28 April 2021

Bruegel: Confronting the risks: corporate debt in the wake of the pandemic

As European economies emerge from lockdowns, it is becoming clearer that corporate debt has reached critical levels. A new French scheme, in which the state guarantees portfolios of subordinated debt, shows how financial support could be targeted better.

Publicly guaranteed credit and moratoria have been the main instruments used by governments to support companies during the pandemic. By the end of 2020, €318 billion in loans was subject to moratoria according to the European Banking Authority, with the bulk of suspensions then expiring in the first quarter of this year. There has also been substantial use of public credit guarantees, with Italy and Spain among the most active users of this instrument. Additional credit of 8% and 9% of GDP respectively was created in these two countries by end-2020, in part backed up by the European Investment Bank’s €25 billion European Guarantee Fund.

These measures were highly effective in the acute phase of the crisis but addressed only short-term liquidity shortfalls. The loans had relatively short grace periods, so will soon add to debt-service requirements. Moreover, even though governments would assume the risks of default, the banks that extended guaranteed credit would rank level with other senior lenders in any insolvency proceedings.

The upshot is that additional debt offered throughout the pandemic has left the EU corporate sector more vulnerable to insolvencies, and less likely to muster additional hiring and investment. In the recovery, excessively indebted companies are likely to delay investment and focus on deleveraging. At current levels of leverage, many businesses no longer have any margin for error. The slow investment recovery in the aftermath of the 2008 European crisis could be repeated: according to one empirical study roughly 60% of the drop in euro-area business investment in that period was due to excessive leverage in some firms.

‘Hybrid’ debt

What debt-distressed enterprises therefore need are long-term financial liabilities that are relatively junior in the creditor hierarchy.

To address the scale of the recapitalisation requirement, which was last estimated by the European Commission at somewhere between €720 billion and €1.2 trillion, institutional investors must be involved. Equity injections on this scale are unlikely to come from private investment funds, let alone from the still limited IPOs on European equity markets. In any case, small and medium-sized companies (SMEs) generally have very limited access to capital markets, and are reluctant to take on board new owners. Banks, with their established branch networks and knowledge of SMEs’ credit risks and growth prospects, should be relied on to identify suitable borrowers and target loans only to viable companies with sound growth prospects.

Subordinated debt and other instruments where the lender’s risks are similar to those for equity could be an alternative to common equity. This is typically long-term debt, often with a grace period, which leaves the lender in a very junior position in case borrowers default. At that point, the lender would be highly exposed to a write-down or conversion into equity, in line with the local insolvency regime which determines risk premia.

Various forms of such debt are offered across Europe, including Italian mini-bonds, payment-in-kind bonds or convertible bonds. The common characteristic is that the lender shares a much larger portion of risk and, in most cases, such instruments will not dilute ownership once they convert. Overall, the European market is relatively small. Between 2016 and 2019, non-financial firms in the EU (excluding the UK) issued about €68 billion in subordinated debt, compared to about €569 billion in ordinary bonds. There was remarkable growth in 2020, though once SMEs are highly indebted they are more likely to be cut off from such high-risk debt....

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