International Capital Markets
Developments, Prospects, and Key Policy Issues
September 1997

Published by the International Monetary Fund
© 1997

B. Credit Markets: Spread Compression and Increased Volumes

Bond markets

During the past twelve months, low and declining inflation, fiscal consolidation, ample international liquidity, and a stable international environment supported a global compression of interest-rate spreads (relative to benchmark yield curves) and record levels of new issuance in both domestic and international bond markets. Low interest rates in Europe and Japan, and the global search for yields, facilitated capital flows into the U.S. and higher-yielding mature domestic bond markets outside of Europe (Canada, Australia, and New Zealand), and corporate bond (Figures 5-7) and emerging markets (see Chapter IV). The demand for higher-yielding domestic issues was broadly based geographically, and included investors in the major European countries, Japan, and North America. In international markets, strong demand for dollar-denominated instruments raised the share of dollar issuance by more than 100 percent in 1996, whereas the shares of yen and deutsche mark issues dropped almost 80 percent and 40 percent, respectively.

Although substantial, the decline in interest-rate spreads in the high-yield sectors stopped short of the low spreads reached as recently as 1994. Fears of a tightening of U.S. monetary policy caused periodic, temporary, retrenchments from U.S. bond markets (as with the large sell-off in early 1996). By late 1996, the extent of the narrowing of spreads in some segments of the higher risk markets—notably the high-yield corporate sectors and selected emerging markets—raised concerns about spreads having narrowed beyond what was warranted by the fundamentals. In anticipation of a rise in U.S. interest rates, spreads widened modestly in most of the higher-yielding markets during the early months of 1997, and when the Federal Reserve eventually raised the federal funds target rate by 25 basis points in late March 1997, the bond market reaction was muted.

In European bond markets, even though recently interest rate spreads have widened modestly, market participants have priced in a high probability of EMU going ahead in 1999 (Table 4). Spreads over deutsche mark yields peaked in early 1995 as a result of the flight-to-quality associated with the global bond market correction in 1994 and the Mexican crisis in 1994-95. The subsequent narrowing of intra-European spreads continued in 1996 as doubts about political and economic commitments to EMU dissipated, and monetary policy in Germany was further eased. In core-Europe,⁶ where spreads were thin to begin with, French and Dutch long-term yields fell below deutsche mark yields by late 1996. Spreads in some other EU countries have been strongly influenced by fluctuations in the probability of EMU participation in 1999, and have displayed considerable sensitivity to news events. Against the German benchmark, the Italian 10-year yield spread narrowed by about 350 basis points from early 1996 through the end of May 1997, Spanish spreads fell 300 basis points, and Swedish spreads fell by 130 basis points. The United Kingdom is the notable exception to this convergence, which is attributable to the unique U.K. cyclical position, and could also be related to the uncertainty about U.K. participation in EMU.

In 1996, gains in total return indexes for European long-term bonds ranged from almost 50 percent in Italy to about 10-15 percent in core-EU countries.⁷ Returns on aggressive convergence plays have been even higher. Convergence plays in the early 1990s typically exploited yield differentials in cash markets, whereas convergence plays in 1996 were executed largely through interbank swap markets,⁸ a tactic that avoids much of the capital outlay required to establish positions in cash markets. As a result, deutsche mark denominated swap activity—the "pay side" of convergence plays—increased 44 percent in the first half of 1996 to $2.2 trillion. By late 1996, most of these convergence positions were reportedly unwound with the narrowing of spreads.

The compressed spreads in secondary markets created favorable conditions for issuance of debt securities in international and domestic markets in 1996. In international markets, the funds raised in debt securities markets slightly exceeded funds raised through newly announced syndicated lending facilities. Despite sluggish economic activity and fiscal consolidation in some advanced countries, record volumes of debt securities were issued in both international and domestic markets. In international markets, issuance increased by nearly 100 percent on strong demand for funds by U.S. corporations, and by Dutch, German, U.K., and U.S. financial institutions (Table 5). Financial institutions accounted for two-thirds of this sharp increase, and U.S. corporations accounted for more than half of all issuance by nonfinancial corporations. In domestic markets, private issuance rose 10 percent, half of which occurred in U.S. domestic markets; most of the remaining issuance occurred in Germany, Italy, Japan, and the United Kingdom. Public issuance declined slightly.

