Eurobonds at 50 Threatened by EU Transaction TaxJohn Glover
The tax regime that’s been the backbone of the Eurobond market since its inception 50 years ago is now threatened by the same regulatory overhaul driving corporate borrowers to issue bonds rather than take bank loans.
Eurobond sales this year are on pace to reach $4 trillion, approaching the record $4.5 trillion set in 2009. Corporate bank lending in Europe fell 8.7 percent to $379 billion in the first half from the period in 2012, and is down 37 percent from the $598 billion recorded in the first half of 2011, according to data compiled by Bloomberg.
The market for Eurobonds is facing its biggest challenge as lawmakers enact rules to protect taxpayers after the worst financial crisis since the Great Depression compelled governments to bail out lenders. At the same time as the amount of dollar-denominated bonds held by international investors rises 7.4 percent to $4.5 trillion this year, proposed taxes on financial transactions may cut demand.
“We’d be pretty worried about the imposition of a transaction tax because of the effect on liquidity,” said John Pattullo, who manages the equivalent of $4.67 billion as head of retail fixed income at Henderson Global Investors in London. “There’s still the long-term structural trend of banks withdrawing and the bond market taking up the slack. That will continue.”
Just as companies from Findus Group Ltd., the London-based frozen-food maker, to cinema operator Vue Entertainment sell their first bonds, the average number of dealers regularly quoting prices for Europe’s biggest corporate debt securities fell to four, down from as many as nine in 2009, according to Andrew Sheets, head of European credit strategy at Morgan Stanley in London. Fewer dealers may make it harder and more costly to buy and sell securities.
Banks may further reduce trading because the European Union plans to tax stock and bond transactions at a rate of 0.1 percent, adding $10,000 to the cost of a $10 million bond deal. Derivative trades will be charged at a rate of 0.01 percent,
The levy could begin as soon as next year. If the 11 nations that have so far signed up to take part are able to agree on the structure, they can impose the taxes involving transactions by entities based in their countries. The European Commission estimates the proposal may raise as much as 35 billion euros ($46.4 billion) a year.
The tax treatment of Eurobonds helped make the market a success when bankers led by Siegmund Warburg, the founder of S.G. Warburg & Co., underwrote a $15 million debenture for Autostrade SpA, the manager of Italy’s freeways, in 1963.
A quirk in the U.K. tax code dating from the 19th century allowed financial transactions originating in the U.K. between foreign counterparties to go untaxed, according to Stanislas Yassukovich, who traded those first bonds at White Weld & Co. The new securities gave borrowers access to a pile of cash called Eurodollars because they were held outside the U.S., and were kept offshore for tax, regulatory or political reasons.
The market expanded from about $22.3 billion in the first 10 years to $166 billion in the second decade through 1982, according to Ian Kerr’s “A History of the Eurobond Market.”
By 2000, sales reached $1.4 trillion a year, peaking at $4.5 trillion in 2009 before easing to $4 trillion in 2012.
Bonds are becoming even more important than loans in Europe, accounting for 82 percent of company debt structures, up from 68 percent in 2008, according to a Fitch Ratings study of 201 large European issuers.
The tax would penalize investors in shorter maturity debt disproportionately because the levy wouldn’t differentiate between commercial paper and a 30-year bond. A one-year loan using 90-day commercial paper would attract the tax four times while a 30-year bond transaction would only be charged once.
“The tax would have a considerable impact on secondary market activity,” said Ben Bennett, a credit strategist in London at Legal & General Investment Management, which manages the equivalent of about $120 billion of corporate bonds. “It basically makes active fund management impossible.” He expects the tax to be “watered down.”
Rules known as Basel III have been agreed upon and are being brought into law. Along with demands that banks hold more, better capital, lenders must also maintain enough liquid securities to withstand at least a 30 day-long crisis. Banks will start to phase in the measures by January, with full implementation set for the start of 2019.
The U.K. already plans to impose a 3 percent floor on capital as a percentage of total assets to stop lenders reducing their balance sheets by manipulating internal models used to assign risk weights. They are also reviewing those formulas.
London-based Barclays Plc said on July 30 that regulators gave it until June 2014 to plug a 12.8 billion-pound ($19.5 billion) capital shortfall. The U.K.’s second-largest lender subsequently announced plans to sell 5.8 billion pounds ($9 billion) of stock and 2 billion pounds of loss-absorbing subordinated debt, plus cut leverage and retain earnings, to satisfy the regulator.
Frankfurt-based Deutsche Bank AG, which raised 2.96 billion euros of new capital in a share sale at the end of April, announced on an earnings call July 30 a plan to reduce its 1.58 trillion-euro balance sheet by 250 billion euros to comply with what it expects to be more onerous leverage requirements.
