot-com bubble 1995–2001

Russian financial crisis 2014

19

90

20

09

Finnish and Swedish banking crises 1990s

European sovereign and Greek government debt crisis 2009 onwards

19

87

20

08

Black Monday 1987

Russian financial crisis 2008–2009

Irish banking crisis 2008–2010

Icelandic financial crisis 2008–2012

20

07

20

15

US subprime mortgage crisis 2007–2009

Chinese stock market speculative bubble and crash 2015–2016

– 2 0 1 51 9 2 9

Fore

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d Foreword by:

Rob Jones Director

Sophie O’Mulloy Executive


government. Unemployment rates in Europe soared and social unrest escalated with the effects of unemployment, in addition to the rise of nationalism. Seeking solutions to the global financial crisis, more than 60 global leaders met at the World Economic Conference in London. When the conference ended without agreement, the global economy experienced a prolonged economic depression.

The economic and social hardships of the global financial crisis led to the destabilization of global politics. Nations, one by one, led first by the US and then the UK, turned inward to try to solve their problems. The lack of global economic and political cooperation fuelled the growth of nationalism.

The timeline below provides an edited history of the Wall Street Crash in 1929 and the Global Depression that followed in the 1930s.

2008 to 2016 was a period of significant social, political and economic change in the wake of the Global Financial Crisis. The year 2016 was dominated globally by macro political events,

as well as social unrest. Politically it was a year of great change and yet most global credit markets remained stable, with the underlying fundamental drivers of global credit markets remaining strong. Today, market liquidity continues to benefit from the significant levels of quantitative and monetary easing enacted by central banks since 2008.

Global economic, political and social change is also being driven by the Fourth Industrial Revolution. The impact of artificial intelligence, robotics, the Internet of Things, autonomous vehicles, 3-D printing, nanotechnology and quantum computing, to name just a few, can be seen across all sectors. It is changing the way we work, live and interact with one another. It is difficult to believe that global credit markets can continue to remain unchanged with this level of disruption.

So far 2017 looks like a year in which access to global credit markets will depend, more so than usual, on global political events. History has demonstrated that global financial markets are as much about sentiment as they are about underlying financial

JA

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WEF (Davos) 17–20 January

Donald Trump’s first day in office 20 January

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Dutch parliamentary election 15 March

UK begins the formal Brexit negotiation process End of March

SE

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German parliamentary elections September

MA

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AP

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French presidential election First round in April, run-off in early May

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19th National Congress of the Communist Party of China Autumn

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Iran ends diplomatic relations with Saudi Arabia January

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UK votes to leave the EU 23 June

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Former UK Prime Minister David Cameron resigns from Parliament 12 September

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The Brazilian Senate votes to impeach the President of Brazil, Dilma Rousseff August

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Theresa May becomes PM following David Cameron’s resignation 13 July

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Donald Trump wins US presidency 8 November


and economic drivers. Positive upwards cycles have historically rarely gone unchecked. Small triggers can have large unintended consequences. The Fourth Industrial Revolution, and the changes that it will bring, has the potential to raise global productivity and improve the quality of life for people around the world. However, there are a number of social, economic and political issues to navigate alongside these technological changes.

Uncertainty brings challenge, but also brings opportunity. Globally, credit markets remain open, with debt available on borrower friendly terms. The key to navigating uncertainty and seizing opportunity is ensuring that you have access to capital (when required), with terms that provide you with sufficient headroom to navigate your way through what lies ahead.

Global commodity prices

0

50

100

150

200

250

300

Dec 08 Aug 09 Apr 10 Dec 10 Aug 11 Apr 12 Dec 12 Aug 13 Apr 14 Dec 14 Aug 15 Apr 16 Dec 16

Inde

xed

Crude oil Natural gas Gold Platinum Copper

Source: S&P Capital IQ

Global equity markets

0

50

100

150

200

250

Jan 07 Aug 07 Mar 08 Oct 08 May 09 Dec 09 July 10 Feb 11 Sep 11 Apr 12 Nov 12 Jun 13 Jan 14 Aug 14 Mar 15 Oct 15 May 16 Dec 16

Inde

xed

FTSE 100 Index S&P 500 Index Germany DAX Index (performance)

Nikkei 225 IndexHang Seng Index

Shanghai Stock Exchange Composite Index

ASX Limited

Source: S&P Capital IQ

Foreword continued


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European leveraged financeDespite market uncertainty from macro events, Leveraged Loan issuance in 2016 was resilient and in line with 2015 volumes. European Leveraged Loan volumes for 2016 were €70.8b, compared to €62.8b in 2015.

In terms of the underlying drivers of volume, 2016 Leveraged Loan volume linked to M&A activity declined 15% on 2015. This was partially driven by European companies and sponsors delaying investment decisions till after the outcome of the EU referendum. However, post referendum, despite an outlook that continues to be uncertain, M&A processes have continued to push ahead.

In 2016 Leveraged Loan volumes were also driven by an increase in opportunistic transactions, capitalising on high levels of liquidity and low pricing to execute dividend recapitalizations and refinancings. Both activities saw a significant increase versus 2015.

High levels of liquidity and lack of supply are creating a borrower friendly environment with lower pricing, higher leverage appetite and looser documentation (including an increase in covenant-lite transactions). The average margin on B-rated loans declined from 499bps at the beginning of 2016 to 424bps at the end of 2016. Senior leverage in 2016 increased to c.4.5x compared to a 2015 average of c.4.3x, which is the highest level since 2007.

High levels of liquidity in the European Leveraged Loan market has been driven by several dynamics:

► Banks: A continued strategic push by European lenders to deploy capital after several years of deleveraging post-financial crisis. Many European banks are seeking to prioritize maintaining existing portfolio assets, often with aggressive refinancing terms.

► Alternative Lenders: Record levels of fundraising over the last few years have allowed direct lenders to compete in larger transactions, as well as to aggressively pursue the mid-market. Alternative lenders continue to gain market share of the European Leveraged Loan market from banks, following in the footsteps of the US market. Alternative lenders are becoming increasingly innovative and aggressive to complete with banks. Unitranche transactions are increasing in size, with a handful of alternative lenders now offering debt facilities in the US$1b range, increasing competition with traditional bank underwrite and syndication options.


► Collateralized Loan Obligations (CLOs): The European CLO market has continued its re-emergence within the increased regulatory environment post-financial crisis. European CLO volume for 2016 was €16.8b from 42 deals, compared to €13.8b from 34 deals in the same period in 2015. This is a post-financial crisis record.

