If you believe the hype, 1998 is the breakthrough year for high-yield corporate debt in Europe. Already by the end of February more deals had been done than in the whole of 1997, a reward for the banks that have been dabbling in this market since the early 1990s. Changes in bank lending, investor flight from Asia and the onset of Emu are driving the market forward, say its promoters.
“The key to the development of any market is momentum,” says Robin Doumar, co-head of European leveraged finance at Goldman Sachs. “We are reaching critical mass in the high-yield market right now, it’s a very exciting time.”
High-yield bond issues this year have included a Dm300 million ($164 million) issue in February from Fresenius Medical Care, the world’s largest producer of dialysis products, and a £180 million ($269 million) issue from IPC magazines in March. These were swiftly followed by NTL Cable’s issue of £300 million, and the first ever euro-denominated high-yield deal, raising almost €147 million ($160 million) for Cellular Communications International (CCIL).
Most recent deals are thought by bankers and investors to have performed well; the market has yet to encounter a truly bad deal, or worse, a default. “It’s a terrific sign that we are seeing deals priced well and trading reasonably well,” says Doumar. “This is the kindling phase of the market – get it stoked up and it will take off.”
The small group of banks that dominate high-yield origination are united in their zeal for the new European market. Emu will remove the opportunity for banks to make money on currencies, and bankers seem to think that growth in high yield will fill the profit gap. Bankers Trust, Donaldson Lufkin & Jenrette (DLJ), Morgan Stanley and Credit Suisse First Boston (CSFB) have the lion’s share of the market, followed closely by Merrill Lynch and Goldman Sachs. These banks lead the field in the US, which has given them a head-start in Europe, where skilled high-yield personnel are scarce.
“There is a strong consensus that things are happening in European high yield, and you can see this in the hiring process, the war to get hold of talented credit-research analysts,” says Pierre-Olivier Masmejean, managing director of high yield in Europe at DLJ. Since Christmas analysts and bankers have been frantically shipped over from New York offices, or failing that, poached from other banks. Ben Booth, vice-president of high-yield research at DLJ, moved to his present post from Bankers Trust at the beginning of March. Vincent Keith, principal of the European debt syndicate at Bankers Trust, admits that poaching is rife. “It is a problem. Everyone here has been approached. However we keep people busy and compensate them very well, we give them no cause to leave.”
The American banks may already have the product expertise, but do they have meaningful relationships with European issuers and investors? Joe Biernat, managing director and head of high-yield origination at Deutsche Bank, feels that they lack flair for the local market. “My impression is that US firms are still focused on the US market. They’re not yet thinking about the euro, they’re still thinking about dollars and about New York law,” he says. “As a European firm we have a different approach and are strong on distribution. We talk to every single big European investor.” Deutsche Bank has yet to do a European high-yield deal, but has several issues in the pipeline. These include a large lira issue from Spanish car maker Seat, expected in the first half of April.
Deutsche Bank and CSFB are seen as the main European challengers to the American clique in European high yield. SBC Warburg Dillon Read contends that after digesting the merger with UBS it will compete head to head with the American banks. “We have the best chance of all the European houses of challenging the Americans, given both of our distribution capabilities and client relationships,” says Jay Nawrocki, head of high-yield origination at SBC.
There is a surprising breadth of opinion on what European high yield is. In this young market banks disagree about what qualifies as a high-yield deal, and when it can truly be called European. “Banks argue over criteria to make the market more favourable to them,” points out Keith at Bankers Trust.
Some American banks insist that deals registered in the US and issued in dollars (as the early deals in the market were) are still European if the issuer or some of the investors are from the continent. Others, including Deutsche Bank, feel that deals in this market should be denominated in European currency, regulated by European law and targeted at European buyers. Keith Alexander, co-head of European high-yield capital markets at CSFB, argues that many European corporates, such as shipping firms, need dollars, and that deals are classed as European by the nationality of the issuer.
Depending on which bank estimate you believe, US investors currently make up between 20% and 70% of European high-yield buyers, even on non-dollar deals. The number of European investors is steadily growing, but it is likely that there will always be an American presence.
DLJ claims that it could place over 75% of its deals with European investors, but it must respect the needs of its clients in the US. “Now the competition in high yield is so intense, having the option to sell to the US gives the company more flexibility to achieve its goals as it expands its investor base,” says Keith. “It costs about an extra $50,000 for access to the US market. This is a cheap insurance policy.”
Spread is what primarily characterizes high-yield debt, though credit rating is also an important factor. Deutsche Bank considers spreads between 100 to 400 basis points over the benchmark to be high yield. Other banks think high yield begins further up the scale; for Citibank, Merrill Lynch and DLJ high-yield starts at 250bp.
But Mark Sanders, fixed interest manager at Aberdeen Asset Management, says that he regards investments with spreads of over 350bp as high-yield. This is straying into true junk-bond territory with spreads akin to the American market. The widest European spread so far has been for the Esprit Telecom Deutschmark deal in December last year, which opened at 621bp over 10-year German Bunds.
