Interest market

Higher interest rates are here to stay, but how high can they become?

The Federal Reserve (FED) showed the way and aggressively raised the central bank rate by 4.25 percentage points during 2022 and additional 0.25 percent in February. European central banks followed and both the ECB and the Riksbank raised their central bank rates by 2.50 percentage points in 2022 and have followed up in February with additional 0.50 percent. Unlike the US, where consumer prices haven’t moved much since June, Europe still has a problem with rising consumer prices. At the latest ECB meeting the tone was hawkish, with higher inflation forecasts, an upside inflation risk assessment and heavy guidance towards a +50 basis point rise in March. ECB will then evaluate the subsequent path of its monetary policy. The Riksbank followed the ECB and raised by 0.50 percentage in February. The Riksbank is caught between an interest ratesensitive economy and an increasingly weaker SEK. If the SEK is not to weaken further, it is likely that the Riksbank will need to raise the central bank rate at least or somewhat more than the ECB going forward.

Financial uncertainty and concern will continue in 2023 and volatile interest rates are, therefore, to be expected. A likely scenario is that central bank rates will reach their peak during 2023, which the market is pricing, which currently means inverted yield curves where longer rates are priced lower than shorter. When and how high the interest rates will reach is hard to predict, but the market is pricing for short market rates to peak between 0.30–1.00 percentage points higher than current levels, with the peak after summer, while the long-term interest rates may already have seen the peak.

An interesting observation is that short-term rates in the Eurozone and the Nordics are set to converge to just above 2.50 percent in 2025, which is expected in a world where inflation is back at central bank target levels.

80%

Decrease of issuance of real estate bonds in Q3 2022, compared to Q3 2021.

Credit market

Uncertainty around inflation and the number of rate increases that will be required to mitigate these broad price increases is still contributing to deteriorated liquidity in the capital markets for real estate corporates. At times, during the last six months, liquidity has almost been nonexistent in the EUR bond market for real estate issuers. This situation has emerged as investors have sought more secure placements towards other industries with less exposure to interest rates at the same time as central banks have ended their corporate bond purchase programs.

The liquidity shortage in both commercial paper and bond markets has pushed spreads upwards significantly. This is clearly a game changer, especially for investment grade rated companies, as bank financing has become the more attractive alternative. This situation will, in the long run, cause headaches for some of the rated companies as increased amounts of bank financing will decrease the level of unencumbered assets, which is one of the criteria for an investment grade rating.

The Nordic banks are still showing appetite for lending but are primarily focusing on existing relationships. Some of the Nordic banks have even been able to offer unsecured loans to support their clients’ ratings. Even though their appetite is still good, they are now more cautious about offering higher levels of leverage, particularly for low yielding segments. During recent months, it has become more prevalent for some of the Nordic banks to require hedging in the loan agreement. The question is will the banks be able and willing to absorb the volume for the bond market if this situation persists throughout 2023?

Despite the market structure differences in Sweden and Finland, we see the same pattern in financing conditions in both countries. Banks are focusing on existing clients and are very selective and conservative in loan metrics in new financings. They are very much focused on cash flow of the assets and, overall, banks have not yet significantly lowered their interest coverage ratio (ICR) targets for new loans. This means, in this higher rate environment, the only way to meet the ICR targets is to lower the LTV. Hence, LTV is currently the result of the cash flow metric rather than the starting point, which was the norm in the earlier zero rate environment.

Outlook

To solve the upcoming redemption ‘wall’ of outstanding bonds (over € 13 billion annually for 2023–2025, of which 75 percent is related to Sweden) we expect to see a variety of arrangements, including support from current Nordic lenders, divestments, mergers and acquisitions, as well as international lenders providing new liquidity to the loan market. These arrangements are not exclusive to the bond issuers. In general, we are likely to see deleveraging in the entire sector.

Stabilising rates are likely to ease the financing conditions somewhat later this year. However, we expect to see more covenant breaches in the sector -especially in cash flow covenants for investors with lower hedging ratios. Lower valuations will also increase LTV levels in general. This will lead to banks being obligated by regulation to reserve more capital for the real estate sector. Consequently, new lending will be further squeezed and loan margin levels are likely to continue to creep up over the next few months.

Joakim Nirup Head of Debt & Financial Advisory Stockholm, Sweden

Eemeli Lehto Head of Debt & Financial Advisory Helsinki , Finland