Capital Markets – Shaping an Appropriate Response to COVID-19
05 June 2020
The COVID-19 pandemic is affecting all aspects of economic activity and has generated significant market volatility. We discuss the impact of COVID-19 on both public and private sector capital markets.
After some initial uncertainty, the Eurozone Member States agreed a rescue package consisting of pandemic credit lines. These measures consisted of making loans available from the European Stability Mechanism with limited conditionality, a pan-European €25 billion guarantee fund managed by the EIB and an unemployment insurance scheme valued at €100 billion (SURE). In addition, the ECB committed to purchase an additional €750 billion in sovereign and corporate debt under the Pandemic Emergency Purchase Programme.
The EU’s response has not been without its critics. Nine member states, including France, Italy, Spain and Ireland, argued that the rescue package did not go far enough and advocated the issuance of “coronabonds”. These bonds would have been joint mutualised European debt instruments guaranteed by all Eurozone member states. This proposal met opposition from other member states who typically staunchly oppose debt mutualisation. These opposing states included Germany and the so called ‘frugal four’: the Netherlands, Austria, Denmark and Sweden. In addition, the German Constitutional Court recently demanded that the ECB produce a proportionality assessment to justify its pre-pandemic bond-buying programme within three months. This ruling caused further uncertainty, challenging the ECB’s monetary measures in support the EU economy and the primacy of EU law at a turbulent time.
A potential breakthrough
In an attempt to break this deadlock, on 18 May 2020, France and Germany proposed a €500 billion ‘recovery fund’. Under this proposal, the European commission would raise funding on the capital markets and the proceeds would be distributed in the form of non-refundable grants rather than loans.
While France has historically supported these types of initiatives, German support came as a surprise to commentators, as it usually heads the camp opposing similar measures. However, the concerns raised by the recent ruling of the German constitutional court on the ECB’s bond-buying programme may have persuaded Chancellor Merkel that European national governments must show more fiscal solidarity to shore up the European project in a time of emergency. On 27 May, the Commission proposed an even larger recovery fund of €750 billion dubbed “Next Generation EU”. Of the €750 billion raised, €500 billion would be distributed as grants and €250 billion as loans. The recovery fund would be wrapped into the EU’s next seven year budget, yet to be agreed by EU leaders. This proposal also consists of borrowing on the capital markets and distributing the proceeds to member states. It would involve establishing a yield curve of debt issuance, with 30-year bonds as the longest maturity. Repayments would start in 2028 and be completed by 2058. The plans require unanimous approval, so it remains to be seen whether the objections of the member states that are most averse to grants can be overcome.
Within Ireland, the NTMA has turned to the bond markets in an effort to fund the coronavirus response and raised €6 billion in April 2020 – its largest bond sale in over a decade. The sale was heavily oversubscribed. This would indicate a strong demand amongst the investor base, demonstrating the significant progress made by Ireland in the years since the financial crisis. However, the extent of the economic damage that will be caused by the pandemic remains uncertain and the State will undoubtedly face challenging times ahead.
Private sector developments
As capital markets have stabilised in Europe, the private sector has seen increased appetite for higher risk classes of debt. In early May, Deutsche Bank issued €1.25 billion of new sub-investment grade bonds: a move which its group treasurer, Dixit Joshi, says would allow the bank to “support further business growth” and give it “additional finance flexibility”. The timing of this move also enables Deutsche Bank to take advantage of the ECB’s temporary relaxation of its capital requirements..
Modest signs of recovery have also been detected in the market for collateralised loan obligations (‘CLOs’). CLOs are single securities backed by a consolidation of debts of varying degrees of risk sold in tranches, with those investing at the latter stage bearing the greatest risk of default but also benefitting from the greatest margins. However, the prospect of increased default and corporate downgrades threatens to upset the careful balance between investment-grade and junk loans held in a typical CLO and may be of concern to investors.
Finally, there is a concern that the current levels of interference in the markets at a national and supranational level may impair the ability of investors and analysts to accurately interpret the market. This distortion may impact the private capital markets, which are typically measured against traditionally ‘secure’ sovereign debts.
This article has offered an overview of some important recent developments in the capital markets as a response to COVID-19, but the ultimate impact of the pandemic on future economic activity is difficult to predict. Nevertheless, it is clear that the capital markets have a significant role to play in shaping the response.
The content of this article is provided for information purposes only and does not constitute legal or other advice.