The aforementioned liquidity trends have enhanced banks’ capability and appetite to underwrite transactions with increased CLO demand for paper and private debt funds’ ability to act as an anchor investor to reduce underwrite risk.

Leveraged Loan volume

0

100

200

300

400

500

600

700

800

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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 2015 2016

US$

b

Europe US

Source: LCD S&P

Leveraged finance


continued

For 2017, it is expected that market demand will continue to exceed supply, driving competition amongst lenders. As a result, we believe that the market will see further innovation in leveraged finance solutions and increasingly borrower friendly terms to differentiate offering amongst competitors.

Market participants will also keep a close watch on the European Central Bank’s (ECB) guidelines on limiting leverage and the impact on the deal structures. It is anticipated that draft guidelines will be in line with US Leverage Lending Guidance, which limits leverage to 6.0x. European lenders and investors will look to US market trends to understand the potential impact of such a cap.

European High Yield bond marketActivity in the European High Yield market in 2016 declined 17% on 2015 (€53b vs €64b). There was a recovery in volumes in the second half of 2016. High Yield volumes for the first six months of 2016 were down 48% versus the same period in 2015, as issuers and investors waited for the EU referendum outcome.

The strong recovery in European High Yield issuance in the second half of 2016 has been driven by ECB’s corporate bond buying programme, CSPP, which drove down yields. Borrowers took the opportunity to refinance their high coupon debt at lower pricing with longer term maturities.

In terms of sponsor-backed issuance, 2016 volumes declined to €13b from €20b in 2015. High levels of liquidity allowed financial sponsors to access covenant-lite bank financing on beneficial terms. European High Yield activity was therefore underpinned by corporate issuers, which accounted for 83% of total volume in 2016.

For 2017, market expectations are that borrowers will continue to capitalize on low yields to execute refinancings. However, the supply of refinancings will come to an end and investors will need to see more acquisition financing volume come to market to support future European High Yield activity.

Average number of covenants per transaction

3.52 3.71 3.64 3.66 3.65 3.56

3.00

2.50

1.43 1.27

0

1

2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: LCD S&P

European alternative lending marketThe alternative lending market continues to establish its position in the mid-market space as a primary source of financing.

Given the number of alternative lenders operating in the European mid-market (EY Capital and Debt Advisory have relationships with more than 100 in Europe alone), there is significant competition to deploy capital and establish a track record in order to sustain continued investor commitment to the fund and the market.

“ Despite market uncertainty from macro events, Leveraged Loan issuance in 2016 was resilient and in line with 2015 volumes.”


In 2016 there was an increasing awareness from alternative lenders for the need to differentiate themselves from competitors:

► Transaction size: Alternative lenders have extended the range of transaction sizes that they can invest in, mainly through either partnering with banks or increasing their hold appetite. For larger funds, deploying more capital into a transaction mitigates against competition risk in closing further transactions. Smaller funds have focused on identifying niche areas and financing small mid-market transactions, where there are more off-market opportunities and hence less competition.

► Non-sponsor: There is significant competition between various pools of liquidity (banks; alternative lenders; high-yield and CLOs) for sponsor-backed transactions. An increasing number of private debt funds are moving to finance non-sponsor owned companies, given the lower levels of competition.

► Growth capital/special situations: Alternative lenders have an increasing appetite to finance transactions with higher credit risk characteristics, through junior and/or equity-like financing.

Alternative lenders’ flexibility in structuring financing with more covenant headroom, fewer covenants and minimal amortization has applied pressure to banks’ market position on terms. In turn, banks are competing on leverage to reduce the differential versus the alternative lenders core unitranche offering.

In 2017, the pressure for banks and alternative lenders to deploy capital should increase further, with market participants forecasting a continued borrower friendly environment. As lenders create more innovative solutions and broaden their origination efforts, there will be a greater penetration of the mid-market with (i) more event-driven opportunities; (ii) companies shifting from equity funding to debt funding for growth strategies; and (iii) family-owned businesses taking a less conservative view on debt financing.

European leveraged finance by:

Greg Moreton Director

Mark Tsang Assistant Director

US leveraged financeDespite a slow start to 2016 driven by wider macro concerns, the US Leveraged Loan market was resilient in 2016 and accommodative to issuers. 2016 volume was 13% ahead of 2015 (although over 27% behind 2013’s all-time high). The surge in new issue volume in the last six months of 2016 was driven by strong underlying demand from CLO creation and retail fund inflows. The issuance in September 2016 marked the highest monthly total in over three and a half years. Indicative of favorable market conditions, both new issue and secondary spreads tightened throughout 2016. Leverage multiples remained near historical highs, with structures and credit protections loosening.

The following trends were observed throughout 2016:

► New issue M&A/LBO volume was relatively balanced with opportunistic (recaps and refinancings) transactions versus M&A/LBO accounting for nearly 48% of issuance in 2016.

► While the broad M&A environment remained supportive (availability of debt, strong cash balances), elevated valuations led to a pull-back in M&A activity in 2016. Dampened by high valuations and continued leverage lending regulatory oversights, LBO activity remained subdued, although relatively less than corporate M&A volume. The effects were also seen in LBO equity contributions nearing 45% of capital structure — the highest since 2009.

► While in line with last year (approximately 22%) and up significantly versus historical (<10%), year-to-date pro rata proportion of total volume declined steadily throughout 2016. The decline in proportion throughout the year (pro rata accounted for 49% in Q1 versus 14% in Q3) was the result of reduced corporate M&A activity versus LBO activity. LBO backers typically favor the more aggressive institutional market.

► After several years of outflows, retail investors have finally begun to creep back into floating rate loans as rates begin to rise. LIBOR has climbed to 98 bps (at time of writing) compared to 54 bps at the same time in 2015.

Going forward into 2017, it is expected that technical conditions should support favorable loan market conditions for issuers. Market participants eagerly await the flow through impacts from the US administration change — will it be a non-event or a catalyst for change, either positive or negative? As commodities begin to show signs of stabilization and modest economic growth supports cash flow and debt service, fewer anticipated energy and metals/mining defaults are also expected in 2017.

