Zachary Swabe, total return portfolio manager for European high yield and global credit at UBS Asset Management, spoke to The DESK about the current state of European corporate debt, the rise of private markets, and what’s to come.
The DESK (TD): How are you expecting to see demand for European corporate debt to evolve?
Zachary Swabe (ZS): I see its evolution as a reflection of QE and post COVID fiscal and monetary supply.
So many trillions have been pumped into the world’s financial markets driven by quantitative easing and then post-COVID monetary and fiscal supply.
Demand for corporate bonds has been extraordinary over the last 10 years, because there’s so much capital chasing a return. It does that increasingly efficiently, or aggressively, in a digital world. Nine out of 10 deals will have order books five to 10 times oversubscribed, and going forward, that behaviour will continue. You can see that going into private markets.
Corporate lending of banks has declined by 15 to 20% in Europe from 2007, and it’s declined even more in the States. It’s shifted more to other markets, including high yield and leveraged loans. We’ve identified private debt, now that’s moving forward, and we expect the disintermediation to continue. That means more assets possibly going off banks and balance sheets to private markets.
However, Europe will never be the same as the States. Banks in Europe fulfil a more permanent role in corporate lending and their capital structures, and that won’t change. There are cultural differences, and banks need to provide a return to their own shareholders. They do this not only through mortgages, but also through large corporate lending and other transactions.
We will get shifts from banks towards other markets, investments into high yield and markets other than private debt, but I don’t expect the shift to ever meet the pace of the US. It will continue and it will be reflected by and complemented by its massive demand and those technical money supply factors.
TD: What are the key differences between the US and European credit ecosystems?
ZS: Private equity deals in high yield are far higher in the States than in Europe. They just have so many more private equity companies.
That means that the US has more B [rated] companies, which probably means it has higher credit risk. Europe has more BB companies.
Once there’s the private involvement, there’s more private equity deals, more private equity capital chasing transactions. That trajectory will continue, I think private equity will always be greater in the US, as a percentage of total financing and some investment grade financing.
The animal spirits are vastly different in the US and Europe. The UK might be a little bit similar to the States, but the rest of the region is vastly different. There is a more social background, even with the current right-wing governments coming in.
When you have an economy like the US, which is underpinned by robust animal spirits and entrepreneurial growth, and the ability to transact and do business is quite a bit easier than some European countries, you naturally get a higher long-term growth outlook.
There’s a more open bullish mindset for bond financing in the States. That includes high yield loans, private debt, investment grade, and corporate issuance. On the investment grade side, those factors are less prevalent.
Aside from that, the US also has very large, listed business development companies, whether it’s Apollo or Ares. We don’t really have that in Europe, which does affect the ability of European companies, often private companies, to raise assets. It’s just slightly easier in the States to raise assets to the investment grade level in the non-bank world.
TD: How is regulation playing into that?
ZS: Basel III and IV are from the European Commission, but they’re effectively global rules that govern banks’ capital ratios.
Since 2008, banks have been forced to hold a much higher degree of core Tier 1 equity. But as a result of that, when you get a mining or energy company for example that might have high risk weighted asset (RWA) requirements, some banks might shy away and go to the IG or sub-IG market. Capital requirements mean it’s not actually sensible or profitable for banks to lend to some of these sectors that have high RWAs.
As more of that goes to the public or public markets, that’s the main driving factor here.
ESG is also a factor here—banks will have tight ESG lending standards in their lending book, so for banks that have tight RWAs on sectors that might have more questionable ESG profiles, such as oil and gas exploration, there’s a double factor that pushes them to say, ‘we don’t want to lend to this sector anymore, go to the public markets’. The banks then go and arrange that. They won’t suddenly shut up business, they would try and do something into the public market.
This has been going on for more than 15 years, so banks have now built up their capital base sufficiently enough that they can start to actually do some lending to those more troubled sectors.
For European banks, capital ratios are fixed and are very strong. The disintermediation that was forced upon them by the European Commission or the European Banking Authority (EBA) might have finished from a regulatory perspective. Going forward, that might not be such a large factor, but it has been for the last 15 years and for some sectors like energy exploration, it will continue to be.
TD: What are European credit’s greatest tail risks?
ZS: Let’s not talk about the geopolitical situation in the Middle East, because you can see markets have really recovered meaningfully.
The main risk to the global economy is still tariffs, the risk of slowdown in the States and the inflationary risk. In July and August respectively, the European and Chinese tariff exemptions run out.
We don’t know whether Trump will decide to put the tariffs back up, and then we get a massive repeat of the negative price action, markets fall, credit spreads widen, and people are a bit unsure about corporate profitability. Then you get a spiral of analysis required to figure out what fair value is in markets based on the risk of lower profitability of companies, more difficult funding markets.
The US, and therefore global, economy is also a major risk. The second order effect from that is the inflationary impact in the US, and therefore the effect on the Fed’s interest rate setting policy.
TD: What would the impact of the savings and investment union (SIU) be in European credit?
ZS: A single market framework, capital markets union (CMU) and SIU would allow capital to be effectively distributed from the vast savings in Europe.
The UK is a bit of a spending country, culturally, but most countries in Europe are savers. That makes for some quite amazing savings statistics. If the SIU was introduced, there would be mechanisms for pooled savings channels to be used in more financial products, which could help generate returns for savers.
This is important in an ageing society, but those funds could also be funnelled into digital green infrastructure, which needs capital. There are large projects that banks can’t fund themselves, so you might be able to get to a stage where this free movement of savings capital allows for the funding of things like HS2.
Banks need to better connect to large lending platforms. At UBS, that could be our global unified alternative division, which manages US$250 billion of private assets or my department, where we manage more public high yield assets.
Banks can only connect better with each other if there’s dynamic freedom of movement of data and the companies are speaking to each other better. Currently, there are some cross-border issues. That’s where a single market framework would help.
TD: Who is investing in European corporate debt now, and will that profile change?
ZS: Unless we do move towards more of a union, or implement [Enrico] Letta’s single market reforms, then I imagine it will stay similar to what we have now – a mix of wholesale channels.
Without changes to knowledge and data sharing, making it easier for people to access information and for the banks to package up and sell products, it won’t change that much.
If you take the UK pension system, for example, if they pulled all their capital, I’m sure they would have a higher allocation to private markets. But at the moment, some of them are too small to bother and they can’t do the due diligence because they don’t have the professionals to do it.
Often, the pooling of capital can often create specialism, and you get these network economies. That will help to spread products, whether it’s private markets, whether it’s high yield, whether it’s investment grade debt, into more hands.
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