Is the growth of bond finance threatened by recession?

Citation

Robinson, B. (2001), "Is the growth of bond finance threatened by recession?", Balance Sheet, Vol. 9 No. 2. https://doi.org/10.1108/bs.2001.26509bab.001

Is the growth of bond finance threatened by recession?

Is the growth of bond finance threatened by recession?

The re-birth of the UK corporate bond market has been a recurring theme in this column. The market has in recent years seen a massive surge in bond issues, from just over £5 billion in 1996 to £23 billion in 2000.

The strong UK bond market is part of a global phenomenon. It has been driven by the long economic upswing, which has increased both demand and supply. On the demand side, the long boom has made businesses more confident and hence more willing to take on extra debt. On the supply side, the boom has boosted government revenue and reduced their need to borrow. The reduction in the supply of bonds by government has opened the way for an increase in the supply of bonds from corporates.

Suddenly however the economic environment looks a lot less benign. The bursting of the dotcom bubble, symbolised by the dramatic fall in the Nasdaq index, has provoked a crisis of business and consumer confidence in the USA. The economy is slowing rapidly and recession fears are rife. What will happen to the bond market issues in this new environment?

There is clearly a change in perceptions. A year ago, advisers in the UK debt markets were mainly employed helping companies to gear up. The average debt to value ratio in the FTSE 350 is less than half the US average, and a majority of companies have debt of less than 20 per cent of value. For many firms this is well below the optimum. They can create value by taking on more debt, which reduces their cost of capital and increases enterprise value.

But in the more difficult economic conditions this year, there is a significant minority of companies, particularly those dependent on US sales, which are concerned that they may have too much debt. They are looking for advice on how to reduce it. These problems are most visible in the telecoms sector, where balance sheets have been stretched world-wide. Companies have had to pay high prices in the 3G auctions just to stay in the game, and now need to roll out a huge investment programme in order to meet their growth targets.

These companies face a difficult choice. Investor nervousness about their high gearing has driven down bond prices in the sector. This drives up yields, and the cost of new capital, at a time when the sector has a continuing need to go to the market to finance new investment. But since the problems are so visible, it is difficult to restore balance sheets by selling off assets. The market sees the sellers coming and the assets fetch fire-sale prices.

However problems in one sector and slowing growth in the USA do not spell the death of the recently re-born UK corporate bond market. Bonds remain a potentially attractive form of finance because nominal long term interest rates have not been so low since the 1950s, as Figure 1 shows. Real interest rates are also lower than at any time in the 1980s or 1990s. (Low real borrowing costs in the 1970s were associated with very high nominal borrowing costs, and were not an attractive proposition.)

The remarkable decline in long term interest rates has been driven by the fall in inflation, as Figure 2 shows. In the past, double-digit bond yields were needed to compensate investors for expected inflation. Inflation expectations have fallen because the government has established a track record of lower inflation, buttressed by lower budget deficits. The fiscal discipline is much more likely to be maintained now that the Bank of England is independent. The fall in UK inflation is part of a Europe-wide phenomenon with the same causes: a convincing track record, low budget deficits and an independent European central bank.

Figure 1 Real and nominal long term interest rates since the 1950s

Figure 2 Falling inflation and falling long term interest rates

However, these benign conditions for government borrowing are not entirely replicated in the corporate debt markets. Companies pay an additional risk premium on top of the gilt rate and those spreads have been widening. And as the fear of recession has grown, monetary authorities around the world have taken offsetting action. Short term interest rates have been falling this year as the Fed has cut aggressively and the Bank of England has followed suit. This has increased the attraction of bank, compared with bond, finance for those companies still looking to take on more debt.

So how will it all play out? In the short term we could see a slowdown, if not a fall, in new bond issuance. But that does not mean the end of the newly re-born UK corporate bond market. The long run fundamentals underpinning its revival are low inflation and low government borrowing. Both remain in place. Inflation is still very subdued and the feared recession, if it arrives, is hardly likely to re-ignite it.

Unless the US downturn turns into a global catastrophe, the UK downturn is likely to be mild. Demand will be stimulated by interest rate cuts and the planned acceleration of public spending. If this leads to an acceleration in inflation, then short term interest rates, and hence the cost of bank borrowing, will go up again. That is the moment at which the UK corporate bond market might resume its growth. The present gloom does not mark the beginning of the end, just the end of the beginning.

Bill Robinson is head UK business economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former special adviser to the Chancellor of the Exchequer.