Leveraged finance continued


continued

US Leveraged Loan volume

0

100

200

300

400

500

600

700

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Volu

me

(US$

b)

Pro rata Institutional

Source: LCD S&P

US High Yield Bond marketNew-issue US High Yield volume was down approximately 13% year-on-year. With a slow start to 2016, on the heels of the December 2015 rate hike, EU referendum and on-going rate hike uncertainty, the bond market was unable to sustain prolonged issuer-favorable market conditions. While US treasuries widened throughout the year, credit spreads tightened. Strengthening macroeconomic trends support improved cash flow generation, but, conversely, also support Fed tightening. The US economy, political transitions and central bank policies may shift sentiment going into 2017.

► Higher rated credits (three-B profile and higher) accounted for nearly 45% of year to date volume versus nearly 53% over the same period last year.

► Refinancing accounts for nearly 63% of 2016 volume, versus 46% last year.

► M&A supply, including acquisitions, mergers and spinoffs, represented roughly 19% of total issuance in 2016, down when compared to 34% for 2015.

The outlook for 2017 in the US High Yield market is expected to shift from favorable to less favorable. US High Yield bonds are expected to experience pressure as the Federal Reserve evaluates the frequency and magnitude of rate increases as inflation is forecast to increase.


US High Yield volume

0

50

100

150

200

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300

350

400

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Volu

me

(US$

b)

Secured Unsecured Subordinated

Source: LCD S&P

US investment grade by:

Todd Ulrich Director

Leveraged finance continued

“ Going forward into 2017, it is expected that technical conditions should support favorable loan market conditions for issuers.”

Canadian leveraged finance marketThe Leveraged Loan market in Canada is influenced by North American bank and non-bank institutions. The market remained relatively robust for non-oil and gas participants in 2016, with senior leverage multiples, for non-sponsored borrowers, approaching 4x. Assets Based Lenders continued to compete for assets and a share of the Canadian loan market, resulting in pricing near or below that of conventional lenders.

continued


European investment grade marketMany themes in 2015 in the UK and European investment grade debt markets persisted into 2016. As mainstream M&A volumes remained supressed, lender demand continued to exceed supply, with a lack of issuers coming to market. Although banks and investors still hunted for yield, particularly in the low benchmark rates environment, the first half of 2016 was marked by a notable contraction in credit spreads. Despite key market mover events as the year progressed, such as the EU referendum and US elections, upward pressure on credit spreads was largely contained as competitive tension prevailed. The emergence of further central bank market interventions, including the Bank of England’s (BoE) corporate bond purchase programme, further exacerbated investor demand for new issuance.

Global M&A volumes

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2

3

4

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

US$

t

Source: Dealogic

Unsurprisingly, many issuers’ timetables were dictated by the global economic calendar as borrowers looked to avoid transacting during periods of heightened market volatility. As such, we saw healthy momentum in supply ahead of the EU referendum in June 2016, followed by lacklustre issuance volumes as market participants paused to evaluate the possible effects of the EU referendum result. However, as we started to approach the US elections in November, there was a noticeable surge in supply, particularly in the Private Placement (PP) market, making October 2016 the largest recorded month of issuance of all time at US$13b.

European bank marketIn 2016, UK and European bank debt volumes totalled £535b (28% down from 2015). With continued suppression in mainstream M&A activity in 2016, the vast majority of bank transactions were for the refinancing of existing debt, with borrowers targeting committed financing well beyond the expected date of the UK’s exit from the EU (2019). “Amend and extend” deals were seen in the market, albeit to a lesser extent than 2015, on account of the sheer number of corporates who had already undertaken such transactions. Overall, the loan market continued to present a strong source of liquidity, with banks offering increasingly competitive pricing which, in turn, put increased pressure on growing ancillary income. Ongoing regulatory pressure has ensured the most attractive pricing, and terms for borrowers have been typically limited to a maximum of five years, with frequent inclusion of extension options. Longer term financing remains challenging/uncompetitive for lenders in comparison to non-bank capital markets sources.

NAIC-1 US Private Placement spreads (bps)

500

150100

200250300350400450500

Spre

ad to

US

Trea

sury

/bps

10–year high 10–year low

Dec

11

Apr

12

Aug

12

Dec

12

Apr

13

Apr

14

Aug

13

Dec

13

Aug

14

Dec

14

Apr

15

Aug

15

Dec

15

Apr

16

Aug

16

Dec

16

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

Dec

11

Apr

12

Aug

12

Dec

12

Apr

13

Apr

14

Aug

13

Dec

13

Aug

14

Dec

14

Apr

15

Aug

15

Dec

15

Apr

16

Aug

16

Dec

16

Source: Private Placement Monitor

Investment grade


European public bond marketAs expected, supply in the GBP public bond market fell well below investor demand (GBP primary bond volumes totalled £24.3b vs. £14.3b in 2015), principally driven by a lack of M&A (away from a handful of jumbo transactions) and borrowers diligently adopting a “wait and see” approach to issuance strategies. There was, however, a flurry of deals following the EU referendum result as a number of issuers looked to take advantage of the immediate fall in Gilt yields and the impact of the BoE’s bond purchase programme.

Competing investor demand kept credit spreads low at the beginning of the year, but growing uncertainty over the result and effects of the EU referendum saw an uptick in pricing in the lead up to 23 June 2016 when it was held. There was an immediate spike in credit spreads after the vote, as political uncertainty was compounded by investors looking for compensation for falls in Gilt yields and the resultant impact on all-in coupons. This trend was swiftly reversed as the BoE’s bond purchase programme accelerated through late July and August, after which Gilt yields crept steadily upwards, accelerating through the autumn, which in turn saw credit spreads compress.

Private placement marketDespite scepticism at the start of 2016 that global volumes would match recent years, which were close to US$60b, the PP market continued to be an attractive source of long term liquidity for (implied) investment grade borrowers and current reports suggest that 2016 was a record year for PP volumes. Supply was dominated by utilities (25% of 2016 global volumes), infrastructure (15%) and real estate (14%).

In terms of geographical demand, notwithstanding the EU referendum, interest for UK credits remained strong, with the UK being the second largest contributor to global supply (US$9b equivalent in 2016). UK issuers were able to benefit from the competitive funding environment, not only from competitive tension driving spreads tighter, but also the wider availability of non-USD funds. More than 90% of the reported UK transactions included a GBP and/or EUR tranche, with numerous deals fully funded on a non-USD basis. Delayed drawdowns were also offered, which ranged from the standard one month delay to up to two years. It was also encouraging to see that over 45% of UK transactions were from debut issuers.

