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Skip Navigation LinksHome :: Back Issues :: Growing pains of leveraged finance

September 2000

Growing pains of leveraged finance


High-yield bonds and loans are the business every bank wants to be in. But when bond markets turn nasty, junk debt is the first to suffer. Michael Peterson reports




Nowhere is the convergence of bond and loan markets more obvious than in the business of lending to less creditworthy companies. Over the past three years, Europe has gained a reasonable-sized high-yield bond market. But another high-yield market has also grown rapidly in that time - leveraged loans. In 1999 just over $22 billion-worth of high-yield, or leveraged loans were extended, with nearly $17 billion lent in the First half of 2000. By comparison, high-yield bond volumes in 1999 were just under $21 billion, with a further $10 billion or so raised up to June 2000.
       

Leveraged loans typically Finance leveraged buyouts and other acquisitions. Since LBOs are also the classic source of high-yield bond issuance, it makes a lot of sense to run these two products together in a business some Firms call leveraged Finance, others high yield and some refer to as acquisition Finance.
Europe's high-yield bond market is un-doubtedly a great success. A market which included only a handful of names at the beginning of 1998 now sees nearly two deals a week. There were a total of 90 international high-yield bond issues in 1999 and 44 in the First half of 2000.
And no longer does the market look to US investors to buy European junk bonds. "The European high-yield bond market has grown to the point where it is now a viable, independent market that doesn't have to look to the US for support except in the rare instances of very large deals," says Brian McBride, co-head of JP Morgan's European high-yield group.
In fact, Europe's high-yield market has generally been more healthy than the US domestic junk market this year. Issuance in the US has fallen dramatically as investors worry about rising US interest rates.
But the international market is still a patchy affair. Like a canary in a coal mine, it keels over at the slightest whiff of trouble, closing down altogether when investor sentiment turns against credit. In mid-2000, it has struggled to cope with supply as several large telecom deals have been scaled back or priced with higher than expected coupons.
Part of the problem is that high-yield investors are losing money almost as fast as they can invest it. Corporate bond spreads in general, and high yield spreads in particular, have moved steadily wider over the past 12 months. That has reduced the amount of money asset managers have available to reinvest in new issues.
Diversify and conquer
Many European LBOs have been Financed mainly with bank debt rather than with bonds. "Bank debt is a lot cheaper and to a certain extent more Flexible than high-yield bonds," says Paul de Rome, co-head of acquisition Finance at Schroder Salomon Smith Barney. "So it is attractive to LBO sponsors. And there is no shortage of banks willing to lend. If anything, we are seeing more banks moving into leveraged Finance as a way of getting more yield."
Prices of leveraged loans have risen in tandem with those of high-yield bonds, but they are still much lower. The recent leveraged loan from Callahan, for example, paid a margin of 250 basis points over Euribor, one of the widest margins so far. But the company's high-yield bond, issued around the same time, carried a coupon of no less than 14%.
In part, leveraged loans are cheaper for borrowers than high-yield bonds because they are more senior, and because they have the disadvantage of being amortizing. But much of the reason for the difference in pricing is that the bank market has a great deal more appetite for high-yielding credit than bond investors.
For now, that demand still comes predominantly from banks. But market participants talk enthusiastically of institutional investors starting to enter the market. Most agree that there are Five or six institutions which have been active in buying leveraged loans recently.
Another factor affecting relative demand in the two markets is the interest rate cycle. "One reason that the senior bank market looks more healthy than the high-yield bond market at the moment is that high-yield investors are worried about interest rates," says de Rome. "Bank lenders don't have to worry about the direction of interest rates."
A typical LBO includes not just senior debt - usually a term loan and a revolving facility - but also a more junior sort of loan called mezzanine. This is bank debt with some quirky features. It yields significantly more than senior debt but much of the return comes in the form of warrants. Loans tend to be small in size and are typically held to maturity by specialist lenders.
It is an old product, but mezzanine has grown rapidly in recent years. "A couple of years ago, the largest mezzanine tranche you could have done would have been the equivalent of e75 million," says McBride at JP Morgan. "Now a mezzanine tranche in the order of £200 million to £250 million is achievable."
McBride sees the growth of the mezzanine market as a very significant development. "First, it provides healthy competition to the high-yield market for relatively large transactions," he says. "Second, it gives added confidence to do some smaller deals. The high-yield market can only deliver consistently if you can issue e100 million or more. The smallest mezzanine deals can be e10 million or e15 million."
Mezzanine specialist ICG has been at the forefront of a trend which has the potential to increase demand for all varieties of high-yield debt. In the past 12 months, Europe has seen its First collateralized debt obligations (CDOs) appear. These vehicles, common in the US, are holdings of high-yielding assets Financed by asset-backed bonds. Many believe they could create significant additional demand for high-yield bonds and loans. "If you think that this year there might be about e20 billion of high-yield issuance, an additional e2 billion to e3 billion of buying power would have a massive impact on demand," says James Amine, head of European high yield at Credit Suisse First Boston.
CDOs are one more factor which may spur the creation of a mature, US-style leveraged Finance market. But will a bigger high-yield market fall prey to the usual European vices of excessive competition and fee cutting? Participants report that so far fees are holding up well. "There are a lot of players but it is not necessarily getting more competitive," says one high-yield banker. "We run into the same small group of people all the time."
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