“Regulators’ game plan is to push high-quality credits into the bond markets,” said Simon Gleeson, a financial regulation lawyer in London at Clifford Chance LLP. “But they’ve created all sorts of countervailing pressures in doing so. This is dominated by unintended consequences.”
Central banks have succeeded in making long-term, fixed-rate funding attractive to borrowers by cutting interest rates to record lows following the collapse of Lehman Brothers Holdings Inc. in September 2008. That also helped pull the speculative-grade default rate to about all-time lows, or 2.15 percent in 2012, and made investors eager to buy bonds.
“There has been very strong appetite from investors,” Monica Insoll, the London-based managing director for credit market research at Fitch Ratings, said in a phone interview. “Corporate bonds have not been seen as risk-free but they haven’t suffered so much from the crisis.”
Benoit Coeure, a member of the ECB’s executive board, said in a Paris speech last month that he expects the euro area to “move towards a more balanced financing mix, with a greater role for arms’ length finance based on capital markets.”
Eurobonds denominated in dollars as tracked by the Bank of America Merrill Lynch Eurodollar Index, returned a risk-adjusted 125 percent from the end of June 1988 through Aug. 14, beating Treasuries, U.S. corporate debt and stocks.
This year, the securities are losing 0.78 percent after Federal Reserve Chairman Ben S. Bernanke signaled that the central bank is prepared to start reducing its unprecedented stimulus measures.
Findus, which restructured its debt last year before supermarket companies including Carrefour SA withdrew some products because tests showed its beef lasagne included horsemeat, said bond buyers are more flexible than banks.
The company sold 305 million euros of five-year notes in July to yield 9.125 percent and 150 million pounds of five-year bonds at 9.5 percent to replace its bank debt.
“The company had had a checkered history with the banks and some of them were a little fatigued,” James Hill, who became chief executive officer in April, said in a telephone interview. “Bonds offered longer-term security for us. We’ve got five years now of rock-solid stability.”
Vue, based in London, raised 300 million pounds of 7.875 percent notes in July that are due in 2020 and 290 million euros of floating-rate debt, selling the securities through its Vougeot Bidco Plc unit.
Funding via capital markets rather than through banks has drawbacks, according to Stuart Stanley, a money manager at Invesco Asset Management in London.
While selling securities offers funding for longer periods than banks will accept, borrowers have to produce bond documents for investors, pay for a credit rating and meet reporting requirements, adding to the cost of raising such funding.
With bonds “you get the flexibility that comes with locking in the funding but you pay a premium,” said Stanley, who oversees about $3.5 billion of credit-related investments. “If you get into difficulties it’s much harder to negotiate with a diverse creditor group and much easier for hedge funds to buy up your bonds and make your life very difficult.”
Even without fees the cost of borrowing in the bond market can be higher than in the loan market. The Automobile Association Ltd., the Basingstoke, England-based company that offers motorists roadside assistance, in June sold 300 million pounds of 4.72 percent secured notes due 2018 paying 330 basis points more than benchmark government debt. The company also took out a bank loan maturing 2018 that will cost it 275 basis points more than the London interbank offered rate, equivalent to about 325 basis points over gilts.
By boosting the capital requirements banks must apply to their trading activities regulators have reduced liquidity in the secondary bond market, even as the primary market has swelled from companies turning away from bank funding.
Lack of liquidity can be seen in the difference between the prices at which dealers buy and sell securities. The average is about 0.5 percent of the bond price, about double what it was in the run-up to the crisis in 2006 and 2007, according to data compiled by Morgan Stanley.
The premium may increase further because of the EU’s planned financial transaction tax. The timing, when the economy is sputtering, is a mistake, according to John Hughes, Head of European Regulatory Reform at Bank of America Merrill Lynch in London.
“The Commission is using a tax to try and stop behavior that they don’t like,” Hughes said. “They don’t like volatility and they think that having a transactional charge will damp it down, force pension funds and asset managers to move into less risky buy-and-hold strategies. They’re also trying to move toward longer-term, less volatile funding methods.”
The U.K. is challenging the tax in court and Luxembourg, where Citigroup Inc. estimates assets held by banks are 22 times the nation’s gross domestic product, may do the same.
Fabrizio Saccomanni, finance minister of Italy, one of the countries that has agreed to levy the tax, echoed concerns from the heads of government debt agencies when he told the Senate in Rome last month there were “strong risks” should it be extended to bonds.
The final shape of the tax has still to be decided, as has the way it will be imposed. For the moment, fund managers’ concerns center on the functioning of the secondary market.
“Banks are less likely to go bust and the taxpayer can be grateful for that,” said Pattullo at Henderson. “The market is less liquid, though, because banks have to commit more capital.”