The financial crisis has fundamentally changed debt markets. Banks aren’t lending as much as they did pre-crisis, capital requirements have changed beyond recognition, and both financial institutions and corporates are adjusting to a less certain environment. All of which may explain why corporate bond markets are being used to fill the financing gap.

In November 2012, Barclays raised a US$3bn corporate bond with a difference. The bank issued a contingent capital note (or coco) – a bond that automatically converts into equity as soon as a bank incurs losses that reduce its Tier 1 capital ratio below a specific threshold.

Other European banks have followed similar paths: Deutsche Bank, UBS, KBC, Danske Bank and Banco Bilbao Vizcaya Argentaria (BBVA) have all raised capital using these instruments. But cocos are not the only unusual bond issues that have become a feature of European debt markets since the onset of the financial crisis.

Innovative structures

Hybrid bonds – structured instruments subordinated to normal senior unsecured finance that have both equity and debt characteristics – have also been issued in increasing volumes. GDF Suez, AXA, Veolia, EDF, National Grid, British Gas and ArcelorMittal have all successfully issued hybrid bonds. The key attraction of hybrids is that they can be issued without affecting a company’s credit rating because the bond is effectively open-ended and can be treated as permanent capital. Documentation that has become standardized as investors become more comfortable with the asset has helped too.

Small and medium-sized enterprises (SMEs) in Germany’s Mittelstand, meanwhile, have continued to issue bonds of modest size to retail investors through German stock exchanges. SMEs in France have been tapping into bond markets too, with dairy co-operative Sodiaal raising €10m and €20m in separate issues, and engineering consultancy Altran Technologies pulling in €135m from a bond issue placed with a limited number of institutional investors and listed on NYSE Euronext Paris.

Across Europe, corporate bond issues have emerged as a credible financing alternative in what has traditionally been a debt market almost entirely dominated by banks. In the past, European banks have been all too willing to line up and loan at fairly heavily subsidized levels to build relationships with corporates and win more business.

Two things have happened in Europe. First, bond markets have matured so they have become more liquid, pricing has got a lot better and there is a lot more certainty of execution. Second, lending has become a much more expensive activity for banks, given that their cost of capital has increased and the way that they have to capitalize themselves post-crisis has become more conservative. Europe is moving towards the US model, where people borrow a higher proportion of their debt from capital markets.

Bond boom

Innovative bond structures, like cocos issued by banks, hybrids issued by corporates and small SME-backed issues, coupled with investors who are chasing yield but remain risk-averse, have contributed to the rising popularity of corporate bonds.

According to Thomson Reuters, 2012 saw a record amount of corporate bond issuance, with US$5.4trn worth of bonds issued around the world – a 13.1 percent increase on 2011. Issuance has showed no signs of easing, with a record US$2.83trn issued in the first six months of this year.

Record-breaking high-yield bond issuance in Europe, the Middle East and Africa (EMEA) is another clear sign that corporate bond issuance, a long-time feature of the US capital markets, is becoming established in other jurisdictions. According to credit rating agency Moody’s, high-yield bond issuance in EMEA reached a record US$63bn in the first six months of this year, compared to US$70bn of issuance for the whole of 2012. Companies have been eager to take advantage of low interest rates and investor appetite for higher returns than government bonds. The total debt of 327 sub-investment-grade EMEA companies has climbed by nearly a fifth this year to US$787bn as a result, and new issuers have been turning to bond markets in increasing numbers.

“We have never seen so many first time issuers as we have in the last two years,” says Gilles Endréo, Capital Markets partner at White & Case in Paris. “In the old days, it was mainly companies of sufficient size – €500m for an inaugural issue. These days, you find small companies issuing €10m or €20m, and they are able to find investors through private placement.”

Regulatory run-ins

The increase in bond issuance in Europe and the use of structures such as cocos by banks to bolster their capital ratios have been welcomed by some regulators.

Andy Haldane, Bank of England’s executive director for financial stability, has been quoted as saying that if cocos had been a feature of the market a decade ago, much of the pain of the banking crisis could have been mitigated.

Haldane calculated that if banks had paid 50 percent of the bonuses paid to staff in cocos rather than cash between 2000 and 2007, the capital reserves of the banks would have been £70bn larger, a sum roughly equal to the taxpayer bailout of the UK banking sector.

Paul Watters, head of Leveraged Finance at Standard & Poor’s, says regulators are eager to see bond markets in Europe continue to develop as they provide a crucial source of much-needed private sector investment.

“The European Green Paper published in March 2013 said that to really create a long-term sustainable competitive environment in Europe, there has to be US$1.5trn to US$2trn invested in Europe over the next seven years,” Watters says. “Given the regulatory and capital constraints on banks, the authorities are clearly focused on trying to create the right environment for the private sector to step up and provide a substantial portion of that. They see private bond markets as a significant part of the solution.”

Not all regulators, however, are as enthusiastic about the emergence of cocos and hybrid bonds.

