How you value call protection – and why you should care

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Proponents of European high yield think covenants for issuers should be relaxed if the market is to survive.

The high yield market in Europe has stalled in recent years. Pessimists might say that it has never recovered from the dark days of 2000, when buyers and sellers effectively went on strike. Buyers were upset with the sell side’s tactics and financial sponsors became reluctant to get locked in to high-yield debt that featured significant call protection for investors. Such covenants can greatly increase the cost of refinancing.

Since then, sponsors in Europe have become even more reticent about using the high-yield market. It’s easy to see why. Falling yields, tight bond spreads, ample liquidity and a positive economic backdrop have helped to cut the buyout cycle from five years to between 18 months and two years. Demand for non-traditional products such as mezzanine and second-lien finance have offered handy alternatives to high yield.

According to Fitch, high-yield bond issuance fell some 11% in 2005 – a remarkable statistic against a backdrop of record LBO activity. Mezz and second lien accounted for 38% of junior debt in Europe in the fourth quarter of 2005, compared with 20.7% in the same period a year earlier and 10.5% in the fourth quarter of 2003.

The declining importance of high yield is understandable given massive liquidity in the wider financial market and issuers’ preference for more flexible debt such as mezz and second lien. Such is the liquidity from investors’ quest for yield and alternative investments that financial sponsors are able to spurn high-yield bonds completely in some cases.

This is why the European High Yield Association is seeking to initiate a debate on whether the level of call protection in high-yield bonds needs to be curtailed for the sector to prosper.

The problem with this is that two of the larger constituents of the high-yield investor base are trading accounts and CDO buyers. Both of these would have substantially less incentive to get involved in the sector were the level of call protection to be cut back.

But, so the association’s argument goes, such considerations should be countered by the fact that while the same level of liquidity is maintained for sponsors in alternative markets, if investors want deals they will have to relax their demands.

It’s a tough one to call. Evolution is a natural part of any market’s development. But investors should take care – calls for diminishing covenant protection are a sure sign of an overheating credit market. Investors might do well to remember that the benign environment cannot last for ever.