European market outshines us in 2005
In 2005 European high yield issuance was down on the previous year, but few bankers were glum. Innovation flourished, with Pik notes, first lien and hybrid securities. With a deluge of LBO deals expected this year, Alistair Dawber reports that the market is preparing itself for a busy 2006.
At the end of 2004 European high yield bond bankers gave themselves a collective pat on the back. Issuance in the still young market had doubled to Eu26bn and the outlook was rosy.
Supply dropped off in 2005, but syndicate officials were not swapping the champagne of 2004 for sparkling water at the end of the year. Instead, glasses were raised to toast the most innovative 12 months in the sector so far, and a year in which, some believe, the European high yield market came of age.
"The year will produce about Eu18bn worth of issuance, compared to Eu25bn in 2004," says Mathew Cestar, a managing director in Credit Suisse First Boston's high yield capital markets team in London. "But it will be remembered as the year of innovation: 2005 represents an important point in the development of this market."
Others agree, saying that the slowdown in issuance in 2005 was the result of fewer issuers needing to tap the market. "2004 was much more heavily weighted towards refinancings, as issuers took advantage of robust market conditions," says David Ross, a director in the high yield capital markets team at Deutsche Bank in London. "Refinancings continued in 2005, but new issue supply was much more diverse in terms of both use of proceeds and structure."
While 2005 produced fewer deals, conditions in the market were good for borrowers. "2004 was driven by large restructurings and cable financings," says Andrew Watkins-Ball, head of high yield syndicate at Citigroup in London. "Whereas last year the market normalised and LBO supply returned, European interest rates remained low and credit spreads were attractive to issuers. All round, it was a favourable market for borrowers."
The ideas market
The early part of 2005 was dominated by the increasing use of novel products. Several deals came in the form of payment-in-kind (Pik) notes, from borrowers such as German speciality chemicals company Cognis, which brought a Eu530m Pik bond through leads Deutsche Bank and Goldman Sachs in January. It was only the second ever floating rate Pik in the European market.
Although Pik notes have the same covenants as senior debt, they are issued by holding companies, with no security on companies' assets other than on the shares of their subsidiaries. Interest accrues each year on a Pik note and is paid in full at maturity.
Bankers also point to the rise of first lien products, which offer a higher level of security. In July, South African mobile telephone operator Cell C garnered over Eu1.2bn of bids for a Eu400m offering of first lien notes. The deal marked a sharp reversal of fortunes for the borrower — in May lead manager Citigroup had been forced to pull a Eu625m equivalent transaction in euros and dollars for Cell C as a result of market volatility set off by the downgrading of the US car companies that week.
Watkins-Ball at Citigroup describes the transaction as a first lien deal with strong asset coverage. That allowed Standard & Poor's to rate the bond at BB-, though Cell C's corporate credit rating is B+.
"The first lien structure is a developing trend in the European high yield market," says Watkins-Ball. "In this case the bond takes the place of what is traditionally bank funding." He adds that these types of bonds, with non-amortising, long term structures, are very attractive to borrowers when markets typically offer shorter maturities with onerous repayment schedules.
The story of the year in the investment grade bond market was the birth of corporate hybrid capital securities, but the product has also been introduced to the high yield sector. In the last big high yield deal of 2005, German tourism group Tui brought a three tranche issue with a Eu300m hybrid segment. The transaction was a roaring success, and with investors' appetites for the product whetted, many expect further transactions in 2006.
High yield specialists are hoping for progress in two directions in 2006: more interesting deals and an upturn in issuance as private equity houses gear up for an attack on corporate Europe.
However, much of the extra demand may come from investment grade buyers looking to pick up additional yield in the speculative grade sector. High grade issuance was subdued in 2005 and with yields at all-time lows, more and more accounts are looking at the high yield market for returns.
The trend of investment grade accounts looking at the high yield market is not new, but has increased in the last two years. "Investors continue to seek yield," says Eric Capp, head of high yield capital markets at JP Morgan in London. "With interest rates generally low and curves almost flat, investors are looking at lots of alternatives, although few offer any yield. And with default rates so low, the high yield market is attracting more and more investors."
