Europeans still shy away from junk bonds. The links with the 1980s excesses of Michael Milken and Drexel Burnham Lambert are still just a little too much to bear. Junk is garbage. Junk is rubbish. Junk is, well, junk – and few in Europe’s conservative corporate world want their company associated with that sort of thing.
Call them high-yield corporate bonds, however, or below investment grade debt and you’re onto a winner. Then it becomes acceptable. Then it becomes a serious means of raising capital. Then companies and investors are interested as never before. As one investment banker puts it, ‘Getting high yield off the ground in Europe has been all about persuading potential borrowers that junk doesn’t mean dirty money.’
The reality is that Europe’s high-yield bond market – heck, let’s call it junk – is booming and investors, banks and companies want to get in on the act. According to figures from Merrill Lynch, in fourth quarter 1997 outstanding European high-yield debt was only worth about $6 bn with around 25 issues. Second quarter this year saw those figures grow to around $37.5 bn and some 150 issues. And most agree that this is still early days – it remains only a fraction of the level of the market in the States.
‘Everything comes down to the euro,’ according to David Hughes, head of high-yield investment at Invesco Asset Management. ‘It’s giving us price transparency. With all goods priced in the same currency, companies want to become price leaders and that means they are having to restructure. It’s the same as in the US in the 1980s.’
Double trouble
Europe’s growing willingness to experiment with high-yield instruments is driven by a range of factors from both the demand and supply sides of the equation. As Hughes notes, the euro has undoubtedly been key to the process – in the eyes of investors and companies. Before the introduction of the single currency, Europe’s institutions could obtain yield enhancement by looking at currency plays and different interest rate curves within the countries involved in European Monetary Union. Then, overnight, that all disappeared. That meant that investors in the region would have to be willing to move down the investment grades in order to obtain better returns on corporate debt.
Compare this to the broader US market and you can see one reason why European investors have been slower to move into high yield in their droves. The US bond market has had to deal with no currency play or differential interest rates for years. It hasn’t just been a greater willingness to move down the grades – it’s almost been forced upon them. Europe has only recently found itself in the same situation.
The greater desire for high-yield debt from European investors has also helped pull the region’s corporate restructuring along at a greater speed. A spokesman at Standard & Poor’s notes that the restructuring has moved at very different speeds in each sector, driven by its own particular needs. All sectors have been pushed into new capital raising channels by a general reduction in bank lending across the Continent and the result of post-war succession questions. Previously management-owned businesses, such as Germany’s Mittelstand companies, are restructuring their finances as a new group of leaders takes over. Many are looking to sell off operations or businesses to private equity investors and leveraged finance is providing the means of operation (see Leveraging it up).
Agnes de Petigny, an analyst at Standard & Poor’s Ratings Direct, summarized the consolidation situation in a report released earlier this year. She notes that the number and size of European M&A transactions increased substantially last year and that the trend is likely to continue. Consolidation, however, has led to a rise in investment downgrades as the perception grows of a more aggressive, risk-laden approach. ‘The European corporate landscape, underpinned by a still-fragmented industrial base, is undergoing radical restructuring and consolidation, triggered by economic globalization, the advent of the euro and the impact of the internet. The M&A frenzy has had a negative impact on the credit quality of European corporates…Although acquiring solid market positions improves earnings quality and credit measures, the financial impact of such moves is crucial in determining future credit quality.’
Fast movers
Of course, some sectors have had to move a lot faster than others. Invesco’s Hughes points to the fact that the pan-European deregulation of the telecoms industry started earlier than other sectors and has also been extremely capital hungry as new companies seek to move to an infrastructure level where they can compete. The result? Below investment grade telecoms stocks with capital requirements to buy up the competition and invest in networks way over and above their cash flow.
David Ross, an assistant in Deutsche Bank’s capital markets team in New York, affirms that much of the explosion in high-yield in Europe has been in telecoms and media. Recent issues in the States have also been concentrated on these sectors, but he says that the market is that much broader there, providing wider options for investors.
Saying that telecoms and media dominate European high-yield bond new issuance is something of an understatement. In the first half of this year the two sectors accounted for 81 percent of the region’s junk-bond issues: 46.7 percent in telecoms and 34.3 percent in media, according to the latest figures from Merrill Lynch. To many observers this is a classic symptom of Europe’s immature high-yield market. Sure, growth has been fast but concentrated too heavily in these two sectors.
Christopher Garman, vice president of global high-yield strategy at Merrill Lynch, suggests demand from investors for high-yield bonds from media and telecoms companies has probably peaked, particularly as many are experiencing further downgrades from rating agencies. Poor returns don’t help and are beginning to have an impact.
‘European high-yield bond markets posted a dismal -2.34 percent total return for the second quarter 2000, the second worst quarterly performance on record since 1998,’ reports Garman in his first half 2000 review of the market. ‘Equity market volatility in the telecoms sector was the primary culprit for the price declines among European credits, while the more industrially diversified US high-yield bond market returned 0.65 percent.’
Like Ross at Deutsche Bank, Garman believes that the relative immaturity of the European market is beginning to show. Investors are demanding high-yield bond issuance from other sectors in a bid to reduce the risk of having their portfolios disproportionately full of telecommunications and media paper. ‘For diversification’s sake, investors have become very interested in non-telecom industrial issues,’ he explains. This lack of supply from non-TMT sectors is expected to change in the coming months as other industries progress further down the restructuring road.
‘Europe is going to be a very important part of the high-yield market over the next few years,’ says David Ross at Deutsche Bank. ‘My expectation is that it is going to move up to 50 percent of the global market in no short time. The secondary market in Europe has already moved ahead of the US.’
That means more companies are going to have to learn a little bit more about debt investor relations, according to Garman. ‘Wide disclosure and ongoing communication with bondholders is absolutely essential.’