European investment grade outlook Despite the growing uncertainties surrounding the timetable and potential ramifications of the EU referendum result, shifting US Government policies and looming European political events, debt markets should continue to offer corporates financing options at historically attractive costs. However, clearly articulating to lenders how a borrower’s business could (or will) be impacted by local and global economic events, and how those risks are mitigated, will be crucial to credit story positioning. Notwithstanding the large amount of capital that banks and investors still have available to deploy, in our view, lenders may become more selective on credits in 2017, favoring those in defensive sectors (e.g., domestic infrastructure and utilities) and credits with a clear strategy on how to approach what is an increasingly uncertain macro-economic environment.

The recent trend of quasi-public sector borrowers (e.g., universities and housing associations, etc.) accessing the debt capital markets (public or private) should continue into 2017, as government funding for these sectors remains constrained. Regulatory pressures on banks are likely to result in more discussions focused on the refinancing and/or restructuring of legacy fixed-rate long term debt to help alleviate banks’ balance sheets and capital reserve requirements.

14

Investment grade continued

continued


As some issuers choose to take a “wait and see” approach to financing, we expect supply in the investment grade debt markets to still be far short of investor demand, despite increasing talk of a “great rotation” on the buy-side out of bonds and into equities. As such, we believe there will be more options available to high quality credits as lender/investor competition manifests itself into a greater convergence on pricing and terms across the debt markets. Increased competition is also likely to result in larger ticket sizes and bids, putting a further squeeze on the number of banks and investors allocated in any single transaction.

With the UK Government’s proposed end of March 2017 deadline for triggering Article 50 and other upcoming European elections, heavier issuance volumes in the debt markets could be seen in the first few months of 2017. This will likely be underpinned by a focus on long term funds as borrowers look to secure attractive all-in coupons before benchmark yields are expected to rise, whilst avoiding pricing in periods of heightened market volatility. Concerns remain amongst market participants that the effects of triggering Article 50 have not yet been fully priced in to credit spreads. A clear risk to borrowers is that pricing could rise as 2017 progresses.

European investment grade by:

Michael McCartney Director

Giles Barling Director

Caroline Ly Assistant Director

US investment grade marketUS new-issue volume in 2016 was approximately 4% ahead of comparable 2015 levels (a record breaking year in itself). Issuers continued to flock to the market and lock in historically low rates with the ever-looming anticipation of rising rates. Market technicals remained strong due in part to strong overseas demand for US corporate bonds (given their relatively attractive yield compared to foreign bond markets where yields are close to zero, if not negative). Average tenor shortened nearly 12 months throughout 2016 to nine years and nine months as lack of global conviction to long term quantitative easing spilled into the US and pushed up the long end of the treasury curve.

Use of proceeds for investment grade bond issuers was once again dominated by corporate purposes, followed by refinancings 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. One big difference in the use of proceeds year over year is a material slide in deals backing direct shareholder returns via share buybacks and/or dividends. Such offerings were down 26% in 2016 versus 2015, but remained up over 60% compared to 2014 volumes.

The 2016 record breaking pace is supported by attractive all-in yields for issuers. Treasury rates have remained low for most of the year before spiking in late 2016 on increased conviction in US growth and Fed tightening. Consistent with historical trends, fixed rate issuance comprised approximately 87% of total issuance. Additionally, BBB issuance remained the most prolific rating category accounting for approximately 41% of volume.

Going forward, the US supply outlook is cautiously optimistic, though volumes are expected to pull back in 2017 after consecutive record breaking years. Additionally, while analysts may have a bullish outlook on credit spreads given favorable technical conditions, rising treasury rates are expected to weigh on new-issue volume.

“ … lenders may become more selective on credits in 2017, favouring those in defensive sectors …”


US investment grade loan issuance

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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 2015

Vol

ume

of d

eals

(US$

b)

Num

ber

of d

eals

Volume (#Deals) Volume (US$m)

Source: Bloomberg

Monthly US M&A volume (US$b)

050

100150200250300350400450

Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Dec 16

Volu

me

(US$

b)

Source: Bloomberg

US investment grade by:

Todd Ulrich Director


“ Going forward, the US supply outlook is cautiously optimistic, though volumes are expected to pull back in 2017…”

continued


Canadian snapshotThe Canadian corporate bond market in 2016 continued to be dominated by investment grade issuers, with the High Yield debt market remaining subdued. Bond issuance in the corporate sector in 2016 was dominated by financial services companies, with the next most active sector being energy.

The bond market was primarily driven by government issuance versus corporate bonds. Canadian government yields continue to be at near historic lows. In July 2016, the Canadian 10-year bond yield had its lowest close on record, closing below 1% as investors moved to the safety of government bonds.

The Canadian Federal Government continued to take advantage of low interest rates as it looked to stimulate the economy.

Brazilian snapshotThe uncertain political environment that prevailed for most of 2016 prevented policy makers approving fiscal reforms to address the fiscal deficit. A deteriorating fiscal position contributed to increased debt and investment-grade rating losses. On the demand side, resilient inflation, influenced by energy and utilities, forced monetary authorities to maintain high benchmark rates, which significantly contributed to reduced investment across all sectors. High benchmark rates also had a material impact on default rates.

All of the above shaped Brazilian capital markets, which were highly selective, leading to shorter tenors, higher margins and lower volumes. Local debt capital markets activity lost momentum, with volumes and total transactions down approximately 5% versus 2015. Excluding leasing operations from banks, the reduction was even higher (approximately 19%).

On a more positive note, M&A, venture capital and private equity activity increased, driven predominantly by currency depreciation and lower valuations.

2017 will remain a challenging year for Brazil, though it has the potential to offer more opportunities to the debt capital markets. On the political front, uncertainties for lenders and borrowers will likely decrease with the conclusion of the Lava-Jato investigation, and a smoother interaction between the legislative and executive branches of government. On the economic front, a decreasing inflation rate trend shown at the end of 2016 should prevail, bringing inflation down to the Government’s target. This should continue to feed through to lower benchmark rates.

Brazilian investment grade by:

Gustavo Vilela Partner

MENA snapshotIn 2016, MENA continued the trend of volatility witnessed in 2015 with continued ongoing turmoil in Syria and Iraq, leadership transition in the Kingdom of Saudi Arabia (KSA), currency devaluation in Egypt and a widespread fiscal pinch caused by a depressed oil price.

