Capital Markets Weekly: Tightening monetary policy increasing financial dislocation risks

The European Central Bank held an unscheduled meeting on 15 June after expectations of tighter monetary policy in both the US and EU pushed peripheral European bond yields to levels not seen since 2013, with Italy and Greece's 10-year debt briefly trading as high as 4.29% and 4.72%: US bonds also have displayed downward volatility ahead of the 75 basis point rate increase announced by the FOMC on 15 June.

The rising cost of borrowing is increasing financing risks: Kenya has followed other recent examples of African sovereign borrowers cancelling planned international bond sales due to prevailing yield levels.

Emerging markets

The planned USD1 billion international bond for Kenya was withdrawn, with local media claiming it would be replaced by domestic bank facilities. Treasury Cabinet Secretary Ukur Yatani was cited by Business Daily newspaper as having stated that "the cost of borrowing has gone really high", recognizing that new borrowing would cost "over 12%...and is no longer feasible". Instead he stated that Kenyan authorities were exploring options with banks, suggesting that such funding would bear a "cheaper rate" close to last year's borrowing costs of six percent.

This seems somewhat misleading. Bank borrowings might have a lower initial cost but are likely to be on a floating rate basis and for a relatively short term, increasing future liquidity and rollover risks versus a longer-term bond sale. The cost of such instruments would increase when the US raises its policy rates. If raised instead from local banks, this would increase sovereign-bank risk linkage, and threaten to crowd out loans to domestic corporates. Kenya last used the syndicated loan market in 2019.

Kenya's decision nevertheless is unsurprising and indicates wider pressure on market access for Emerging Market borrowers. In late May, Cote D'Ivoire indicated that it would seek to raise funding from its regional debt market rather than the wider international arena given prevailing market conditions. Similarly Nigerian Finance Minister Zainab Ahmed announced on 8 June that Nigeria has cancelled plans to raise a further USD950 million from international markets, stating that "market pricing was not good" during May, when the issue had been expected and that the approval period for issuance had expired (as of end-May).

Some Emerging market supply is nevertheless being completed, despite the difficult conditions. Last week, the Kingdom of Jordan sold an increased USD650 million long five year deal at 7.95%, versus 8% guidance. It increased the issue from USD500 million after gaining some USD1.8 billion in demand. The deal was the first sub-investment grade sovereign sale in the last month.

Within the investment grade EM space, Hungary also sold USD3 billion and EUR750 million of debt, filling funding gaps left by the delay Hungary is facing in accessing EU funding over rule of law issues. It sold USD1.75 billion of seven year debt at 5.46%, 240 basis points over US Treasuries, and USD1.25 billion of 12-year bonds at 5.83%, a 280 basis point margin. The Euro-denominated tranche was priced at 4.5%, 250 basis points over mid-swaps. Hungary's AKK debt management agency claimed the deal was twice subscribed and noted that some of the funds raised would finance repurchase of dollar bonds due in 2023 and 2024.

Additionally, the Bahamas used an unusual structure for an international "Blue Bond" sale which had been provided a USD200 million performance bond guarantee by IADB. Rather than using this to price a single issue of blended credit risk, it divided the operation into two portions, one fully guaranteed and the other a "series B" tranche on a stand-alone basis. The series B bond raised USD250 million for seven years at a 13.5% yield, in line with initial guidance. The issue bears a coupon of 9% and an issue price of 80.024%. While the Bahamas will benefit from a substantially lower cost of borrowing due to the blended average cost of the two tranches, the structure has been criticized for leaving it to obtain unguaranteed liabilities despite its strained credit position, with investors unable to benefit from the supranational backing on the stand-alone portion.

Other debt

The ECB's planned end to bond purchases and to consider a more sizeable rate increase in the autumn after an initial 25 basis point adjustment have led to further deterioration in peripheral Eurozone bond yields, which have returned to levels last seen during the European debt dislocation of a decade ago. Italy's 10-year bond yield briefly reached 4.29% on 14 June, from 3.14% at end-May and 1.185% at end-2021, while Spain's 10-year bond reached 3.16%, versus 0.6% at end-2021 and 2.13% at end-May. The 10-year Bund moved to 1.76%. Greece also was badly affected: its 10-year yield rose to 4.72%. The upward trend in rates only abated after reports that the ECB planned to study recent financial dislocation and how to address this to prevent new financial stress within the EU periphery, with the Financial Times suggesting it would reinvest maturing portfolio proceeds at least on a selective basis to help weaker credits.

Similarly, fears of a faster trajectory for US policy rates triggered a sharp selloff in dollar bonds on 13 June, with 10 year yields rising some 25 basis points on the day to 3.38%, and peaking on 14 June at 3.49%

Against this background, and ahead of the FOMC meeting, where a rate increase of 75 basis points was both discounted within the market and then delivered, there has been much less supply this week. On 14 June, EFSF did raise a EUR2 billion 10-year deal. IFR reported that EFSF "wriggles through sketchy market", noting that the deal had been priced at the initial guidance without tightening. The offering bears a 2.375% coupon and discounted issue price (99.368%)

This week's deal-flow is in clear contract with conditions late last week. Following recent bank AT1 supply from Julius Baer and Virgin Money, Aviva PLC had sold GBP500 million of restricted Tier 1 perpetual debt, pricing this at 6.875% until the initial call. Moreover, four US sub-investment grade issuers each raised debt on 9 June.

Implications and outlook

The ECB's unscheduled meeting on 14 June indicates that the severity of the selloff in European bonds is starting to raise concerns about debt sustainability for weaker rated and heavily indebted countries like Italy. It shows that European policy makers are facing conflicting policy pressures, needing to tighten conditions to reflect continuing high inflation by raising policy rates and planning to end new net bond purchases, but seeking at the same time to avoid renewed financial stress within the Eurozone.

These pressures are now even more acute in Emerging markets, as shown by the three African deal cancellations. Earlier this year, Bolivia also restricted its issuance to a direct exchange within a liability management exercise, rather than the USD3 billion new sale previously slated.

Kenya's shift in funding stance is wholly unsurprising given the high yields on the country's outstanding debt. Its adverse position reflects its deteriorating fiscal indicators and opposition pledges to seek debt renegotiation if elected. It aligns with our prior forecast that new debt would be very hard to undertake in the prevailing conditions.

Kenya's claim that the cost of a bank loan would be comparable to its 2021 bond funding levels is also highly questionable, as it does not compare "like with like" instruments. A fairer summary for both Kenya and Nigeria would be simply to recognize that bond trading levels are now at yields too high for them to access new term bond debt at sustainable levels. Further market deterioration - driven by near-certain further US rate increases within 2022 - makes such developments likely to affect a growing range of emerging market and leveraged corporate borrowers. Similarly, the sell-off in Europe has brought Italian and Greek yields back to levels last seen a decade ago, during Europe's sovereign "debt crisis", potentially driving the ECB to soften its policy approach.

Posted 16 June 2022 by Brian Lawson, Senior Economic and Financial Consultant, Country Risk, S&P Global Market Intelligence

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.