The coming European Monetary Union and the adoption of a single currency, the euro, by all EMU member countries, promises a dramatic transformation for the European fixed-income markets.
What will change? Nearly everything. Currency exchange rates among participating countries will be fixed starting in 1999, while interest rate differentials will be widely eliminated. There will be only one monetary policy, originating with the European Central Bank in Frankfurt, with no ability to differentiate between economic regions or to accommodate various social demands. Just as the U.S. Federal Reserve does not adjust interest rates nationally to alleviate temporary regional economic dislocations, so the ECB will be unable to adjust European monetary policy to ease an economic slowdown in one of its member states. At the same time, the Maastricht criteria will still be in force, limiting the ability of EMU-member countries to employ a debt-financed fiscal policy.
Eliminating 11 currencies with a stroke of the pen, EMU simultaneously will do away with the ability to use interest rate differentials and currency movements within Europe as a tool for boosting fixed-income returns, long a favorite technique of European bond fund managers. In the short term, debt instruments from participating countries will continue to trade with credit spreads influenced by their individual ratings, reflecting national debt levels and budget discipline (or lack thereof). However, in the long run these spreads will be meaningless as European sanction mechanisms are applied more aggressively and convergence creates a truly pan-European bond market.
With the role of currencies in providing excess return to bond market investors continuing to diminish, European bond investors will be forced to look for other strategies to generate excess return. Two attractive ways, non-EMU currencies and debt instruments originating in the emerging economies of Eastern Europe, hold out the prospects of high returns as these countries move fundamentally closer to the EMU-currency bloc, thereby creating a stronger currency base and reducing interest rate differentials. But perhaps the most compelling opportunity lies in the rapidly evolving European corporate bond market.
HIGH-YIELD BOND MARKET
EMU will change the structure of the European capital markets significantly, moving away from small domestic markets to a more liquid, homogeneous capital market in an economic entity similar in size to the U.S. economy. This will pave the way for any corporate issues (bonds or equities) to meet growing demand on the Euro-domestic markets.
Historically, most European corporate lending relationships have been of the "house bank" variety, involving long-term relationships between a corporate entity and a major bank. More recently, however, a process of disintermediation has begun to take hold, similar to that which occurred in the United States. EMU and the euro are accelerating the development of a European bond market, which will offer issuers both higher levels of liquidity and lower borrowing costs.
Other trends within Europe also mitigate in favor of rapidly growing public capital markets. Deregulation and increased competition, both locally and on a global scale, are driving a wave of mergers and acquisitions across Europe. M&A activity within the presumed EMU-member countries has increased substantially in recent years and has shown little sign of slowing down. According to Securities Data Corp., there were 84 deals last year valued at more than $1 billion, compared with 60 the year before and just 29 billion dollar-plus deals in 1994.
Companies looking to finance a transaction -- or to leverage a balance sheet in order to avoid being acquired -- are providing a ready market for new capital markets products. Privatizations and corporate restructurings, which often involve a debt component, also are rising dramatically.
One result of this activity has been the creation of Europe's first high-yield bond market (the so-call "Eurotrash" market). Still small by U.S. standards, the market comprises fewer than 20 issues. New issuance by European companies in domestic European markets in 1997 was just $1.8 billion, but that amount is expected to increase substantially this year, climbing to somewhere in the $8 billion to $10 billion range.
There is substantial room for further growth, as European markets remain overwhelmingly weighted toward investment-grade borrowers. According to research conducted by Merrill Lynch, 35% of 1997 eurobond issuance was rated AAA by Standard & Poor's Corp.; 34% AA; 20 % A; 3% BBB; 6% BB; and just 2% B. In the United States, on the other hand, these percentages were nearly reversed, with 2% of corporate issuance rated AAA; 5% AA; 38% A; 39% BBB; 9% BB; and 6% B.
European investors initially were cautious in moving down the credit quality scale, with the result that spreads were significantly wider than those available on U.S. issues of comparable credit quality. However, that, too, has started to change, with spreads narrowing rapidly. Now, spreads on B rated, deutsche mark-denominated debt are averaging around 400 basis points over comparable 10-year bunds. This compares roughly to a spread to the 10-year Treasury of 350 basis points for a B credit in the United States.
Interestingly, the European high-yield bond market has developed ahead of the market for investment-grade corporates. (This is primarily a function of the tight relationships European banks maintain with their investment grade clients.) Much of the new issuance is driven by leveraged buyout activity and by telecommunications companies, and until just recently all of it has been denominated in either deutsche marks or sterling. Just recently, the first euro-dominated high-yield issue was priced for a telecommunications company, Cellular Communications International.
The historic realignment of economic interests now taking place in Europe will create the world's second largest economic bloc, with the EMU-member countries alone encompassing approximately 280 million people with a combined gross domestic product of $5.1 trillion. With the euro, a third major currency will be available for the issuance of corporate bonds in addition to the dollar and the yen. In this environment, we believe the demand for high-yield bonds will continue to rise significantly, driven by the need to enhance portfolio returns.
The European debt market is already a substantial one, with EMU-member bond markets currently about half the size of their U.S. counterparts. In 1997, bonds issued by EMU-member states will account for 28% of worldwide issuance, compared with 43% for U.S. dollar-denominated issues and 19% for yen-denominated debt. Over the next few years, you would expect these numbers to shift in favor of EMU as the corporate capital markets continue to mature.
Clearly, European fixed-income investing has entered a new world, although the landscape -- with its permutations now centered more around credit quality and less around currency-related matters -- will be very familiar to U.S. investors.
To meet the demand of this credit sensitive environment, the major investment firms will have to start to grow their analytical capabilities on the fixed-income side.
Like the U.S. market, the euro-denominated debt market will attract investors and issuers worldwide. Also like the U.S. market, it will be one in which diligent credit research and local knowledge will be critical elements to success.