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* Improved tone headed into new year
* Central banks seen driving sentiment
* Regulatory needs clamping bank issuance
LONDON, Dec 7 (IFR) - Europe's credit markets are heading into 2013 in much better shape than 12 months ago, after unprecedented central bank commitments helped put a lid on a crisis of confidence.
Issuers are now seeing some of the best conditions in a long time, investors are willing to embrace riskier credits in the hunt for yield, and the market is altogether on a sounder footing.
"The outlook is much brighter for next year," said Martin Egan, global head of primary markets at BNP Paribas. "But there are still plenty of risks and constraints that will impact financial markets."
Soothing talk from the European Central Bank has helped mitigate those risks in the minds of many investors, as ECB chief Mario Draghi insisted he would not let the euro come undone.
Boosted in part by those comments, and bolstered by the backstop of the ECB's OMT programme, Europe's peripheral sovereigns have come in from the cold. Ten-year yields on Spain and Italy have plunged from over 7% to 5.2% and 4.4%, respectively -- and broader credit indices are now around their 18-month lows.
And as central banks maintain the low-rates environment, investors are likely to welcome a much wider piece of the credit spectrum into their portfolios.
"Central banks will likely continue to drive market sentiment, while investors' search for yield could enhance market access for infrequent and less well-known issuers," said Melissa Smith, head of EMEA high-grade debt capital markets at JP Morgan.
TOTALLING IT UP
Certainly the markets will be hard-pressed to replicate 2012's stellar returns in investment-grade (12%) and high-yield (18%).
But the fragile outlook for economic growth should help maintain the strong inflows into credit markets, where supply is likely to continue to be strong.
Euro-denominated corporate issuance this year is the second-highest annual total in the past decade.
"Corporate issuance should be robust in 2013 as the bank-to-bond trend continues. But we will likely need M&A activity to see high-grade volumes rise to EUR230bn, a net EUR90bn increase," said Mark Lewellen, head of European corporate DCM at Barclays.
M&A activity has largely been muted in 2012. The leveraged buyout market has disappointed, mainly due to mismatched price expectations between buyers and sellers,
And a continued lack of large-scale M&A in 2013 will mean less opportunities for private equity firms which often benefit from picking up non-core assets.
Even so, the high-yield market is one of the most promising areas for growth, bankers say.
"Unless we see an uptick in M&A activity, the leveraged loan markets will likely continue to see limited deal flow," said Kristian Orssten, head of EMEA high-yield and loan capital markets at JP Morgan.
"The trends of bank deleveraging and lack of new replacement CLO issuance will again dominate the agenda in 2013."
High yield bond markets will therefore continue to increase its importance as an alternative funding source, with most issuance in high-yield related to refinancing.
"Of all capital markets, the growth prospects of high-yield is the one market that we feel most optimistic about," Orssten added.
Meanwhile bank deleveraging in the face of new capital regulations is suppressing senior unsecured bank issuance, which is already at half the peak volumes seen five years ago.
Although senior unsecured funding will remain subdued, any peripheral issuance will be a key test of sentiment - especially as the risk of bail-in draws closer and investors become more concerned about restructurings that could lead to haircuts on senior debt.
"Senior funding for bank periphery is a real barometer of investor sentiment," said Richard Boath, co-head of global finance, EMEA, at Barclays.
But capital raising will dominate the financial landscape.
Regulatory uncertainty will mean that issuers focus on Tier 2 bonds to boost capital rather than Tier 1. A focus on shorter-dated floaters may also be more common.
As much as EUR200bn of Tier 2 could potentially hit the market over the next few years, and once rules governing Tier 1 are clearer, issuance could be as large as EUR150bn, Citi said.
However, hybrid bankers warn that structures could be complex. They predict greater granularity among bank Tier 2 issuance, as issuers grapple with local regulatory requirements, or seek to address specific balance sheet needs.
In the covered bond space, peripheral jurisdictions will feature as the main growth areas. Global benchmark volumes are expected to grow by around 5% to EUR160bn-equivalent next year and EUR165bn in 2014, according to Credit Agricole.
BULLISH ON IRELAND
On the sovereign side, issuance is expected to be 13% lower in 2013 at USD5.25trn, with a sharp contraction in Europe as gross supply falls by EUR80bn to EUR759bn, Morgan Stanley said.
But bankers are bullish that Ireland will make a return to syndicated markets, driven by a political will to show that struggling countries are on the mend.
European supranational and agency supply is expected to trump the record volumes of EUR504bn in 2012, rising to EUR520bn in 2013. The massive front-loading experienced in 2011, however, is unlikely to be repeated with as much fervour.
"Markets are much more constructive, with some issuers already pre-funded, so the first months of 2013 could be a little different," said Dan Shane, head of SSA syndicate at Morgan Stanley. (Reporting by Natalie Harrison, Josie Cox, Aimee Donnellan, John Geddie and Alex Chambers; Editing by Marc Carnegie)