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By Rom Badilla

The European debt crisis is creating market volatility in equities as evident by the recent decline in stock prices and a subsequent rise in the CBOE Volatility Index. The uncertainty is creating waves that is not only rocking equities but also the corporate debt markets as new issuance dries up and liquidity fades. Bloomberg reports:

The market for corporate bond sales closed as concern European banks will take more writedowns and losses led investors to shun all but the safest government debt.

No companies issued bonds in the U.S. yesterday, compared with $2.2 billion on the corresponding day following the Memorial Day weekend in 2009, according to data compiled by Bloomberg. In Europe, 1.35 billion euros ($1.66 billion) was raised from two sales of covered bonds, versus 6.5 billion euros a year earlier, Bloomberg data show.

The global new issue market failed to revive after declining to $70 billion last month, less than half of April’s tally and the least since August 2003, Bloomberg data show. The European Central Bank forecast that financial institutions will have to write off 195 billion euros of bad debts by 2011, according to a biannual report published May 31.

Furthermore, the market uncertainty is leading Wall Street dealers to reign in risk which in turn leads to less trading activity for corporate bond players, as John Detrixhe from Bloomberg wrote:

Wall Street banks are pulling back from providing capital that helps clients trade, making it harder for Loomis Sayles & Co. to purchase the corporate bonds that the $145 billion investment firm seeks.

“With the uncertainty that we’ve had, any rational person performing this function is going to get their exposure down,” said Daniel Fuss, vice chairman of Boston-based Loomis. “That makes the markets thinner. It also makes it harder to bring new issues.”

Loomis sees value in corporate credit, Fuss said, after the debt lost 1.2 percent in May, snapping four months of positive returns. The gap between the cost to buy and sell the securities widened last month as the European sovereign debt crisis stoked concern the global economy will sink back into recession. Borrowers issued $32 billion of bonds last month, the least since November 2008, according to data compiled by Bloomberg.

Higher transaction costs and market illiquidity usually spells trouble for the corporate bond markets as mentioned last week.

Essentially, corporate borrowers are waiting for market volatility and borrowing costs, in the form of lower spreads, to subside before coming to market to issue debt. This is a questionable move since the source of volatility is deep rooted in the fundamental problems of the EU and escalating scrutiny on sovereign debt. This latest episode is by no means a liquidity problem but part of a bigger problem of global debt. Hence, unless a solution occurs overnight which seems unlikely and spreads continue to widen, waiting may ultimately incur higher borrowing costs once companies are forced to issue debt due to immediate funding needs.

This same dynamic occurred during the onset of the real estate crash as Wall Street firms waited to issue mortgage securitization deals with the hopes that volatility will subside. Wall Street waited for as long as it could before clearing their balance sheets by issuing mortgage deals. Ultimately, the deals, which were one of the last of its kind, were issued at less favorable borrowing costs and higher yields in order to attract demand. Since then and for the better part of two to three years, new issues in the securitizations markets have been non-existent.

At this point in time, it is difficult to see the corporate market shut down for a long period of time as some might call it “irrational”. However, it is worth knowing that such irrational environments has occurred during times of high uncertainty and that a frozen primary market can happen as illustrated above. This should be considered when weighing whether to issue new debt or not.

Famed economist, John Maynard Keynes once said that, “the markets can stay irrational longer than you can remain solvent.” While he has yet to be right about other things (namely, the significance of fiscal spending), he might be onto something here.

In May, corporate spreads over comparable Treasuries increased. The BofA Merrill Lynch High Yield Index widened 137 basis points to a spread of 698 as the sector lost 3.5 percent. Similarly, spreads in the Investment Grade sector widened 47 basis points to yield 202 basis points over Treasuries as the Corporate Index declined by 0.57 percent.

Source: Corporate Bond Market Is Feeling the Heat