The cost of flexibility is less than the cost of financial distress

A bigger and more sophisticated bond market is here to stay, according to Nordea’s Morten Ristvedt (MR) and Lars Fischer (LF). However, a less forgiving capital market environment during the past year has led to some important lessons learned for corporate issuers, they tell Johan Trocmé (JT) in this Nordea On Your Mind interview.

They also highlight how sustainability will be a watershed for funding going forward, and that Nordea is willing and able to help corporate borrowers navigate the new funding landscape.

JT: The past decade saw a very significant migration for Nordic large corporate funding from bank loans to corporate bonds; What have you seen as the key drivers for corporates to rely more on capital markets and less on banks during this period?

MR: I think the migration towards more bond funding has been natural in the sense that both bond investors and corporate borrowers have gradually become more mature and sophisticated in the use of capital markets. Companies have seen obvious potential benefits from diversifying their funding and issuing bonds, such as long debt tenors, attractive funding costs and broadening interaction with capital markets to include both equity and debt investors. This coming of age for corporate bond funding has been particularly notable in markets such as Denmark, where historically, the corporate bond market has been underdeveloped. Large corporates, especially those with external credit ratings, have increasingly set and followed a norm of using bonds as core long-term funding, in combination with bank funding (revolving credit facilities) as backup.

LF: Bond funding has become a bigger part of total corporate funding, but total borrowing has grown sharply over the past decade. So a more nuanced way ofdescribing the trend is to say that bond funding has grown even faster than bank funding. Corporate demand for longer-term funding has been a strong driver. Banks have typically provided corporates with loan maturities of 3-5 years, while bond tenors can be considerably longer. Local corporate bond markets particularly in Norway, Sweden and Finland have also deepened, offering corporates more and better access to local capital market credit.

MR: The evolution of the corporate bond market has led to a bigger universe of corporate borrowers being able to tap it, not least in the high-yield segment. Some companies with higher leverage have been able to get bond funding with acceptable covenants and tenors, where banks have opted to be more conservative. In the past, these companies may not have qualified for bank financing, instead relying on equity capital.

LF: The sophistication level of investors has gone up. A decade ago, having a minimum of two credit ratings from the big three agencies was considered a blueprint for a good bond transaction. You needed a minimum issue size of EUR 500m. Across the Nordic corporate landscape, there were not that many with those kinds of needs, or the size and resources to justify meeting all the needs for issuing EUR 500m worth of bonds maturing in five years. You could say that there was a 'maturity wall'. With the development of local Nordic currency markets, corporates now have access to liquidity with smaller minimum issue sizes and an improved currency match. The other consideration is that many companies have grown over the past decade and now have funding needs on a level where bonds are a natural instrument to meet these needs. In Denmark, big companies such as AP Møller, DSV and Vestas did not have credit ratings 10-15 years ago. Now they do. They have all recognised that bond funding can offer real value for them. With tighter bank regulations after the global financial crisis, and now again from Basel IV, I would expect corporate interest in obtaining a credit rating to increase, in order to maximise the availability and cost of both bond and bank funding.

MR: Interest in credit ratings is clearly on the rise. There are examples of companies that have improved their credit profile after getting a rating, and that have hence been able to reduce their cost of capital through the bond funding that then became available. The combination of becoming both rated and investment grade is a pretty natural and powerful driver towards using long-term bond funding.

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.

JT: Based on client situations and transactions you have been involved in over the past few years, can you think of any suggestions or pieces of advice you would offer corporates regarding availability and cost of funding, and management of funding and debt servicing risks? Any good safeguards against ending up in trouble?

MR: I would again emphasise using the bond market window when it is open. We know from experience that there are swings in the capital markets; the window can be wide open, partially open or shut. This is particularly true for the high-yield bond market.

MR: The cost of financial distress is typically high. If you get into such a situation, breaching your debt covenants, and have a very complex capital structure with many sources of capital, many different investors, and many layers of debt in your legal structure, you could run the risk of creditors interfering with your business. You want to stay on top of your capital structure and your creditor space, and have a good, constructive dialogue and sensible debt covenants. There are borrowers who have found out the hard way that it may be challenging to manage high leverage in a complex capital structure. It is during this past period of rapid corporate bond market development that we have also had niche distressed debt investors enter the Nordic market, which may make it more difficult to align the interests of all the creditors.

JT: How can Nordea help corporate clients navigate today’s more uncertain funding landscape?

LF: Nordea is a full-service wholesale and investment bank in the Nordic region, which means we can offer advice and solutions around a company's whole capital structure. We can go in, take a holistic view from the company's perspective, and assess what under the current circumstances is the right level of leverage, what financial covenants are consistent with the growth outlook for the business in question, and how can you best access investors or your banking partners to fund it. This is a highly rewarding discussion to have with clients that can lead to more strategic discussions about potential growth opportunities, acquisitions, or focus and potential divestitures of noncore units or assets. Our size, scale and solutions offering makes us well placed to have this discussion and guide our clients.

MR: We are able to have both an equity discussion, if that is needed, or a discussion on debt funding, rating advisory or risk management, including for example FX or derivatives. We look at the totality. This is important because it all hangs together. Your equity ratio. Your funding mix. Your maturity profile. Your liquidity buffer. Your interestrate sensitivity. The currency composition of your cash flows and your funding. We can help with all of this, looking at the full picture, always with the totality of the customer's best interest in mind.