IFR Comment: Questions for Europe's rampant high-yield market

Cash inflows of US$858m poured into the European sub-investment grade asset class – the largest on a weekly basis so far this year – taking the annual tally to US$2.2bn. The run rate was on par with the first five weeks of 2011, when expectations of a record year for volumes were sky high.

French cable company Numericable and leveraged buyout business Securitas Direct are holding the baton for the newly awakened European high-yield bond market this week, but concerns are already surfacing that investors are piling into deals without doing their credit homework.

Last week saw the best inflows in credit across the board, according to Bank of America Merrill Lynch.

Chemicals company Ineos and German industrial Schaeffler raised US$1.65bn and €2bn respectively last week – around double the amount of debt they had both initially expected to sell – as they took advantage of deeper US investor pockets and thawing euro high-yield markets with dual-currency issues.

So far European speculative-grade companies have raised US$8.7bn this year, predominantly in dollars, according to Thomson Reuters.

But just a few heady weeks into 2012, some experts are voicing concerns that the market may be getting ahead of itself. Last summer’s heavy losses are already a distant memory for many investors, who are fretting about being left on the sidelines of the current rally.

“It’s hard to see how the European high-yield bond market is going to be able to get itself on a long-term stable footing without a more convincing resolution to the European sovereign crisis,” said Edward Eyerman, managing director and head of Fitch’s European Leveraged Finance Group.

“The deals so far this year remind you just how quickly risk appetite can return and set in motion virtuous cycles. My worry is that some European high-yield funds, who are sitting on very high cash balances, may find no alternative when secondary markets tighten other than to buy riskier new issue paper, as they need to demonstrate performance with benchmark high-yield indices.”

Currency risk

If systemic risk does recede, high-yield bond volumes could well surpass the record €42bn seen in 2010 and lessen the risk of rising defaults at the same time. Moody’s estimates that some €181bn of unrated leveraged loans maturing over the next three years are expected to be refinanced with bonds, as banks tidy up their own balance sheets.

The downside is that investors may bear the brunt of a sharp turnaround in sentiment. If the rally runs out of steam, the herd mentality of some investors may come back to hurt them.

The Crossover has tightened by some 350bp since October highs of 900bp

• trading at 556bp around 14:30 GMT today – but there is still a risk of a disorderly Greek default and the potential for further private bondholder losses if Portugal follows a similar path.

Some market participants were taken aback by the size of Spanish cable company ONO’s US$1bn high-yield refinancing last month – which was upsized from US$400m – partly because of its peripheral Spanish domicile.

The bonds initially traded down on market talk that investors unexpectedly received full allocations.

The biggest concern is that some European companies will have a big currency risk exposure, as dealers remain reluctant to put in place currency swaps – even if it means missing out on fees.

Even when banks are willing to play ball, the fees they charge for swaps are usually so high that they erode any funding cost advantage a company might gain by issuing in dollars, one banking source said.

“In the past, currency swaps would have been a lot more prevalent because the banks could earn fees and also make a lot of money if they bet on the right side of the trade,” said another high-yield analyst who declined to be named.

“But I can see that banks would not be as keen to do them now because of the perception that derivatives caused the problems we are in now in the first place, and also because they do not want this long-term exposure.”

The worry is that companies that have predominantly euro-denominated revenues but increasing dollar liabilities would see their leverage rocket if the euro weakens significantly. Their bonds could potentially drop, giving investors a nasty shock.

“It’s fair to say in general that banks’ swap capacity is limited, and this is an issue for some of those European companies that have funded in dollars and only have limited dollar revenues,” said one high-yield syndicate official, referring to recent dollar deals from European telecom and cable companies ONO, UPC and Polkomtel.

Banks that managed those bonds were not immediately available to comment on whether the issuers had swap agreements in place.

 

Hung deal resurface

The increase in primary activity shows little sign of relenting. Single B issuer Numericable is looking to raise €350m from a seven-year bond to refinance bank debt. The company last month asked its senior lenders to extend a deadline to raise a high-yield bond to May from February, as part of an amend and extend agreement on its debt.

Physical bookrunner JP Morgan, along with joint bookrunners Goldman Sachs, BNP Paribas, Credit Agricole and HSBC expect to price the deal on Friday after a European roadshow which starts today.

The €600m Securitas Direct bond, meanwhile, to be issued via a vehicle called Verisure Holding, will refinance a large portion of a €900m bridge loan that has been sitting on underwriters’ balance sheets for around seven months.

Originally, the US$3.3bn LBO by private equity firms Bain Capital and Hellman & Friedman had been expected to be financed by approximately €1.3bn of high-yield bonds, consisting of a near-€900m senior secured tranche and a €395m subordinated portion. That latter bond was replaced by a mezzanine loan, after high-yield bond markets slammed shut in July and banks were unable to shift the debt off their books.

Even now, the Securitas Direct deal, at close to seven times earnings, is considered too highly leveraged to bring to market; so it has been sliced and diced to be more appealing to investors. The senior secured bond will now be split between the €600m bond, with leverage of about 3.25 times, and a €322m second-lien, yet to be marketed to investors, with a leverage ratio of around five times.

A banking source close to the Securitas Direct deal said that US investors, who have come to the rescue of European high-yield issuers this year, were already showing an interest.

A European roadshow and calls for US investors will start on Monday, with pricing expected on Thursday via physical bookrunner JP Morgan and joint bookrunners Goldman Sachs, BNP Paribas, Credit Agricole and HSBC.

One bank close to another hung bridge – a €375m deal for French mechanical engineer Spie – said the group of underwriters was eyeing market conditions for the possible launch of that bond. Morgan Stanley, HSBC and Societe Generale had been planning to sell the bond before the market shut in July.