The European high yield bond market is back in business after a difficult period last year, and looks set to become a major source of finance for secondary telcos. But start-up companies may need to offer generous coupons to attract investors.
The last eight months have been a testing time for Europe's band of telecom start-up companies seeking debt finance. Following the devaluation of the Russian rouble last summer (which sent bond investors scurrying for the shelter of triple-A and double-A credits), the European high yield market all but closed down between August and November.
This posed something of a problem for many of the region's small and medium-sized telecom companies, who had come to rely on the market to provide debt financing for the construction of their mobile and fibre-optic cable telephone networks.
Well known names such as the UK cable TV companies Telewest and NTL were able to raise debt in the US, but start-up companies looking to tap the market for the first time were left stranded.
"We may see a lot of companies running into trouble," warned one telecom analyst last November. "They all need debt financing to start construction, but banks are not that keen to lend them large amounts of money."
The collapse of Ionica (a well known UK telecom company) in November did not help matters either. The Cambridge-based company, which had pinned its hopes on the development of a radio-based telecom technology, had issued several bonds during the mid-1990s.
Its failure left many bondholders sitting on substantial losses. At the same time, the bonds of another UK telecom company, Dolphin, were trading well below their issue price.
Signs of life returned in December with a Ecu85m seven year deal by Hermes Europe Railtel -- a secondary telecom company building a fibre-optic network in continental Europe.
But attempts to bring new names to the market ran into difficulties. In February, Salomon Smith Barney had to reduce a $300m bond for Completel, a French start-up company, to $75m after investors complained that the company was too highly leveraged.
However, conditions have improved significantly in recent months as fears of a stockmarket collapse have receded. In February 1999, the UK cable company Telewest came to the market looking for £250m of convertible debt.
Such was the demand for the eight year paper which offered a 5.25% coupon that the deal, arranged by Dresdner Kleinwort Benson, was increased to £300m.
Two months later, NTL paid just 9.75% for its £330m 10 year deal -- 100bp less than it had paid for a similarly dated issue in March 1998, but slightly more than its £125m 10 year deal launched in May 1998 -- an indication that pricing has still not returned to its pre June 1998 low.
In a sign that investors were prepared to forgive and forget the emerging market meltdown of 1998, @Entertainment, the Polish media company, received a rousing reception to its $257m deferred coupon 10 year deal launched by Merrill Lynch in January -- a success which will give other Polish, Czech and Hungarian telcos the confidence to bring similar issues later this year.
The most significant move came in April when Jazztel (a sub-investment grade UK start-up building a fibre optic network in Spain) managed to raise $216m of 10 year debt, despite having no revenues and no powerful shareholders.
Split into two tranches ($100m and Eu110m), the bonds, which also offered equity warrants, sold out quickly to a range of European fixed income investors -- including, according to arrangers CSFB and Merrill Lynch, a number of Spanish funds which had never bought high yield debt before.
With a coupon of 14%, the Jazztel deal was not cheap. But the fact that a euro denominated tranche was completed at all speaks volumes about the market's ability to provide funding to fledgling telecom companies.
"We were all a bit worried that investors had been put off start-ups," says one high yield banker. "But Jazztel showed that deals could be done if priced correctly. Hats off to the arrangers."
Buoyed by the success of the deal, many bankers are now predicting a surge in euro denominated high yield issuance by telecom companies. "Our pipeline is looking pretty good," says John Ezrow, managing director at DLJ in London. "There are a lot of companies preparing to launch deals."
Putting a figure on future issuance volumes is always hazardous, but most bankers believe it will exceed $1bn. "Euro denominated issuance in the telecom sector increased from zero in 1997 to the equivalent of $770m in 1998," notes a recent report by Merrill Lynch. "We expect this trend to continue."
As in 1998, most of the issuance will come from established telecom companies (like Colt Telecom and Telewest) who have raised high yield debt before and are now back in the market to finance their new construction plans.
However, DLJ's Ezrow believes that resellers (which lease lines off the former monopolies to sell to business customers) and satellite companies may also start to tap the market.
At the same time, the market should see the arrival of several new issuers from the straight telecom end of the market. Over the last few years year, dozens of telecom companies such have begun construction of European fibre-optic networks.
Meanwhile, there are a significant number of new mobile operators which have won cellular or digital mobile licences and need money to finance the establishment of base stations.
Their willingness to use the high yield market rather than commercial loans or equity finance will depend largely on the type of shareholders backing the individual company.
Many mobile companies backed by former state monopolies -- such as Cellnet, for example, which has BT as a major shareholder -- may prefer to use shareholder equity rather than debt.
"It would seem to make more sense for them to use more debt and less equity," says Ezrow. "But not everyone has figured it out yet." Earlier this year, there were reports that Dutch mobile operator KPN Qwest was looking to raise $800m in the bond markets.
Despite predictions of a mass move by European fund managers out of government bonds into higher yielding paper, the investor base for sub-investment grade bonds remains relatively limited.
Bankers estimate that there are only 100 to 150 regular buyers of high yield bonds in Europe. However, Ezrow believes the numbers are growing. "We had more than 200 institutions at the high yield conference we held in March," he says.
As more fund managers are tempted into the market, coupon levels will fall. At present, they range from 9% to 14% depending on the maturity of the individual issuer. However, bankers believe that they could fall to 7% or 6% in the coming months.
"We have already seen coupon levels decline from 13% in November back down to their June low of around 9%," comments one high yield banker. "With returns on investment grade bonds declining, I can see them coming down [for well known borrowers like Colt] to 7% or even 6% this year."
If this does happen, start-up companies should find it easier to raise money as investors -- who were used to getting 9% on a Colt bond -- seek out bonds offering 12% or 14%.
At present, only a third of the 150 or so investors who do buy high yield paper are willing to invest in bonds issued by start-up companies. Bankers estimate that this could rise to 50% or 60% if spreads on double-B and single-B rated paper falls.
At the same time, the institutionalisation of European savings over the past three years has led to many funds becoming far larger than they were before.
This means that they can afford to take more 'high risk' bets. "You used to get $1bn funds putting $50m into this kind of paper," explains Ezrow. "Now they have become $3bn funds, they can put in $150m."
This is not to say that every new telecom company will find it easy to raise money in the market. "It is probably easier now than it was in 1996," says Ezrow. "But there were weeks in 1996 that were better than today."
But he warns that demand for such paper may remain patchy. "Start-ups are the most volatile portion of the market," he says. "There are some days when deals fly out of door, and there are other days when people decide they won't touch them." *