European high-yield debt: the ties that bind
Europe's high-yield bond market has had a roller-coaster ride this year. Hardly had it recovered from last year's Russian crisis when jitters in the equity market and fears of rising US interest rates pushed volatilities to spectacular levels.
To add to these uncertainties, US Federal Reserve chairman Alan Greenspan has made moves - essentially through issuing cryptic statements of his intentions - to stop the markets from overheating. "Greenspan's strategy is to continue to inject into the market some uncertainty about his own actions," says John Wotowicz, European head of high yield at Morgan Stanley.
The result has been that issuers and investors alike have been hanging on his every word in an attempt to second-guess him. And this in turn has led to a stop-start issuance of high-yield bonds.
"The behaviour of the market has been influenced by the Fed's timing of its meetings," says Malcolm Stewart, co-head of European leveraged finance at Salomon Smith Barney. "Since the August Fed meeting, the secondary high-yield market has firmed up, and the European market has been performing better than the US."
Because the European high-yield market continues to rely on US investors, and sometimes US issuers to provide its base, it has been subject to all the vagaries of US interest-rate speculation.
However, James Amine, head of European high yield at Credit Suisse First Boston, thinks that in time European deals will not have to depend as much on US investors. "The European market is becoming more independent in the sense that deals can be sold nearly entirely into Europe," he says. Amine also considers that what happens in the US economy and the US high-yield market will have less direct influence on the market in Europe.
"Over the last year as new investors have entered the market, and those involved have committed more capital and expertise, the European high-yield market has become stronger, deeper and more sophisticated," says Alasdair McPherson, director of high-yield research at Paribas. "The market is no longer nascent, it is now recognized as an important asset class - albeit one that is in the awkward stages of adolescence."
The problems in the US stem from the fact that many investors are switching into markets that are less interest-rate sensitive. Because the US high yield market is a mature one, there are fewer new investors to replace them.
At the start of the year there were large inflows of cash into the sector, but since interest rates have become a concern, money has been pouring out. In May, for example, $903.5 million (1.2% of total assets) left US high-yield mutual funds. The funds' buying capacity is down.
In addition, the CBO (collateralized bond obligation) market - where high-yield debt is securitized by a third party and re-sold with a range of risk profiles - has begun to dry up. CBOs had accounted for 20% of all US high-yield investment, as they appeal to investors with a wide range of risk appetites.
So in July when a flood of new supply in the US arrived - mostly single-B rated - the market could not absorb it. The number of pulled deals increased and many were repriced and restructured to cope with the growing volatility. "Single-B CBOs had to give coupons of 13%, and the structures began to become onerous for borrowers," says Carolyn Aitchison, head of European high yield at DLJ. "It was the first time since 1994 that we have seen warrants on industrial deals become commonplace."
Spreads widened dramatically as issuers rushed to get deals done before the much-anticipated 25bp interest-rate hike in the US at the end of August. However, after the summer lull the flow of deals in the primary market has picked up considerably. At the end of August mutual funds again recorded positive inflows of cash.
The anxiety of US high-yield investors has been heightened by the growing level of defaults in the market, which Standard & Poor's, the US ratings agency, claims are at an all-time high.
The most high-profile failure was by telecoms company Iridium, which defaulted on its high-yield debt in mid-August. So far there have been few defaults directly affecting European investors, though there have been worries over chemicals company Brunner Mond which has already violated covenants on its bank debt.
How a high-profile default would affect investor sentiment in Europe depends in part on how much can be recovered. Most - but not all - investors understand that a certain number of defaults is the price paid for greater yield. "European high yield hasn't experienced a recession yet, so you can't call it a seasoned market," says Jean-François Astier, head of leveraged finance in Europe, at Lehman Brothers.
Predicting the improvement and decline of high-yield credits is becoming a major part of investors' strategy. "As the European high-yield market matures, credit events, both positive and negative, will become much more common," says McPherson at Paribas.
For example: Derby Cycles has had to reset the covenants on its debt due to poor sales; magazine group IPC has reset debt repayments and has requested a new injection of equity from its sponsors; and television channel Central European Media has been hit by political problems in the Czech Republic. More positively, German toilet manufacturer Geberit has launched a successful IPO and its bonds have been called, while Dolphin Telecoms also looks set to launch an IPO next year.
The foundations of a stable high-yield market in Europe - a consistent supply of deals and reliable investor demand - are gradually falling into place again after the disruption at the end of 1998.
Issuance of dollar and non-dollar paper by European high-yield borrowers for the first half of the year was up 6% on the previous year to e9.5 billion ($10 billion). Issuance volumes for 1999 should match, if not exceed, last year despite a quiet first quarter. Some are predicting a total of e20 billion ($21 billion) issuance this year.
One noticeable change in this year's market is the increase in euro-denominated new issues compared to dollar deals, which have declined. In the first six months of 1999, 48% of high-yield issuance was denominated in European currencies, compared to 39% in 1998.