By Yoruk Bahceli

(Reuters) – European companies hoping to fund M&A and capital expenditures on bond markets this year are facing a sudden jump in borrowing costs and wary buyers after the ECB’s shock pivot towards tighter monetary policy.

The key source of financing for businesses is through bond issues. They have increased in importance in comparison to eurozone bank loans, especially since the financial crisis.

After Christine Lagarde, President of the European Central Bank’s February Meeting, which allowed for rate increases this year, Christine Lagarde’s pessimistic tone has led to yields from European investment-grade (IG), bonds seeing a 60 basis point increase.

With IG bonds delivering less losses than the United States, January volatility in U.S. Federal Reserve was less severe for Euro credit.

However, those drops accelerated after the ECB. Yields rose more than twice this year, to as high at 1.18%. This is the highest level since May 2020 according to BofA.

Although this is still a low level, a sharp increase in borrowing costs can be significant. It can affect companies’ investment ability, ultimately slowing down economic growth. Central banks monitor credit spreads closely.

BofA’s February credit investors survey revealed that almost half (48%) of respondents to the survey believed that IG spreads increasing from approximately 110 bps now would lead to a dovish turn at the ECB.

Many see a boom in mergers and acquisitions as well as the demand for capital investment driving a rise this year’s European corporate bond sales. JPMorgan (NYSEM:) is expecting a record 645 Billion euros worth of IG issuance.

Although these steps have not been enough to discredit those hopes, Helene Jolly at EMEA IG Corporate syndicate, said that they are still possible. Deutsche Bank (DE) According to the DE:, borrowers and investors are adapting to “the new norm”.

Jolly explained that corporates had to examine the requirements for coupons due to changes in rates. Investors had to reflect on what all this meant to them.

The mood has changed quickly — only 16% of European credit investor are net long on IG Deb, the lowest level since 2019, and down from 27% December. However, corporate debt funds have more cash than ever before, according to BofA’s survey.

The result has been a decrease in sales of bonds — companies have raised 9 billion euros in the two weeks following the ECB meeting. This is similar to volume during the one week before the meeting according to Refinitiv data. Several sessions delivered zero issuance.

(Graphic: https://fingfx.thomsonreuters.com/gfx/mkt/mopanyenqva/euro%20IG%20chart.png)

WARY

There is not panic about companies borrowing cheaply or abundantly during the pandemic.

Only two junk-issuers sold bonds in the ECB’s time, IFR reports. According to IFR, the majority of issuance was from Cerved (an Italian credit management group and data provider), which received most of its financing from floating-rate bonds. Investors are compensated by these bonds as interest rates increase.

“People are concerned about new issues. They don’t think that they are bad creditors, but because of the possibility of buying credit with 3.5% yields today, while in a week it yields 3.75%, you could lose a couple points,” explained Ben Thompson of JPMorgan, co-head for EMEA leveraged financial capital markets.

ISUANCE BOOM

The ECB is expected to end bond buying by September so issuers could be forced to begin hitting the market soon.

Last year, the ECB bought company debt worth over 70 billion euro. This represents 6% of all its purchases in that time period.

Spreads for IG have widened by more than 25 bps in this year, and premium companies are paying extra to sell new bonds. This is according to BNP Paribas.

Viktor Hjort, global head of credit strategy at BNP, estimates an upcoming rush for M&A and capex-linked borrowing could widen spreads another 15 bps.

Hjort stated that corporations have a significant need to spend, particularly capex which is not sustainably low. Therefore, the credit market will have to finance a capex cycle and is also going to face a demand shock.

According to Refinitiv Datastream’s average yield on BofA’s index, it is more expensive than its coupon. This means that new issuances will typically cost companies more than current interest.

However, it is unlikely that higher yields will stop borrowing.

Shanawaz Bhimji, strategist at ABN AMRO (AS:), estimates that firms’ total returns from equity this year will exceed the current cost of equity even when assuming a much higher cost of net debt than current rates, so they should continue investing in M&A and capex.

According to bankers, borrowing may choose shorter-term financing options or floating-rate notes in order to reduce funding costs. This is a way for borrowers to get lower-interest loans.

Thompson from JPMorgan explained that it was important for debt-holders to accept the reality of debt.