JT: Far less forgiving capital markets and question marks over the outlook for inflation, interest rates and the economy have now dented the bank-to-bond funding trend; Do you think we will see a reversal, or will there still be a long-term trend towards more capital market funding for large corporates in the Nordic region?
LF: It is interesting to compare Europe with the US with respect to the funding mix of corporates. Fifty years ago even the US had a high reliance on bank credit, in fact the level was fairly comparable to that observed in the Nordics and the EU today. Since then, the share of bank funding for US corporates has shrunk to about 30%, compared with an average of 55% for the EU and the Nordic countries. I don't expect that we will see any major reverse in the coming years. One important reason is the vast investment needs related to the global renewable energy transition and the shift to a more sustainable society in general. Bonds, bank loans, equity and other forms of funding such as project finance will all be required to make this possible. And in today's environment of higher interest rates, credit spreads and volatility, we would also expect additional funding diversification by corporates in the form of more convertible bonds.
MR: I agree. The need for capital will be so great that bond markets will have to continue to play a key role going forward. Banks will not endlessly keep increasing syndicated loan ticket sizes or grow single exposure risks. Also, the rising interest rates could increase the attraction of bonds as an asset class for investors, offering a potentially appealing balance of risk and return in an environment of higher volatility than in the past. It could also be the case that bond markets will offer more competitive funding than banks for certain sectors or market segments, as has arguably been the case for example with the oil and gas industry, and with the Swedish real estate sector. Both sustainability-related and regulatory drivers can make banks view or measure certain risks differently than investors, leading to sometimes different appetites or pricing for certain types of credit exposure. I would point to the offshore sector as one example where high default rates have prompted greater regulatory capital reserve requirements for bank lending, which has not been mirrored on the bond side, where such a regulatory impact can be different.
JT: Do you think this past period of many years of exceptionally low funding costs has changed corporate attitudes towards risks? Has there been an element of taking funding and/or low interest rates and spreads for granted?
MR: It has to be said that the sort of clients we service in Nordea Large Corporates & Institutions are of course quite disciplined and professional in their approach to investments and funding. This has not fundamentally changed during the era of ultralow interest rates. But the sharp rise in interest rates has naturally been a rude awakening, and many companies in growth sectors such as renewable energy have needed to revise their NPV calculations for investments quite substantially.
LF: I would argue that Nordic corporates stand out in an international context in that they very clearly understand the importance of liquidity. A source of corporate distress during a sharply rising interest rate environment is related to very short maturity structures that result in considerable refinancing volumes at much higher costs. If you have longer tenors with maturities spread out over time, your average funding cost will have been much less impacted by interest rate rises over the past year. And you will have some time to adjust your pricing, sourcing and production in your business to cover for the increased funding cost. Over the past ten years, I think few companies imagined a scenario where funding costs would start to matter enough for any adjustments in the business to be needed, at least on a level where it would involve group management or the board of directors.
MR: We as private individuals as well as corporates got used to very low interest rates. It is certainly not that companies have seen money as free and gone berserk. But funding cost has dropped lower on the agenda as it has ceased to be such a material cost item. Now that interest rates have risen so quickly and sharply, albeit from very low levels, the most highly levered corporate borrowers will of course face the greatest challenge from the magnitude of the increase in their funding bill. They face a double whammy from higher variable interest rates and a widened credit spread being even more notable for weaker credit profiles.
JT: If you compare with ten years ago, should Nordic large corporates think differently about funding today? Is the playing field different in terms of availability of bond, commercial paper or bank funding? Local versus international banks? Fixed versus floating interest rate? Optimal cost of capital?
LF: As ever, corporates have to consider their asset and liability structure. If you have a very capital-intensive business, you normally want to have long-dated debt. Then, within the parameters of your financial policy, how long is long? Should you aim for somewhat shorter debt maturities hoping or expecting that in a few years' time, inflation will be under control, and that nominal interest rates will be lower than today? While I may have some sympathy for such views, I certainly would not rest my funding strategy on that being the case.
MR: The bond market has become accessible for a greater number of corporate issuers in the Nordics, so it is clearly a more natural part of their capital structure today than ten years ago. What this past decade has shown is that the corporate issuers who are able to, should tap the bond markets when they are open, available and attractively priced. This is even clearer and more crucial for high-yield issuers, where availability and terms vary even more. Investment grade bond markets have seen depth and liquidity vary, but they have remained open also during difficult periods. High-yield bond markets, however, have closed at those times. Some bond issuers in challenging financial circumstances are now experiencing that covenant breaches or amendment processes can be very different processes with bondholders than with relationship banks as counterparts. Today many more companies have experience of bond issuance and its benefits, plus the potential risks and challenges. Many have benefitted greatly from bond funding and will continue to do so, while others have a preference for bank financing.
LF: One of the appeals of bank lending is related to the flexibility on repayments; however, there may well be other restrictive terms in the covenants. On the bond side, it is generally not possible to repay the bond at par ahead of the scheduled maturity, which means that in those cases you will need to resort to liability management, e.g. such bond tender offers on terms that will be dictated by the market at that point in time. One of the fascinating things about the bond markets is how greatly terms can vary over time. For example, Argentina was able to issue a 100-year bond in 2017, roughly a year after emerging from bankruptcy. Only a few sovereigns would be able to tap into this maturity segment at present, and the terms would hardly be compelling.
JT: Sustainability has soared to the very top of corporate agendas over the past 5-10 years. How do you see it playing into corporate funding in the years ahead? How do you think it will impact bank funding?
LF: Sustainability is still very much on the ascent. Corporates are determined to ensure their businesses will become sustainable, and funding is often a suitable and important tool. European banks have committed to embarking on the very same journey, and this will extend into improving the sustainability profile of their lending book. Over the past three years, we have seen a massive increase in the number of sustainability-linked loans. Corporates are sitting down, making transitioning plans, and engaging with their banks to determine what this means for their external profile. Ultimately, sustainability and credit risk will be increasingly interlinked. The pool of funding and liquidity available for non-green and non-sustainable assets and businesses will likely shrink, and the pool of sustainable and green assets will continue to grow. And then there is again the additional powerful driver from the renewable energy transition. For Europe, Russia's invasion of Ukraine and the subsequent shortages of imported Russian gas and oil have made it imperative that this transition go faster. The vast investments needed will require green funding in many forms, including loans, bonds and project finance.
MR: I think we will see a gradual sharpening of the requirements for what can be labelled as green or sustainable. Today, some 80% of new RCFs and term loans from banks are sustainable. I think the categorisation will be calibrated and thresholds for qualifying will be higher going forward. But generally, corporates with a sustainable business will get access to a bigger and more diverse pool of creditors. To put it bluntly, over time they will have access to more and cheaper debt than those who are not able to show that they have a sustainable business. Many banks, including Nordea, have made their own public commitments in the form of targets for their own sustainability profile. Delivering on those targets is a necessity, and inevitably means prioritising redit to sustainable borrowers, and potentially reducing or even exiting credit exposures that are unable to become sustainable. However successful banks may be in reducing emissions and improving sustainability in their own operations, becoming sufficiently sustainable will simply not be possible if the client portfolios they fund are not sustainable.