A sell-off in the domestic bond market in mid-2015 pushed up credit spreads for A-rated corporates by 35 basis points (bp). Spreads have risen a further 17bp this year. So far the loan market has lagged movements in corporate bond spreads but the pricing differential is unlikely to persist as banks look to manage cost of funds pressures.
Banks’ cost of funds is rising – Credit spreads for the four major Australian banks widened by 24bp last year. The further 18bp increase this year is essentially due to uncertainty around the outlook for underlying profitability and earnings in an era of low interest rates and regulatory change. Offshore many banks face negative interest rates and there are concerns around the capital adequacy of European banks. There’s also the risk associated with the 23 June referendum on Britain’s exit from the EU. Greater uncertainty means greater market volatility and therefore wider risk premiums.
Distress Ratio at post-GFC high – Representing the percentage of speculative-grade bonds that are trading at spreads exceeding 1,000bp over US Treasurys, the Standard & Poor’s Distress Ratio has reached 29%. Thus S&P expects the speculative-grade default rate to reach 3.9% by the end of 2016, up from its earlier forecast for a mid-2016 default rate of 3.3%. Given the historical relationship between US speculative-grade defaults and A$ credit spreads, CommBank’s credit strategists have lifted the higher end of their forecast range for corporate spreads by 7bp to 170bp.
Healthy loan pipeline – After M&A volumes grew 20% to $139 billion in 2015, M&A activity will remain buoyant as ongoing weakness in the Australian dollar and the combination of low interest rates and liquid debt markets continue to drive strong inbound M&A interest.
Various transport projects in New South Wales and port privatisations are among the infrastructure and utility transactions expected. As the New South Wales electricity distribution assets transfer from government hands we anticipate around $25 billion of debt must be raised over the next 18 months to acquire the assets and operate within the private sector.
If bond pricing remains high relative to loans, borrowers may take advantage by refinancing maturing bonds with loans.
Further spread expansion? With regulatory changes by the Australian Prudential Regulation Authority continuing and as the adoption of Basel IV gains traction among banks globally, there is further upside risk to cost of funds which has already tracked higher in response to higher debt issuance costs. Lenders are becoming more sensitive on price as yields test hurdle rates.
Transport and Infrastructure clients may want to consider securing some of their debt funding now:
- All-in pricing levels remain attractive with the cash interest rate maintained at a record low.
- Commitment fees are stable and arranging and underwriting fees are still competitive.
- Investors remain active in the domestic loan market, contributing to what has proved to be resilient market liquidity. This will benefit investment-grade borrowers in particular, especially where new money opportunities arise (versus refinancing).