Half the deals in the market are rated single-B. Maturity is important in high-yield debt, the majority of bonds have maturities of seven to 10 years. Banks lend for up to seven or eight years, and corporates needing longer-term funding turn to the bond markets. Many of the corporates borrowing are new growth companies that need time and capital to expand. Banks are often unwilling to take risks on these new enterprises. It may take several years before the firms make a profit, as in the cable and telecommunications sector, and the potential risk of default on short-dated bonds would be high.
High-yield debt provides flexibility of structure to corporates which want less stringent conditions and the option to delay coupon payments. Investor interest in high-yield debt usually drops off when maturities exceed 10-years and the risk of default escalates.
Corporates have been issuing high-yield debt in Europe for years, but until last year the deals were dollar-denominated or domestic sterling issues. In April 1997 Geberit announced a Dm157 million issue, lead-managed by Merrill Lynch and widely seen as the first true European high-yield deal.
John Wotowicz, executive director and head of European high-yield capital markets at Morgan Stanley, questions the now near-legendary status of the Geberit deal and points out that it was registered in the US with the SEC. “From our standpoint, Geberit was still a half-American deal and didn’t address the issues of the European market,” says Wotowicz. He contends that the Dm175 million deal Morgan Stanley brought the next week for Exide Holdings was the real landmark, as the deal was done without SEC registration and according to French accounting principles.
Since then European deals have been issued in Deutschmark, sterling, lira, French francs, and last month in euros. Dollar deals are still popular but Michael Browne, head of high-yield and emerging-markets fixed-income corporate finance at Citicorp Securities, estimates that in 1998 50% of issues will be in European currencies.
The euro147 million deal for CCIL was led by DLJ and opened at 475bp over. Opinion is divided on whether euro-denominated deals will catch on before the start of Emu. SBC is keen on the idea but wants to wait to see how the CCIL deal performs. Deutsche Bank is working on a euro deal now. Deutsche’s Biernat says the denomination is “partly for marketing, but partly for the ease of future transactions”.
Wotowicz at Morgan Stanley is indifferent. “Euros are fine,” he says. “But you might as well bring a Deutschmark deal as this is the most prominent euro-proxy and has a wider investor base. For the next few months euro-denominated deals will be more about headlines than real market impact.” A banker at another American bank views issuing in euros as irrelevant. “No-one wants to buy them,” he says. “Deutschmarks suit investors fine, euros are a gimmick.”
Whatever the currency, deals seem to be getting larger. In September 1997, a Dm575 million deal from Belgian publishing company ITT Promedia proved that non-dollar high-yield issues need not be small in size. It was the biggest Deutschmark high-yield deal of the year.
In March this year UK magazine publisher IPC issued a relatively large sterling high-yield bond, a £180 million issue, with Goldman Sachs as sole bookrunner. Doumar at Goldman thinks the deal size in European high yield still has a long way to go. “It will be a little while before the market digests the equivalent of a $1 billion deal, but everyday the deals get bigger,” he says.
The IPC issue was oversubscribed, but many think it was priced too aggressively – spreads widened after launch. A rival banker says: “It has hardly been a roaring success.”
Bankers and investors alike highlight the £300 million deal for NTL that came to the market just days after IPC. DLJ and Morgan Stanley were joint bookrunners. Including the dollar tranche, the issue was worth the equivalent of $1.3 billion, making it the largest high-yield deal so far. Zak Summerscale is investment officer for European high yield at the United Bank of Kuwait, which has been buying high yield for 12 years. “NTL was important for its sheer size, proving that there is some depth in the market,” he says.
The non-dollar market now contains over 20 deals spread over around 10 different industries, although, as in the US, telecommunications and media dominate issuance. Although the size of each issue is relatively small, the total volume of bonds is just about big enough to create a healthy secondary market.
However, investors worry about achieving sufficient diversity to offset the added risk of high yield. A diversified investment portfolio generally contains eight or more unrelated issuers.
Choice of deals is still relatively small, and many investors want to wait until the market matures before buying. DWS mutual fund in Germany has been investing in high yield since 1991, and has a budget of $800 million to invest in both high-yield and emerging-markets debt. The fund managers are not permitted to invest more than 5% of the budget with any one issuer, so a diverse supply of issues is crucial.
“Investors will pay a premium to buy something that is a diversification play,” says Keith at Bankers Trust. “They would like to see in Europe the development of the breadth in industries seen in the US high-yield market”
But many investors are still reluctant, something that seems strange to many used to the US market. Doumar at Goldman Sachs insists that “every single asset manager in Europe should be looking at high-yield”. Rick Deutsch, co-head of European credit research at Merrill Lynch, has found that “Europeans were traditionally suspicious about high yield, as though it was some kind of financial sleight of hand”.
Wotowicz at Morgan Stanley feels that “high yield is a very logical asset class, and one very natural for European investors. My first impression was that European equity investors were like high-yield investors. But even though equity is the most risky instrument you can invest in, these investors never thought of buying higher yielding corporate bonds which offer superior returns”.
