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Seat Pagine Gialle has just sold e1.3 billion of junk bonds, the largest high-yield issue ever priced in Europe's single currency. The Italian directories business completed its deal just one week after UK cable operator NTL sold the biggest-ever sterling-denominated junk bond, worth £375 million ($664 million). What can explain these record-breaking achievements?
Both Seat and NTL have idiosyncratic features that helped them stretch the limits of the market. Seat comes from a cash-cow industry where no major public borrower has ever gone bust. And its financial position is among the most secure in the directories business, because of a quasi-monopoly position in its domestic market. Seat converts an enviable 80% of its underlying profits into cash. This helps explain why junk-bond investors were keen to lend it more than e1 billion, on a subordinated basis, even though it is leveraged up to the gills.
Collapse shrugged off
The case of NTL is even more extraordinary. Barely a year has passed since the cable operator collapsed under the weight of its borrowings and swapped its debts for equity. So it may seem astonishing that investors are pumping in more cash. Then again, NTL's finances were subjected to massive scrutiny during its lengthy restructuring. The company has also installed new management, which is working to a more sensible business plan than before.
There is also a more general reason why junk bonds are selling in such numbers – the bull market in credit. In an era of low interest rates, investors have piled into credit to pick up extra yield, driving up the price of bonds.
Yields on investment-grade bonds have fallen to levels where further performance gains will only be meagre. The average seven-year triple-B bond issued in euros now yields only 90 basis points over government debt, for instance, according to the ratings agency Moody's Investors Service. So investors are moving down the credit spectrum into junk.
Clearly, part of this move is speculative. Hot money will soon flow out when market conditions worsen. Yet there are reasons to believe that Europe's market for riskier bonds will continue to deepen.
One is that the market is still in its infancy – and should therefore be able to keep growing through a bear phase. On some measures, the European high-yield market is barely an eighth as deep as that in the US. The Merrill Lynch index of single-B-rated euro-denominated bonds is capitalized at e27 billion, for instance. That compares with the $278 billion (e228 billion) capitalization of the bank's similar dollar-denominated index.
What's more, investors have been forced to get to grips with lower-quality credit after the borrowing binge of the late 1990s. Fully 59% of bonds issued in euros by industrial companies are now rated triple-B, for instance, the lowest investment-grade rating. And with interest rates so low, credit quality can have an enormous impact on the performance of investment-grade corporate debt.
Take those triple-B bonds again. Their average credit spread is 90 basis points and their average yield 4.6%. This means that credit risk accounts for almost a fifth of the total yield. Investors in the huge investment-grade market have had to learn the skills to manage this sort of risk. So branching out into junk no longer looks so daunting to them. Indeed, the number of hedge funds specializing in high yield has shot up.
A deeper junk-bond market is great news for European companies. Until recently, junk borrowers who wanted to raise sums close to e1 billion from bondholders had to include a US dollar element in their deals if they wanted to generate any price tension. While some companies like diversifying their funding sources in this way – especially those that generate lots of dollar-denominated sales – for others it is a pain.
Tapping the US high-yield market has two main downsides for European companies. One is the cost of swapping the proceeds back into euros if necessary. This varies over time but is currently estimated at 40bp to 50bp per annum for a 10-year deal – not an insignificant sum.
Then there is the administrative hassle of registering with the SEC and complying with the new Sarbanes-Oxley securities act. In particular, the US regulator asks every company subsidiary guaranteeing bonds to file a separate set of accounts under US accounting standards.
For companies with a sprawling mass of subsidiaries, this is a huge impediment to borrowing in dollars. So the deeper Europe's junk-bond market, the better.
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