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How you value call protection – and why you should care

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.

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