Outside the UK, Germany and Spain, where cocos have proven popular, there are concerns that any breach of a bank’s Tier 1 capital ratio triggering a conversion of the coco bond into equity would lead to a dramatic fall in the share price.

“In Italy, there have been no coco issuances because the position of the Bank of Italy is unclear; instead the banks have done straight issues, such as the rights offering from Intesa Sanpaolo and UniCredit. In a period of time when you are not sure where the regulators are going to end up, it is the safest way to go,” says Michael Immordino, partner in the Capital Markets Practice at White & Case in Milan.

Regulators are not unsympathetic to the need for access to debt financing, adds Immordino. For example, Italy recently introduced a bill to help free up unlisted enterprises from otherwise tight restrictions on issuing corporate bonds to raise debt.

A group of parties, led by lawyers at White & Case, petitioned the government to provide equal treatment of listed and unlisted companies, based on a concept initially conceived by Immordino in 2011. The resulting Decree Law No. 83, passed in August 2012, gives full access to the corporate bond and commercial paper market for private Italian companies. It puts private enterprises on an equal footing with their listed counterparts and creates more favorable conditions for raising debt.

Neither type of company is required to apply withholding tax on payments of debt interest. While unlisted companies were once not permitted to issue bonds in excess of double their share capital and distributable reserves, there is now no limit, which opens up the Italian capital markets significantly.

This has resulted in a rash of issuances from private companies, led by those owned by private equity houses.

The new, new thing

Regulatory concern has not discouraged issuers from putting together their own new structures. If anything, it has sparked further innovation in bond structures.

A prime example of this is French bank Société Générale’s (SocGen) issue of a European Banking Authority-compliant temporary write-down Tier 1 bond in August 2013.

The hybrid capital instrument differed from a UK-style coco in that a fall in the capital ratio below 5.125 percent triggered a temporary write-down in the principal of the bond sufficient to restore the capital ratio, which would then be written back up when the bank’s capital position improved.

“From a legal point of view, these deeply subordinated notes are debt instruments, so in France we don’t have the problem that exists concerning the deductibility of coupons. In a number of jurisdictions, if the hybrid instrument is too close to an equity instrument, there is a risk the coupon will not be deductible,” says Endréo, whose Capital Markets Practice at White & Case in Paris advised SocGen on the issue.

“From a regulatory point of view, if you fulfill all the criteria set by the banking regulators, these instruments are regarded as equity instruments in the consolidated accounts and, so far as the rating agency is concerned, you get 50-50 treatment, with half treated as debt and half as equity.”

Here to stay

This kind of innovation, rising issuance and the willingness of small and first-time issuers to turn to the capital markets suggest that the recent explosion of bond issuance in Europe is no flash in the pan. As White & Case’s Immordino points out, “As banks step away from the non-investment-grade credits for regulatory reasons, this will be the only place businesses can go.”

Whereas the model has always been that the high-yield market was fickle and the bank market would support a business, that hasn’t proven to be the case. Many companies realized they needed to diversify their debt funding structure and have done so.

If Europe’s bond markets continue to grow and innovate as they have done, then the Barclays coco issued at the end of last year – which was regarded as something of a breakthrough for bond issuance at the time – could become bog-standard.

“What we are seeing is not a short-term switch from bank finance to bonds, it is a structural change,” adds White & Case’s Endréo. “Banks have difficulties lending for long maturities, so companies are switching to bonds. The bond market is here to stay, and we are likely to see an increase in the number of small and medium-sized enterprises accessing it.”

“Historically, European capital markets have accounted for only 20 percent of total funding for corporates,” adds Stuart Matty, head of the Global Capital Markets Practice at White & Case. “Compare this to the US, where 70 percent of funding by public companies comes from this source. It’s clear that if European markets start to move towards the US model, which all the indicators point to, it’s going to lead to a massive increase in the size and depth of capital markets across Europe.”

High-yield in focus

Bond issuances are not just for investment-grade corporates such as Royal Dutch Shell, which raised US$3.75bn in its August 2013 issuance, but also for those in the high-yield market. A high-yield bond has a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds because of the higher risk of default.

A clear sign of the importance of this market comes with news that the US high-yield bond activity rebounded in July 2013, posting US $21.1bn in issuance – up from US$12.8bn in June, when the markets plummeted after the Fed announced a possible tapering of its quantitative easing program. For example, telecoms company Sprint completed a US$6.5bn offering in September 2013 – the third-largest high-yield issue ever. And this activity is not just limited to the United States.

The growth and size of the high-yield market in Europe is significant. In 2008, according to Dealogic, high-yield issuance was only US$1.1bn. The market was small and could only be accessed by a handful of large corporates. The high-yield market was also notoriously fickle in Europe – closed one minute, open the next. High-yield could never be relied upon as a genuine alternative to banks.

Since 2008, however, the market has expanded and issuance windows have been longer and more consistent. Smaller businesses have been able to use high-yield markets and larger corporates have found that high-yield is more reliable. Banks are no longer the only show in town.