European corporates have traditionally had strong relationships with their banks and seldom went to the capital markets, making corporate bonds scarce. “The US benefits from a credit culture, which, to date, hasn’t existed in Europe,” says Booth at DLJ. “Historically, if a fund manager wanted yield they might buy higher-yielding government bonds, but with Emu fast approaching these opportunities are evaporating. Now, one of the few ways to find yield is to take credit risk.”
One stumbling block for the market is a regulatory issue concerning the credit ratings of corporates. One fund manager estimates that 85% of institutions are not authorized by their trustees to buy below investment grade. That policy excludes the majority of corporates but, because of a loophole, unrated, riskier companies further down the credit scale are open to investment.
Most bankers and fund managers see the rules as outdated and predict that they will change soon. “The parameters are simply archaic,” says Booth at DLJ. “They only exist because, until now, high yield hasn’t really featured in the European corporate debt markets.”
Helena Morrissey, director of fixed income at Newton Asset Management, believes the shift towards investing in European high yield will be gradual even after the rules change. She manages the Newton High-Yield Fund, launched in November 1997 as one of the first funds to concentrate on high-yield corporate debt. “Management agreements will be rewritten to go below investment grade, and even pension funds will look at corporate debt,” Morrissey says. “European investors are traditionally conservative, but eventually high yield will almost be forced upon them. After all, what else are they going to buy?”
Why should high yield be important to investors this year in particular? “The primary driver of the recent high-yield growth has been the interest rate convergence for Emu,” says Morgan Stanley’s Wotowicz. Yields on southern European sovereign debt such as Italy and Spain, traditional favourites with institutional investors, have dropped from over 10% to a paltry 5% or 6%.
Meanwhile for issuers, there is growing pressure to cut out bank lending. The banks themselves can no longer afford to support loss-leading debts and are themselves on a hunt for yield. As a result, European corporates are moving their funding to the capital markets.
This is not to say that high-yield debt will replace bank loans. “This is misrepresentative,” says Nawrocki at SBC. “High yield is not meant to replace bank debt or equity. Nor is it meant as an iron-lung for failing companies. It provides growth capital for companies who wish to avoid dilutive equity issues.”
The close banking relationships in Europe have prevented some corporates from breaking these ties and rushing towards high-yield debt. “It has always been harder to get an issuer to issue than an investor to buy, but this is changing,” says Keith at Bankers Trust. “Now the option of a high-yield deal is obvious and more and more finance directors are looking at it.”
Saudi International Bank has been investing in European high-yield debt since the Fitzwalton sterling deal in November 1996, and has bought into about three-quarters of non-dollar deals. Shelley Moledina and Diana Gordon from the bank say that there is plenty of supply in start-up media companies, but as investors they would prefer “a few good deals on the industrial front, in the mould of Geberit”. There have been fewer deals coming out than they expected at the beginning of the year.
Joe Bencivenga, global head of high-yield and emerging markets at Barclays Capital, raises the issue of disclosure and transparency of company accounts, a vital component in developing accurate credit-research skills and educating investors about the risks of high yield. Many argue that Europe hasn’t developed the necessary infrastructure of credit research for the high-yield market to thrive, and that the American banks are pushing the market forward too fast.
Another issue that could define the market is banks’ ability to create liquidity in the secondary market. Although the market is still small, bankers say that liquidity depends on the commitment of the lead managers, and that investors can feel secure about reselling their bonds. John Ezrow, head of European high-yield capital markets at DLJ, emphasizes the importance of good underwriting. “There is an understanding that the quality of banks’ underwriting is key,” he says. “Those that gain a poor underwriting reputation simply will not be able to sell bonds in the future.”
Last year the European high-yield market contained $4.2 billion of dollar deals and the equivalent of $1.8 billion of non-dollar deals. This was a fraction of the huge US high-yield sector, estimated at $130 billion. Predictions vary wildly about the rate of growth this year, but most bankers agree that it may never catch up with the American market. “It would be a shame if the European market develops exactly the same as the US,” thinks Bencivenga. “The cultures are different enough that there should be divergences in style.”
Deutsche Bank is cautious, predicting the European market will grow to $3 billion by the end of this year, but that 1999 will be the real growth year. At the other extreme, DLJ is optimistically expecting between $10 billion and $15 billion of issuance in 1998.
The big banks certainly have some large deals in the pipeline. The first to be announced is likely to be the much-heralded HMV media-Waterstones deal, £200 million of 10-year bonds brought by Merrill Lynch and SBC, due in mid to late April. Other deals can be expected in April from British betting shop-chain William Hill and Polish cable firm Bresnan.
The future development of the market will hinge on how the market reacts to the first big default. Europe won’t necessarily go into crisis as the US did in the early 1990s, because Europe and America are affected by different problems.
Ezrow at DLJ is convinced that credit research should be emphasised throughout the capital markets: “Whether you look at government bonds, high grade, high yield or equity, credit is credit is credit. It’s as simple as that.”