Set against a background of falling revenues, MENA borrowing activities increased, with October 2016 the busiest month since 2010 for MENA borrowers. This was largely driven by sovereign issuance — one of the key themes for the year. In October 2016, Saudi Arabia placed a triple tranche US$17.5b loan, adding to its issuance earlier in the year and to other Middle East borrowers including Bahrain, Oman, Abu Dhabi, Jordan and Qatar.

Continuing the trend of increased borrowing to fund budget deficits from local and international markets, 2016 witnessed an uptick in interest in Public Private Partnership (PPP). As oil revenues stabilize towards a new normal in the Middle East, states and governments are looking at new ways to deliver infrastructure projects not previously seen in the region.

Recent legislation in KSA, UAE, Oman and Qatar have set the groundwork for more PPPs, with a reported infrastructure pipeline of US$2t. In KSA, plans for the privatization of the country’s airports and aviation services are advancing, with the state aiming for full private sector ownership by 2020. The Saudi Government inaugurated its first PPP airport scheme in 2015 with the US$1.4b Prince Mohammad Abdulaziz Airport in Medina. In the final quarter of 2016, Qatar authorities launched a tender process seeking firms to develop school projects in the country through PPP structures. In the UAE, the Ministry of Climate Change and Environment is planning to invite private-sector bidders to run a large-scale project to handle waste in the Northern Emirates, capable of processing between 1,000 and 1,500 tonnes per day. In Oman, the Ministry of Health is partnering with Carillon for the PPP development of the US$1.5b Sultan Qaboos Medical City.


In the domestic banking market, lower oil revenues have also impacted both banks and lending behaviors. Lower public sector deposits have led to more limited bank liquidity which has had the knock-on effect of increasing pricing and constraining lending patterns. In addition to these trends, there have been a number of financial institution fundraisings and the impending merger of two Abu Dhabi-based lenders will create the largest regional bank by assets.

Debt capital markets remain underutilized in the region, although the recent award of a trading licence to S&P in KSA may help boost supply. Borrowers with good credit have been able to access debt capital markets. However, many highly-rated regional credits have opted for local loan financing.

This year is expected to continue to exhibit many of the same trends as 2016 and 2015. With budgetary deficits likely to continue into 2017, MENA is likely to see a continued trend in tightening of credit in the domestic banking space. Upcoming sovereign redemptions will place an additional strain on credit markets.

The infrastructure pipeline in MENA is estimated at over US$2t. Within this figure are a large number of nationally significant projects which will add to the primary debt issuance required by sovereigns and GREs. This will likely further reduce liquidity as the domestic banking system is leveraged to fund these projects.

A further recovery in the price of crude will lessen the impact of tightening liquidity, and the fiscal stimulus from infrastructure projects should lift growth in MENA. Conversely, a falling crude price environment will likely place additional pressure on sovereigns and credit markets and may even exert pressure on some MENA sovereign currencies pegged to the dollar.

MENA investment grade by:

Hani Bishara Partner

Ben Parton Associate Director

Natasha Shenoy Executive


“ As oil revenues stabilize towards a new normal in the Middle East, states and governments are looking at new ways to deliver infrastructure projects not previously seen in the region.”

continued


UK market overview2016 was a quiet year for the UK mid-market, caused predominantly by political anticipation and uncertainty. Prior to the EU referendum, markets were quieter as transaction completions were delayed pending the outcome.

The referendum result preceded a busier than usual summer, where there was a push to complete transactions, whilst the markets were buoyant and there was a degree of short term certainty. The second half of 2016 was still quieter than normal, as would be buyers and borrowers waited to see what would happen next.

Despite the uncertainty, there have never been more options in the mid-market for borrowers, with new lending products becoming available from both alternative lenders and the public markets. The number of alternative lenders who are willing and able to write large tickets has almost doubled in the past 12 months. The availability of transactions remains an issue for lenders and an opportunity for borrowers. The diverse range of alternative lenders who entered the market in 2011–2015 has remained. They continue to be more creative, with increasing appetite to consider sub-£10m EBITDA and non-sponsor backed transactions. Banks have responded by improving their lending terms in the form of fewer covenants, looser terms and a more aggressive approach to leverage.

Looking ahead to 2017, we believe that uncertainty is the only certainty, but as we saw after the deep economic shocks of 2008, markets quickly adapt to a “new normal”. It remains the case that these are unprecedented “good times” for borrowers and whilst we have seen pricing move up slightly following the referendum result, in the core mid-market liquidity remains high.

UK market overview by:

Amy Griffiths Assistant Director

French market overviewOverall, local debt markets continued to be highly supportive of French companies in 2016. The total amount of financing outstanding had grown by approximately 4.5% year-on-year, as at the time of writing, according to Banque de France data. This was driven by the strong appetite of local banks, which still provide circa 61% of total financing in France. The French banking sector is seen as robust, with healthy levels of capital adequacy and high levels of liquidity, which has led to strong competition between lenders to the benefit of borrowers. The trend towards disintermediation has continued, but the shift was slower in 2016 than in 2015.

In 2017, French debt markets will as usual be very dependent on the overall environment of the Eurozone and of the ECB’s future policies. The main internal issue likely to impact the debt markets will be the upcoming presidential election (first round on 23 April and run-off on 7 May).

The main changes in the structure of the market should again come from alternative lenders and private funds. First, terms will probably keep improving for Euro private placements on the back of competition from banks as well as Schuldschein. As a result, 2017 could see more flexibility from alternative lenders in terms of leverage or structuring to justify higher yield requirements. There are also new initiatives targeted at the smaller end of the mid-market. Banks, in particular, are trying to leverage their local networks to tap this potential market.

French market overview by:

Olivier Catonnet Partner

Mid-market round-up


US market overviewThe US mid-market traditionally lags the broader and larger US Leveraged Loan market. It took the mid-market longer to recover from the early 2016 pullback. As a result, US mid-market new-issue loan volume was down approximately 32% compared to 2015. Despite the prolonged softness lasting into late summer, mid-market new-issue volumes gained traction through the second half of 2016. November 2016 was the highest volume month since July 2015. With supply rebounding and demand remaining strong, arrangers were able to implement more aggressive structures into mid-market leverage loan deals.

All-in new-issue yields for mid-market loans were largely flat versus 2015. While rates are flat, the tightening in the broader loan market has caused the spread between mid-market loans and the syndicated loan market to double. This premium to the broader loan market has helped to bolster demand. The regulatory environment continues to fuel the trend away from traditional bank syndicated processes to originate/buy-and-hold and one-stop debt structures. Market participants expect these trends to remain intact and possibly become more aggressive with corporate M&A and LBO volume remaining sluggish. Looking ahead, the mid-market is expected to remain favorable for issuers as the macroeconomic outlook remains stable.