Moody's global speculative grade default rate fell to 1.8% in November, lower than the agency's prediction a year ago.
"The traditional boundary between investment grade accounts and those buying in the high yield market is becoming increasingly blurred," says Julien Gurcel, head of high yield capital markets at HSBC in London.
"With default rates low, investors are ever more confident about taking higher yielding paper and picking up the extra returns. Any material increase in the default rate, anticipated by many, could slow this momentum in 2006."
Moody's expects the default rate to rise to 3.3% by the end of 2006. The market consensus is that LBOs will be the main driver of sub-investment grade issuance next year, but with buy-outs comes the added risk of defaults rising.
One jolt that hit the market last year was the downgrades of US car manufacturers General Motors and Ford. High yield bonds widened sharply when Standard & Poor's junked the two in May, resulting in a sector bereft of deals for nearly two months. However, the markets came back strongly, leaving little lasting damage.
"In hindsight, the reaction to the downgrades of GM and Ford was overblown, although at the time the impact was difficult to assess, due to its unprecedented nature," says Citigroup's Watkins-Ball. "There were rumours that some hedge funds were facing collapse, although in reality only one or two fund closures were directly attributable to GM, Ford and correlation losses."
New Europe, old US
2005 was also remarkable for the sharp contrast between the European and US markets. While the European sector was awash with new structures and innovative transactions, the US market was quiet, leading to little performance in the secondary markets. Over-supply, rising interest rates and LBO volatility are blamed for the US sector's inertia.
"While there were a number of interest rate increases in the US, European rates have remained benign," says Cestar at CSFB. "Where deals have been brought with dollar and euro tranches, the euro tranches have significantly outperformed; they are more liquid and are typically tighter."
Several deals were launched in 2005 with dual euro and dollar tranches and while some performed well, dollar parts of deals tended to struggle. Greek mobile telephone operator Tim Hellas launched a Eu925m and Eu355m dual tranche bond in October but plans to bring a dollar segment were dropped after joint leads Deutsche Bank and JP Morgan found that appetite for the bond in the US had waned.
One issuer that did brave the dollar market was Italian telecoms group Wind. The borrower brought euro and dollar tranches via ABN Amro, Deutsche Bank and Banca Sanpaolo Imi in November. The Eu825m part achieved the tight end of price guidance, whereas the dollar segment came at the wide end. Market sentiment indicated that it had been priced generously, but needed to be attractive to engineer any US interest.
"The European new issue market has outperformed the US recently," says Deutsche Bank's Ross. "Dual tranche deals have been pricing at even spread versus the even yield."
Wind's two 10 year tranches were priced at the same spread over Bunds and Treasuries, but the yield on the euro note was 9.75%, a full 1% lower than the dollar tranche.
The European high yield market is gearing up for a great year in 2006. Big deals for Danish cleaning company ISS (Eu785m) and cable television company NTL ($1.8bn) are expected to get the market off to a flying start in January and February.
But it is the increase in LBOs that is really exciting market participants. "We expect to see lots of LBO-driven issuance in 2006," says JP Morgan's Capp. "Funds are teaming up and gathering up ever bigger amounts of private equity capital. As a result, we are likely to see some large public companies taken into the private sector in 2006."
Big companies and private equity funds are likely to come to market to finance acquisitions in 2006 and, if the rumours are true, seem to have endless amounts of cash as ammunition. Refinancing these mergers will generate lots of work for investors and bankers in Europe and unlike in 2005, issuers will be forced to come to the bond market, meaning deals are likely to be cheaper, or more innovative, to ensure a successful trade.
According to Ross at Deutsche Bank, "2006 should be an eventful year, particularly with respect to M&A driven financings. Sponsors have recently raised large funds, and corporates have been active in the M&A side as well."
Although many have sounded warnings about increased volatility next year, and any increase in the default rate may cause some investors to shy away from the market, it is likely that by the end of 2006 the European high yield market will be full of smiles once more.