Heightened investor concerns about the direction of interest rates during 1996-97 led to a shift in demand toward floating-rate and short-term paper and away from bonds. Between end-1994 and the end of the first quarter of 1997, issuance of medium-term notes, Euro commercial paper, and other short-term notes grew by 118 percent whereas international bond issuance grew by only 16 percent. The shift away from bonds is partly attributable to the growing sophistication of borrowers who value the flexibility offered by note issuance facilities.

In search of higher yields, and in an attempt to economize on capital requirements, banks' issuance of asset-backed securities continued to expand briskly in the United States and in international markets. In 1996, issuance in the U.S. market—the largest asset-backed securities market in the world—expanded at double-digit rates, and the amount of outstanding asset-backed securities reached about $740 billion. In both the U.S. and international markets, some of the larger asset-backed securities issues included the securitization of loan portfolios and of various types of receivables from developing countries.

International bank loan markets

The ample supply of funds in securities markets in 1996 intensified competition and maintained thin margins in international loan markets. Announced syndicated credits rose 68 percent in 1996, driven by refinancing operations, mergers and acquisitions, commercial paper and asset-backed securities back-up facilities, and project financing. Most of the increase in borrowing was by entities located in the United States, the United Kingdom, the offshore centers, and developing countries (Table 6). The demand for syndicated loans by U.S. borrowers rose by $218 billion in 1996, an increase of almost 400 percent and greater than the increase in announced credits to all other countries.

Much of the increase in lending came from Benelux, British, Dutch, German, Italian, and Swiss banks, and EMU convergence plays provided a significant boost to the international lending activities of European banks. Cross-border activity by U.S. banks was buoyed by demand in the Eurodollar markets and by financing associated with the surge in foreign demand for U.S. bonds. Japanese banks are still the largest international lenders, but they continued to retreat, especially from international interbank markets, as their share of international lending dropped to the 13-year low of 22 percent.

Aggregate loan spreads over LIBOR remained relatively constant in 1996-97, as banks in a relatively benign economic environment sought higher margins by expanding their lending into new geographic areas and to lesser-known names (Table 7). As competition has led investors to ratchet down the credit spectrum, spreads among prime and non-prime borrowers have narrowed.⁹ These considerations prompted once again warnings from regulators that diligence must not be ignored in extending credits at razor-thin margins. U.S. regulators, in particular, expressed concerns also with the lengthening of maturities and relaxation of covenants to higher-risk borrowers.

A notable development is the growing displacement of interbank lending by repurchase agreements (repos). At end-1996, international repos outstanding totaled about $1 trillion, and annual turnover is estimated to have reached between $40 trillion and $50 trillion. The increased use of repos reflects the greater emphasis on collateral in interbank funding, which is attributable to two factors. First, heightened credit-risk awareness, partly inspired by capital requirements, has encouraged the use of repos as banks have extended their funding activities into geographically less familiar markets and as concerns have increased about some major banks active in the international markets. Second, collateralization procedures and documentation are more standardized, which has facilitated the use of repos by banks.

⁶The "core" includes Austria, Belgium, France, Germany, Luxembourg, and the Netherlands.

⁷Bloomberg/EFFAS ten-year government bond Total Return Indexes (coupons reinvested).

⁸A simple example is a cross-currency interest rate swap in which the investor makes a stream of interest payments denominated in deutsche marks in exchange for a stream of interest payments denominated in the higher yielding currency. If the interest rate spread narrows before the contract maturity date, the investor effectively books a profit equal to the change in the spread times the number of months to maturity (see the Background Material for details).

⁹For instance, in November 1996, a large commercial bank in the Czech Republic obtained financing from a group of European banks at a spread of 20 basis points over LIBOR for the first three years of the loan, which is within a few basis points of the cost of funds for any of the highest-rated borrowers.

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