Chinese market overviewAccording to statistics (provided by the People’s Bank of China), aggregate financing to the real economy was RMB13.5t in 2016, indicating a RMB1.5t increase on an annual basis. Bank loans remained the dominant means of financing in China, accounting for circa 68% of all financing in 2016. Bond issuance witnessed a strong increase in 2016, amounting to circa 11% of total new financing.

Renminbi-denominated loans issuance was circa RMB10t in 2016, representing an increase of RMB1t compared to the same period in 2015. Corporate bond issuance was circa RMB2.6t in 2016, representing an annual increase of RMB0.7t compared to the same period in 2015. In 2016, the total issuance of bonds was circa RMB28.2t, representing year-on-year growth of circa 78%. Government and local policy bank bonds accounted for the majority of this issuance. Credit bonds, such as short term financing bonds, corporate bonds, medium term notes, totalled RMB6.3t in 2016, an increase of 61% year on year.

Recently much stricter regulatory policies were launched to regulate the shadow banking system in China. As a result, shadow banking activities were reduced in 2016.

Concerns continue to focus on default rates and non-performing loans in China. The ratio between GDP and aggregate financing had risen from 206% at the end of 2015 to 220% by the end of Q3 2016. A number of asset management companies (AMCs) have been set-up, targeted at disposing of non-performing loans.

Chinese market overview by:

Andrew Koo Partner

Australian market overviewAustralian loan markets witnessed strong liquidity, credit appetite and tightening spreads, due to continued competition among lenders to attract modest corporate borrower demand (Australia loan activity fell from US$79.5b in 2015 to US$72.8b in 2016). This competition was also driven by limited M&A and leveraged buyout transactions and the introduction of new funding sources, including an increasing presence of Asian banks, new bond market platforms and new direct private debt placement transactions.

Whilst an overall softening in corporate lending was observed, the bank market remained highly liquid for investment grade borrowers, leveraged buyout transactions backed by strong counterparties and preferred sectors such as healthcare, aged care and infrastructure/energy. Strong competition for these “preferred” borrowers continues to see attractive pricing in line with the historically low margins seen in the past 12–18 months. In addition, there was strong support for the various “mega deals” seen in the market over 2016.

Conversely, appetite is now severely limited for a number of sectors including real estate construction and development (in particular inner city development), metal and mining services, along with sub-investment grade credits more broadly. The strong property finance transaction activity experienced over the past two years, for both developments and investment assets, has

20

Mid-market round-up continued


reduced substantially, where recent softening in residential market conditions and regulatory pressures have resulted in financiers adopting a more cautious approach.

Due to increased regulatory capital requirements, the major Australian banks have re-weighted lending portfolios towards capital efficient home loan lending by being more selective towards their corporate lending businesses. These conditions have seen the Big 4 domestic banks experience a run-off in their loan books with clients also diversifying into bonds, PP, foreign banks and other sources of capital as the Australian alternative corporate funding landscape continues to evolve.

Consistent with the theme of Australian corporates diversifying funding sources, in the last 12 months we have seen an increase in privately placed alternative debt to around A$45b (compared to A$35b in 2015), the continued emergence of new market platforms such as Simple Corporate Bonds (expanding the A$52b Australian corporate bond market) and increased awareness of Government supported initiatives such as the A$10b Clean Energy Finance Corporation.

The market has continued to see increased demand from retail and institutional investors driven by appetite for stable, higher yielding investment opportunities and asset class diversification, which will continue to drive the development of these alternative funding sources in Australia.

Despite the Reserve Bank of Australia (RBA) lowering the cash rate to a historic low of 1.5% in August 2016, overnight cash rate futures continue to price in potential rate cuts in mid-2017 before potential rate rises in the first half of 2018. There is also some upwards pressure on credit spreads, although this is currently still being offset 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 a meaningful level of cross sell to support their overall return hurdles.

Looking forward to 2017, approximately A$90b and approximately A$115b of syndicated/club loans are due to mature in 2017 and 2018 combined. However, event driven deal flow, including a continued roll out of new infrastructure projects and Government asset sales will likely be a key swing factor for market conditions.

The rise of alternative funding options for Australian corporates will continue to become a more mainstream solution for Australian corporates and a way to diversify funding sources and achieve greater tenor. Further headwinds facing the traditional banks, such as disruption from technological advancement, increased regulatory oversight, flat economic growth and the globalization of capital, will also drive this trend.

We expect to see more global institutional investors (including US PP investors) expand their direct debt mandates, with many now increasing allocations to Australian debt and opening offices in Australia. Domestic superannuation funds are also looking to increase their direct debt investments as both a hedge against global volatility and an opportunity to generate increased returns in a low return environment.

The outlook will be impacted by broader global market movements; despite some relative stability in local market conditions, ongoing volatility due to the changing political climate will flow through to the Australian market.

Australian market overview by:

Jason Lowe Partner


UK asset-based lendingAsset-based finance (ABF) is a form of financing whereby lenders advance funds against a percentage of the underlying value of the borrower’s assets. Companies which have large account receivables balances or other valuable assets such as large inventory stockpiles are typically the types of businesses which are best suited to benefit from ABF facilities. The majority of the ABF market in the UK is comprised of invoice financing where businesses secure funding against their unpaid invoices. However asset-based lending (ABL) is also becoming more prevalent with an increasing number of lenders willing to advance against more illiquid assets such as inventory, property, plant and equipment.

In 2016 appetite for ABF continued to rise, as management teams and financial sponsors continued to become increasingly aware of the benefits of using ABF to fund working capital, free up cash flow to accelerate growth plans and also, in some situations, use it to form a core debt component of a company’s capital structure.

A significant number of transactions which EY’s Capital and Debt Advisory team advised on during 2016 saw an ABF facility form part of the financing structure being put in place. The benefits of ABF from the borrower’s perspective are clear. As a lender’s credit risk is reduced by lending specifically against liquid assets with a readily attributable value, this often results in significantly lower interest costs and non-utilization fees, quicker approval times and flexible terms to borrowers as the size of the facilities can scale up in size in line with the growth of the business. We’ve also seen ABF pricing throughout 2016 remain very favourable for borrowers, partly as a result of the continued low interest rate environment and also due to the strong competition in the ABF market.

