The Spain effect
With parts of Europe gradually recovering from the depths of economic turmoil, the face of high yield could be on the verge of a dramatic transformation. What would this mean for the markets?
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Europe stands on the brink of disintegration in its current form, with the previously unthinkable exit of member states now talked of in the corridors of Brussels in terms of when, not if. What is less clear is by how much the European club will shrink.
Among those most interested in this question are investors in high-yield debt. If Spain, one of those most frequently spoken of as a contender for European defenestration, was downgraded, the high-yield market would increase by multiples of its current size. According to one high-yield banker, the market would cease to exist in any recognisable form.
There are three categories of fallen angels in Europe, according to Eric Capp, global head of high-yield loan and bond capital markets at RBS. One is large national champions like the utilities and telephone companies of Europe’s periphery that have fallen, or are expected to, because they are domiciled in countries that have themselves been downgraded to sub-investment grade. This is the category that will swell most if parts of the eurozone find themselves downgraded.
Then there are the big multinational companies in sectors like auto manufacturing that were formerly investment grade and still borrow as if they are, without covenants, though at higher prices. Crossover investors have already experienced the impact of large, traditional investment-grade names becoming fallen angels, from this category, notably with US car giants Ford and General Motors.
The third group are companies that have been downgraded because of problems with their businesses due to cyclicality or over-leveraging often in connection with acquisitions which force them to issue bonds with more fulsome high-yield covenant packages.
All eyes are now on Spain and Italy. A sovereign downgrade would drag down with it that country’s national champions, but bankers worry the high-yield bond market would struggle to digest the debt of corporate giants like Telefonica.
The effects of a Spain and Italy downgrade would certainly be felt more on the European than the US high-yield market, said Brad Rogoff, head of credit strategy at Barclays.
The US market would expand by about 4%, which is not insignificant, but is absorbable, he said. Europe’s market would double in size.
The effect is likely to be more muted in current circumstances. “The magnitude of the impact on fallen angels is partly driven by the health of the market,” said Kevin Sterling, co-head of leveraged finance capital markets for the Americas & EMEA at Goldman Sachs. “If corporate credit is generally out of favour the price move associated with a transition from Triple B to Double B is likely more dramatic. Today, with spreads so tight, the move would have less impact on a relative basis.”
Beyond the obvious impact on size, it is difficult to predict what such a future European market would look like. Perhaps regulators would relax high-yield investment restrictions, allowing demand to increase to meet supply. Even if they didn’t, such a growth spurt would surely attract new investors, many of which would be familiar with these former European investment behemoths.
Calm before the storm?
So far the issue is largely hypothetical. The high-yield market has been very quiet recently, and although there have been one or two inflows, the market is not yet crowded.
“Investor appetite for bonds is robust,” said Peter Aherne, head of North America investment-grade capital markets and syndicate at Citigroup. “Credit spreads are low, demand is high, and issuers are in the position of having significant pricing power. We’ve recently witnessed several record low coupons being set over a relatively short period of time.”
“If there was a stream of high-yield deals perhaps investors would start to be more selective, but at the moment we are not seeing that,” said Capp. “Right now if a deal struggles it is due to credit-specific issues, not because it is being crowded out.” The Crossover index has gone from roughly 538bp on March 19 to 753bp on May 18 to 577bp on August 8, showing just how volatile the market has become.
This is already contributing to a changing perception of sub-investment grade credits. Clearly it remains in the interests of corporates to be investment grade, for employees, investors and clients alike, and demand for top rated credits is high. “Investment-grade corporates are the new sovereigns,” said Aherne.
Yet the pressure on corporate fallen angels to get back to investment grade has diminished, said Tanneguy de Carne, head of non-investment grade capital markets at Societe Generale. The effect is felt differently according to sector and other factors, but overall the high-yield label has less stigma attached to it than it once did, he said.
This is partly down to sheer numbers. The number of non-investment grade ratings globally has gone up from about 22% of the overall to 29% since 2008, according to de Carne. Funds have increasing flexibility to hold high-yield paper, while to some extent the failure of rating agencies in high profile cases like Lehman Brothers has encouraged investors to rely more on their own assessments.
Historically, ratings have been an important driver in determining the cost of capital for a business. Ford and small-business and middle-market lender CIT both had strong receptions in the credit markets because investors expect their return to the investment-grade universe. In this sense some non-investment grade entities behave more like investment-grade entities, where investors believe it is only a matter of time before fallen angels become rising stars.
