The embryonic German - and European - high yield debt market
could not have faced a sterner test than the global fixed income
turmoil which erupted in September.
Spreads ballooned as liquidity dried up and several planned deals,
principally those involving leveraged buy-outs, are either on hold
or have been cancelled.
Developing a critical mass of outstanding debt and a deep European
investor base for higher yielding corporate bonds are the two key
challenges for banks keen to promote a European high yield
But, in Germany, the fundamental signs are good. The wave of
corporate restructuring and transfer of company control that is
sweeping across the German industrial landscape provides rich
potential for a vibrant corporate debt market to emerge.
And the broadening of the investor base in the expanded euroland
will create a buy side that is more knowledgeable, competitive and
adventurous in its use of credit markets.
In the short term, the high yield market must recover from a nasty
shock. But, longer term, there is no doubt that this is a market
poised for major growth.
"Convalescing, rather than on a life support machine," is how
Mark Aitken, head of the high yield fixed income department at
Dresdner Kleinwort Benson in London, describes Germany's fledgling
high yield bond market.
As an example of the somewhat fragile state of the German high yield sector following the ravages of the global fixed income crisis, bankers point to the latest offering in the market.
This was a DM130m five year issue for the unrated flooring manufacturing company, Rinol, which was led at the start of October by Goldman Sachs and priced at 195bp over the 2003 Bund.
"My understanding is that the Rinol deal was almost a private placement which was not marketed to the European high yield investor base," says one banker. "It offered 195bp over Bunds which was the equivalent of 170bp over Libor. Compared to average market spreads at the time of between 300bp and 700bp, that does not represent very good value. It was a domestically targeted transaction aimed largely at banks as a loan substitute, although I have heard that not all the bonds were sold."
It all seemed so different at the start of the year when the UK shoe manufacturing company, Texon International, chose the Deutschmark rather than the sterling market to launch a DM245m 10 year deal via Chase at 495bp over Bunds - which, as the lead manager reported at the time, could have been entirely placed among yield-starved continental European accounts.
It is also a far cry from the heady days even of July, when Warburg Dillon Read and Morgan Stanley led highly well received Deutschmark-denominated deals for Sirona Dental Systems and Colt Telecom respectively.
The DM170m 10 year Sirona deal, for example, was priced at the tight end of official price talk, which represented a 440bp spread over Bunds, while Colt too saw its DM600m 10 year issue priced at the lower end of its range, or at 312.5bp over the government curve.
With the Colt issue oversubscribed by almost two times and with some 60% of the paper placed in Europe, this raised high hopes that the Deutschmark-denominated high yield market had reached a new level of maturity supported by a critical mass of investors.
Although the recent upheavals in global bond markets graphically demonstrated that these hopes were probably premature, market participants remain hopeful about the longer term prospects for the sector.
Dresdner KB's Aitken reckons the recent turmoil has probably set the development of the market back by between six and nine months, but that simple supply and demand patterns across continental Europe suggest that the high yield market has substantial scope for recovery.
Supply, he believes, will come largely as a by-product of corporate restructuring and the quest within Europe for the buzzword of shareholder value.
"About half the deals which are being done in Europe at the moment are the result of leveraged buy-outs (LBOs)," he says, "which mirrors the way in which the market developed in the early 1980s in the US. I think the majority of dealflow in Germany will arise from LBOs as industrial subsidiaries of major companies continue to be spun off."
A classic example of the process, says Aitken, was the LBO from Siemens of Sirona, which is a leading manufacturer and supplier of professional dental equipment but which hardly fits the Siemens portfolio like a glove.
Another, which appears for the time being to have fallen through, is the planned sale by Hoechst of its auto paints division, Herberts, which was to have been bought out by US buyout fund KKR but which has now been sold instead to DuPont.
Given that an industrial company such as Krupp reports that it has spun off a total of 85 companies with sales of about DM9bn since 1992 alone - and with Siemens announcing at the start of November a $2.4bn restructuring that will involve the sale of businesses with turnover of DM17bn and 60,000 staff - the potential for further restructuring within German industry appears to resemble almost a bottomless pit.
This is especially so given a generational shift in which many company founders are now approaching retirement, while their children are either unable or unwilling to take up management responsibility, or are more excited by the prospect of cashing in on inheritances which over the last decade have spiralled in value.
Matching this potential supply, adds Aitken, is the equally exciting outlook for demand for higher yielding bond issues. With institutional investors concentrating less on currency considerations within euroland and more on credit stories, and with yields on alternative bond investments plunging to historical lows, the high yield market would appear to plug an obvious gap.
According to Dresdner Kleinwort Benson's estimates, there is something in the neighbourhood of $25bn of private equity in Europe waiting to be invested.
Although much of this will be directed at investments in other EU members as well as some of the higher growth economies of central and eastern Europe, it is reasonable to assume that Germany, with Europe's largest economy and its most expansive manufacturing segment, will claim the largest share of private equity investment.
Much of this private equity is also accounted for by pan-European dedicated high yield players. Germany, although it has reportedly made vast progress in recent years in terms of credit analysis, still lags some way behind Anglo-Saxon markets in its ability to evaluate and price higher corporate risk.
"I'd say that DWS and DIT [the investment management arms of Deutsche Bank and Dresdner Kleinwort Benson respectively] are probably the best equipped to assess high yield bonds," says one banker, "but beyond these two there is really no investor in Germany with half the expertise of a mid-sized US investment management company."
Aitken agrees. "Many German investors have come a very long way, but collectively they still have a long way to travel," he says. "The biggest bottleneck in the development of the high yield market in Germany is the lack of human resources on the buy side. They just don't have the skills or the infrastructure to absorb what is being thrown at them from the sell side."
In part, say some bankers, that is understandable, given the dizzying array of product which has come off the high yield conveyor belt over the last year or so in Europe.
After all, 'high yield' has become a very generic term - embracing everything from fairly well-known companies in developed economies such as France and Germany offering spreads to government paper of between 200bp and 400bp, through to those such as the cable television company @Entertainment in Poland, which priced its recent high yielder at a whopping 910bp over Treasuries.
Against a background of such diversity of price, product and credit quality Deutsche Bank's debt capital markets head, Walter Henniges, is cautious about using the expression 'high yield' at all. "In Europe, I would prefer to call them second tier issuers," he says.
Aitken says that for the time being German investors in this market are following the most logical course, avoiding eastern European deals at spreads of almost four digits and using the early stages of the European high yielding market to dabble in better established credits closer to home - such as Fresenius, Geberit and Impress Metal Holdings.
Over the longer term, however, he argues that it must be the job of banks such as Dresdner to take up the initiative and help to guide investors through the potential pitfalls of high yield investing.
"At Dresdner we have a strong corporate and equity franchise, but in the high yield market that will be worthless unless we can focus on investor development," he says.
"One of the problems the US houses encounter in Europe is that they expect too much of their audiences. Some of these transactions involve certain financial concepts and a density of analysis which newcomers to the market are not capable of absorbing.
"Things like how carve-outs work and how covenants are applied which are second nature to investors in the US may not be to a first time high yield investor in Munich or Stuttgart." EW