The growth in the size of the UK ABF market in 2016 was principally driven by larger corporates (revenue of £50m plus) availing of ABF, with the product now no longer viewed as solely being associated with SME’s/turn around stories. Agreed ABF facilities stood at £39.5b as at June 2016 according to the Asset Based Finance Association (ABFA). The use of Invoice Financing in particular is becoming increasingly mainstream as businesses seek to diversify their funding sources away from traditional loans to prevent over reliance on them. Continuing concerns amongst borrowers over any potential EU referendum related credit tightening in 2017 is likely to increase the need to diversify credit sources still further.

The UK leads the rest of Europe when it comes to the use of ABF. The ABF market here continues to grow and develop, with the majority of banks operating in the UK now offering ABF-based solutions, combined with well-established ABF specialists and credit funds who can offer an innovative solution to borrowers in the form of a hybrid ABF and cash flow financing structure.

This combines asset–based finance with a more traditional term loan which increases the overall debt capacity for the borrower. The benefit of this relatively new hybrid structure is that it provides the opportunity to stretch leverage with a single financier, typically for a one-off transaction, such as a buyout or dividend, as opposed to traditional ABF used to fund working capital only. This combination enables lenders then to access a wider range of deals where an ABF structure is more appropriate rather than a sole cash flow lend. Lenders have also demonstrated appetite for larger hold levels on larger ABF hybrid transactions as opposed to cash flow lends which are, in effect, asset light. As funders have become increasingly comfortable with this offering, we’ve seen a notable uptick in the number of these types of debt structures during 2016 and expect this debt product to continue being a key area of growth in the ABF space in 2017.

The growth in popularity of ABF witnessed in recent years from financial sponsors and also publically/privately owned corporates shows no sign of slowing as we move into 2017. The drivers of this growth, being a combination of increased awareness of ABF products coupled with an increase in the flexibility and lending structures offered by the growing number of ABL providers, are expected to result in 2017 being another strong year for the ABF market.

We expect lenders to continue to grow their ABF product offering as the regulatory landscape in Europe continues to change, making it increasingly difficult and more expensive from a capital point of view to provide “unsecured lending”.

The big question for 2017 is how the various ABF lenders respond to increased competition and favorable conditions for borrowers. If 2016 and recent trends are anything to go by, it looks like this could be through continued new innovative product offerings coming to market and further penetration of traditional and non-traditional sectors by ABF.

Asset-based lending by:

Colm Treston Assistant Director

Asset-based lending


Downgrades overtook upgrades in 2015In line with the increased number of defaults in 2015, rating downgrades as a portion of rating actions took over rating upgrades in 2015, continuing the reversal started in 2014. The increased portion of downgrades reflect a global environment with increased risks to growth and overall uncertainty. Though data is not readily available for full year 2016, we note that this trend has continued throughout the year as markets react to unexpected events such as Brexit and the result of the US elections.

Long term trend in upgrades versus downgrades

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-10

-5

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5

10

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1993

1995

1997

1999

2003

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2011

2009

2013

2015

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rat

ing

acti

ons

Upgrades Downgrades Net downgrades/upgrades

Source: S&P, “2015 Annual Global Corporate Default Study And Rating Transitions”, 2 May 2016

Overall, the proportion of rated issuers belonging in the sub-investment grade category has been increasing, partly supported by the ongoing downgrades trend. For S&P, as of September 2016, 55% of active corporate ratings in the US are speculative grade, while in Europe the proportion has increased markedly since the downturn. We note that the growth in share of speculative grade issuers typically precedes an increase in the speculative grade default rate.

Ongoing increase in defaults recorded in 2016Last year was another record year for defaults with the global tally reaching 120 issuers as at September 2016, compared to only 100 in the whole of 2015 (an 100% increase from the 50 defaults recorded in 2014 and the highest default annual tally since the 236 recorded in 2009).

Global corporate defaults by region As of 30 September

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016*0

25

50

75

100

125

150

175

200

225

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US Europe Other developed region Emerging markets

Source: S&P, “Global Corporate Quarterly Default Update And Rating Transitions (Third-Quarter 2016)”, 30 November 2016

The surge in 2016 was driven to a large extent by increases in defaults in the US (which represented approximately two thirds of the defaults recorded in 2016 as at the time of writing), with 81 recorded as of September 2016, against 54 for full year 2015. A large portion of these defaults were energy and natural resources issuers, hit by low commodities prices and reduction of investment in the sector.

Defaults increased materially (albeit remaining at a low level) for other developed countries (Australia, Canada, Japan, New Zealand) and more modestly for emerging markets, also largely reflecting the stresses on commodities and energy sectors. In comparison, Europe has actually seen its YTD default tally reduce as of September 2016 compared to the previous year.

Global credit rating outlook

continued


“ We expect uncertainty to remain elevated in 2017.“

Level of uncertainty remains high in 2017We expect uncertainty to remain elevated in 2017. Political risk is expected to remain on the agenda, with important elections in France and Germany, among others, which could potentially impact the global economic environment. Uncertainties also remain on the trajectory of base interest rates, the potential impacts of rate rises and the unwinding of central bank monetary easing programmes. Overall, economic growth is expected to stabilize, albeit at a historically low level.

Interestingly, Moody’s and S&P anticipate opposite scenarios for 2017, with the former expecting the global speculative grade default rate to fall gradually during the year, while S&P expects the default rate to moderately increase, at least during the first part of the year. Nevertheless, both S&P and Moody’s expect the speculative grade default rate to remain relatively low and close to the historical average.

Moody’s macro economic assumptions

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Brazil China India Russia UK US Euro area

GD

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Source: Moody’s, “Global Macro Outlook 2017–18”, 14 November 2016

Some key trends are nonetheless expected to impact rated universes in 2017:

► Low interest rates remain supportive of refinancing conditions at least in the short term, although negative side effects (rapid debt build-ups, increased pension deficits) can lead to credit quality deterioration.

► Political risk will remain a challenge and lead to further large foreign exchange fluctuations, while the increasing protectionist sentiment may hamper global trade growth.

► Risks of a re-pricing of assets or a hard landing in China remain on the horizon.

From a sector perspective there is no strong trend dominating: for instance for the EMEA region, Moody’s in the last six months upgraded the outlook of six sectors but downgraded the outlook of four others. Five sectors remain with a negative outlook (steel, oilfield services and drilling, refining and marketing, automotive manufacturers and shipping) while only three have a positive outlook (consumer products, exploration and production, aerospace and defence).

