Recently, U.S. Federal Reserve Bank Chairwoman Janet Yellen testified before Congress about the future course of U.S. interest rates. The Fed expects to raise interest rates four times in 2016; economists expect two Fed interest rate hikes and the market is pricing in no Fed hikes in 2016. These diverging views contrast sharply with the situation in Europe, where the European Central Bank (ECB) is in the process of keeping interest rates low, and in some cases creating negative yields with their Quantitative Easing (QE) program.
Negative yields are the strange situation where investors pay borrowers interest to take their money. Sort of like someone paying a bank interest each month to keep their money parked with the bank instead of the bank paying interest to borrow the money. It sounds far-fetched, but it is true. The Financial Times of London reported on February 12 that, according to JP Morgan, there is nearly $6 trillion of government debt with negative yields in circulation, up from zero in mid-2014.
BlackRock’s chart below shows which countries’ bonds are trading with negative yields, and over what maturity. The U.S. currently doesn’t have any negative yielding bonds, whereas Europe has plenty. For example, German debt out to seven years has a negative yield. Equally important is the growing yield difference between the U.S. and German 10-year borrowing rates, despite the fact that both yields are still positive. More on this later.
Such low borrowing costs in Europe present attractive financing opportunities in the market for corporate borrowers. Reuters reported on February 11 that U.S. companies are tipped to sell a record amount of Euro-denominated debt in 2016, precisely to take advantage of low European borrowing costs. The same article goes on to say that U.S. issuers have already borrowed EUR2.3 billion in 2016, around a quarter of the total Euro corporate supply. Bankers are now preparing potential bonds from US technology, biotech and manufacturing companies.Record Low Interest Rates
As mentioned earlier, government yields, the borrowing rate on which all other borrowing is benchmarked, in dollars (USD) and Euros (EUR) are diverging. For example, the chart below shows the difference between the yield on U.S. 10-year treasury bonds and German 10-year bunds. As recently as April 2013, yields on these bonds were more closely aligned but have materially diverged due to differing inflation expectations in the US and Europe as well as diverging central bank interest rate policies. These yields are now nearly 1.4% apart. This is a significant difference in borrowing costs for corporates as well because the spread in government borrowing rates is passed through when pricing company bonds in these currencies. So an investment grade company, for example, borrowing in EUR will have considerably lower borrowing costs than if they borrowed the same amount in USD because of the difference in these base rates. A spread is usually added to these rates to account for a company's specific credit risk, but here we are just looking at government base funding costs in the different currencies.
To provide some context as to how much borrowing rates have changed, the chart below shows the movement in rates in percentage terms. Both rates are indexed to 0.0% to start. Borrowing costs in EUR have declined 87% in slightly less than three years compared with a 20% decrease in USD over the same period. This is a large move in base borrowing costs and from this perspective, it is easier to understand why American CFOs might consider borrowing directly in EUR to fund their European operations.
Lower European Risk Premiums
Even higher risk corporate borrowers can take advantage of lower European borrowing costs. The chart below from the St. Louis Fed shows the effective yield on high-yield debt denominated in USD and EUR, based on indices from Bank of America Merrill Lynch. Companies issuing USD denominated high-yield debt would currently need to pay investors 10% to access funding. Similarly rated high yield issuance in EUR is about 40% less, with a yield closer to 6%. Part of this difference is due to credit spreads mentioned previously, but another reason for the difference is the significant divergence in USD and EUR government based borrowing rates we discussed earlier. In the current price environment, it is simply cheaper for U.S. companies to borrow in Euros rather than USD.
The Bottom Line
U.S. companies with operations that need funding in Europe are likely to take advantage of lower European borrowing rates. In years past, these borrowers would have issued USD debt and then swapped the proceeds into Euros. While this is still an option, it seems more likely U.S. companies will create a natural hedge for their European businesses by matching funding for their European operations generating a EUR cash flow with Euro denominated debt.