Different types of investors have come to use ratings differently, said Barry Donlon, head of corporate and capital DCM syndicate at UBS. The small, highly regulated institutions are still bound by strict rules governing the ratings they can hold in their portfolios. But the larger and more sophisticated institutional investors were less bound by ratings than they were pre-crisis, he said. This had led to a greater distinction between similarly rated credits in where they trade, and to an increase in unrated transactions.
As investors take more responsibility for their own company analysis they have been forced to stick to the businesses they really understand and can analyse themselves, said Donlon. This is demonstrated by how some fallen angels continue to trade in line with their investment-grade peers, said Donlon. It also explains why these borrowers typically continue to issue in their domestic markets following a downgrade below investment grade. The investor base which knows and best understands the business continues to feel comfortable adding to their positions.
It is not that ratings have become irrelevant, but rating changes into or out of investment-grade status are anticipated ahead of time, so forced selling is limited. “People pre-empt these moves weeks ahead of anything actually happening, so the selling occurs gradually,” Donlon said.
The increasing participation of new classes of investors, particularly the private banks that act on behalf of high net worth individuals, may make new high-yield names like Fresenius less of an exception, making it easier for companies to live with a sub-investment grade status. The private banks, which according to de Carne in 2007 accounted for about 3%–5% of non-investment grade allocations, compared with around 12%–15% today, are more discretionary and more open to risk than traditional high-yield investors.
Choice fallen angels can generate a good level of interest among investors looking for yield, with coupons of 6%–7% typically paid on high-yield issues. With many of the big bond funds retaining the flexibility to invest up to a quarter of their portfolios in high-yield names, there is money on the table. Crucially, market participants today are more inclined to form their own opinions than blindly accept the view of rating agencies, so the impact on the likes of Telefonica need not be catastrophic.
Not all one way traffic
While bankers are braced for the possibility of a transformational influx of credits into the high-yield market, it is important to recognise the impact rising stars can have on those left behind. The effect is particularly pronounced in the Double B space, which accounts for nearly 45% of high-yield names in Europe, compared to closer to 30% in the US.
“There is a substitution effect,” said Brad Rogoff, at Barclays. “When Ford went up, the Double B market traded well, with yields now at all-time lows. That is probably because high-yield investors sold their Ford holdings and bought the best paper left in the market.”
Ford is a textbook case for those wishing to win back investment-grade status. It saw material issues with its business and it sacrificed its rating to resolve them, doing what bankers agree was a very good job of managing the dislocation in the market. It fought its way back to investment grade because it had very strong fundamentals, said Rogoff, with an attractive net debt position, strong cash generation and a globally recognisable brand. Its cost structure had transformed during its seven-year sojourn in the high-yield market, he said, and now it is back to investment grade, with unencumbered assets, making its funding cheaper.
However, the impact depends on the size of the issuer, said Rogoff. For the biggest names, like Ford, a rating change can cause a quite dramatic move, but for smaller names the impact is more muted.
Other names have drawn praise for the positive operational steps they have made towards regaining their former investment-grade status. CIT, unlike Ford, used bankruptcy to reorganise and put its cost infrastructure on a more sustainable footing.
For many other companies it is not their business models but broader economic realities blocking the way back to investment-grade status, though recession is not bad for everyone. Discount retailers thrive when family budgets are tight, and Dollar General, a Single B credit at the time of its LBO in 2007, is now Double B, and in June launched US$450m in five-year notes in a deal that was run off the investment-grade desk. It priced at 4.125% and saw the bonds rise in the aftermarket.
Although the euro market had a subdued start to the year, overall the corporate credit market – both investment grade and high yield – have had a good year. “We have seen large volumes at issuer friendly terms,” said Kevin Sterling at Goldman Sachs. “The fundamentals have been good: a low rate environment, diminished expectations for rate increases in the near term, low default rates, and a reasonable earnings profile. These fundamentals combined with elevated cash positions and a search for yield by investors, have contributed to a favourable financing environment for issuers.”
But there are few poster-child candidates like the motor giant. “The biggest rising star story recently has been Ford but I don’t see anything of that significance on the horizon,” said Rogoff. “A lot of rising stars now are small, not multi-billion dollar businesses like Ford.”