Global credit rating outlook by:

Anton Krawchenko Director

Francesco Cauli Assistant Director

Mathieu Scemama Senior Executive

Global credit rating outlook continued


Global interest rate outlookA year packed with surprisesIn EY Credit Markets 2015–16 we noted that interest rate markets had wrong-footed many forecasters and this year was no exception. In particular, financial markets were rocked by two events. Both the EU referendum and the US election results caught many unprepared.

In response to the EU referendum, the BoE cut the UK Base Rate and substantially increased its asset purchase programme. As it stands, the BoE is expected to refrain from further adjustments to its monetary policy, instead remaining vigilant to the uncertainty around the EU exit negotiations.

Elsewhere the US Fed raised the benchmark Federal Reserve rate in December 2016, a year after it started what it thought would be a more regular rate hike program. Meanwhile the ECB has been reviewing the need to extend its asset purchase program beyond March 2017.

Overall it’s been a particularly volatile year for GBP swap rates and UK gilt yields. In the immediate aftermath of the EU referendum, interest rates fell sharply and sentiment was such that economists predicted a further BoE Base Rate cut. However, those thoughts were quashed by comments from both BoE Governor Mark Carney and Prime Minister Theresa May, citing the adverse effects of a negative interest rate environment.

Since then, GBP interest rates have been trending higher. Initially, economic data has not been as weak as feared although economists warn it’s still too soon to gauge the full impact of the referendum decision.

The result of the US election has sparked concerns from some market participants over the inflationary implications of meeting campaign pledges. USD interest rates surged 30bps in the longer end of the curve while GBP swap rates and UK gilt yields also pushed higher. By the end of November 2016, GBP swap rates had reversed much of the post EU referendum fall.

Another major consequence of the EU referendum has been the fall in the value of GBP. Indeed by October 2016 GBP had fallen around 20% to its lowest trade-weighted level for over 150 years.

This led to a rethink over inflation forecasts due to higher import costs. EY’s Item Club expect inflation to reach 2.6% in Q3 2017. Although this will breach the BoE’s inflation target of 2%, it’s expected to be short lived and market participants consider it unlikely to prompt any changes to monetary policy. Certainly the market view at this stage is that the BoE views GDP as the key determining factor in any monetary policy decision rather than inflation, which had previously been considered the more appropriate economic measure to target.

Increased FX market volatilityGBP’s depreciation following the EU referendum result brought home to our clients the risk of having FX exposures. Although painful for importers and those with currency liabilities, the reverse was true for organizations with currency income and assets.

The change in the value of GBP not only sparked a revaluation of budget forecasts with our clients, it often brought about a wider review of the hedging policy. This was particularly true for those with translation exposures as the hedging strategies deployed vary enormously between treasury functions and sectors.

FX volatility has defined 2016

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Dec2015

Jan2016

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GB£/US$ GB£/EUR

Source: Bloomberg

Looking to 2017So what will 2017 bring? When we advise clients we look at what economists are forecasting and compare that with what the interest rate swap curve is implying. Not that it will give us a definitive answer; instead it gives perspective to the thought process. Financial markets are notoriously unpredictable and hedging is about reducing or removing uncertainty.

At the start of 2016, the GBP swap curve implied rates would trend higher, however soft GDP and inflation forecasts suggested otherwise. At the time we favored a continuation of the low interest rate environment.

continued


But what a difference a year makes and as we head into 2017 the signals are mixed. The GBP swap rate curve continues to imply interest rates will trend higher, but the graph shows that the trend is more pronounced compared to the start of 2016. Although UK growth is expected to be soft next year, inflation is likely to be higher.

While the UK is likely to remain in a “low for long” interest rate environment, we may not breach the historically low levels for GBP swap rates and UK gilt yields which were reached in 2016.

LIBOR forward curve has seen a step change higher since June 2016 as inflation expectations build

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Source: Bloomberg

Legacy swaps: The mark to market is not the only consideration As GBP swap rates and UK gilt yields fell during 2016, banks have been actively managing legacy swap positions which have increasing negative mark to market valuations. This year we have helped our clients identify and unlock the true value of their legacy swap positions and we expect this to continue to be a major theme in 2017.

The current trend is towards banks offering discounts to traditional mark to market break costs in recognition of the benefit banks receive when these transactions are either closed, re-couponed or novated. Banks have a substantial exposure to their uncollateralized swap counterparties and these exposures have a profound impact on banks’ capital, funding and credit requirements making these transactions extremely expensive for banks to hold.

And it’s these valuation adjustments that form part of the wider valuation of a derivative transaction. These include credit, funding and capital valuation adjustments (CVA, FVA and KVA) and it is important to calculate these alongside the traditional benchmarking of final breakage costs.

These liabilities have grown as interest rates have fallen, so banks have become increasingly proactive in managing their exposures and specifically in relation to their core and non-core businesses. Swap transactions as recent as 2013 are being included in these risk assessments.

How has this affected our clients?Many of our clients have been approached by banks actively seeking to reduce this exposure. For some the solution has been to find alternative swap counterparties (novation) while others have taken the opportunity to restructure their swap portfolio.

A cash injection is required to close or re-coupon most legacy swap positions, which can be met from cash balances or from raising new funding. Our ability to accurately calculate CVA and FVA gives clients transparency on the size of potential discounts to break costs.

This year we’ve advised and assisted many clients to raise new finance for both growth and to restructure legacy fixed rate loans/pay fixed swaps. By accurately modelling the discounts to break costs and with our experience in raising finance, we can give our clients a complete picture as to the efficiency of different approaches to removing legacy fixed rate/high break cost positions.

Another way banks can remove legacy swap positions from their books is by novating the transaction to another swap provider. In the same way as breaking or re-couponing the swap, it is important to identify the benefit for the exiting bank during the negotiations. We have worked on a number of novation exercises with clients and guided them through the process to get the best economic result.

Global interest rate outlook by:

Stewart Mackinlay Executive Director

Rhona Herbert Assistant Director

Ari-Elizabeth Lewis Assistant Director

Global interest rate outlook continued


“ This year we’ve advised and assisted many clients to raise new finance for both growth and to restructure legacy fixed rate loans/pay fixed swaps.“

Further insights


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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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Documents

Credit Markets 2016 17 - EY - United StatesFIL… · Contents Credit Markets 2016–17 02 Thank you 04 Foreword 08 Leveraged finance 13 Investment grade 19 Mid-market round-up 22