Just like the movies, the US capital market tends to get new releases before the rest of the world. Products may eventually spread elsewhere but not before the US market has had a good look at them, added some twists, and done a few billion dollars worth of business.
High-yield debt is a good example. It's at the cutting edge in the European fixed-income market, but for those who've been brought up on a rigid diet of bonds and loans the next generation of US innovations may take some digesting.
"In the US there is a much more fluid dynamic in the way that borrowers think about capital structure," says John Townsend, managing director at Goldman Sachs. Achieving that fluidity means crossing product boundaries, and the line between loans and bonds is becoming increasingly blurred.
Europe has now accepted the concept of high-yield, low-grade corporate credit but it still has a long way to go to catch up with the US in terms of product sophistication and diversity.
Some US bankers feel it's unrealistic to expect to be able simply to create the European market according to the US blueprint. "A lot of people would like to say, 'yes, it's going to happen', but I think it's going to take quite a while," says Tim O'Hara, managing director at Credit Suisse First Boston in New York.
O'Hara points to products such as deferred-pay option bonds that have a long duration and can be highly volatile, and says: "People won't really understand the nature of that market until external events cause real volatility. That can terrify portfolio managers." In a market where you have 27-year-olds who have only ever experienced a bull market running $10 billion fixed-income portfolios, it's anyone's guess how they will react to a sudden downturn.
Cruising in troubled waters
In the US domestic high-yield market there are signs the market may have become a little overexuberant. The most recent issue to hit troubled waters is the $160 million deal for Miami-based cruise-ship operator Premier Cruises. Issued in mid-March, the bonds have lost around a quarter of their value and, at the end of May, were downgraded by Moody's and Standard & Poor's to Caa2 and B minus respectively after poor company earnings and a change of top management were announced.
With a first-coupon payment due in September, there are rumours that institutional investors are considering taking their grievances to underwriter Donaldson Lufkin & Jenrette. DLJ is refusing to comment.
Market supporters point out that default rates remain comfortably above the historical average, although defaults on high-yield bonds have been steadily rising over the past year.
But Martin Fridson, head of global high-yield research at Merrill Lynch in New York, is not persuaded by the official figures. "The default rate is artificially low, it ought to be higher," he says. "The variable we cannot capture in our analysis is the degree of forbearance on the part of banks towards companies who would be violating their covenants."
One banker suggests the situation brings to mind an old joke about doctors: you go to see the doctor and he gives you six months to live. Six months later you can't afford to pay him, so he gives you another six months to live. A default on a high-yield issue might be more damaging to the underwriter than keeping the issue alive despite the borrower's having technically violated its covenants.
The fact that some companies are defaulting despite the best efforts of banks to keep them afloat is a worrying sign. Among those companies coming under particular scrutiny are what Fridson calls "business plan companies": those that have no assets or revenues but have borrowed on the strength of having a good business plan. Investors may be becoming reluctant to continue to support their borrowing, but without access to new funds many will not be able to survive, causing defaults on outstanding debt.
Arthur Penn, managing director and head of global fixed-income capital markets at BT Alex Brown, agrees that in the rush to bring deals to market some intermediaries may have ignored fundamentals. "The market has been so hot that some underwriters have let standards lapse," he says. "Maybe they've lost a bit of focus on basic due diligence."
The market may be getting a little choppy, but there's no sign of a slower pace of product innovation, especially in the border territory between loans and bonds. In recent months, BT Alex Brown has been at the forefront with its Firsts (floating interest rate subordinated term securities) and Elvis (equity linked venture investment securities) products.
The Firsts product mixes some of the most attractive features of bank loans and high-yield bonds. The borrower pays a premium of about 50 basis points to get the flexibility of immediate callability. High-yield bonds are usually not callable until the end of year five.
Such a provision is particularly attractive to LBO sponsors who may be intending to take a company public in the near term. The callability provision offers a quick means of deleveraging the company, without having to pay the expensive "make whole" call provisions that are included in most ordinary high-yield bonds in order to compensate holders for early redemption.
The call provision adds to investors' yield, and as Penn at BT Alex Brown says: "The floating rate over Libor takes out interest rate risk, so it appeals to naturally conservative investors."
The emergence of products such as Firsts largely springs from increasing interest from institutional investors in the leveraged loan market, what Harold Philipps, managing director and co-head of senior debt at DLJ calls "the biggest trend in the US versus European loan market". Noticing this trend, DLJ introduced its own version of the Firsts idea, calling it the "covenant lite" loan. "Because institutional investors look at credit, and don't have a predetermined idea of what a loan should look like, we can take a loan and put in features you normally find in a bond," says Philipps.
Rather than containing the financial maintenance-based covenants found in loans, the covenant lite deals contain the less strenuous incurrence-based covenants usually found in a bond. They also carry bond-like maturities of seven to 10 years.
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