As returns on government supply have fallen and fears about event risk in the high grade market have grown, more and more institutions have turned to the European high yield market.
These investors have understood that to take full advantage of the market, intensive research is crucial. While using information provided by investment banks, many buyers are establishing in-house research teams.
But unease about transparency, documentation and liquidity has prompted investors to lobby for changes seen as essential if the market is to continue to grow.
Probably the most striking development in the European high yield market over the last 12 to 18 months has been the speed with which the investor base has expanded, both in continental Europe and in the UK.
The reasons for investors' collective and apparently unstoppable stampede down the credit curve are compelling. Uppermost is that today investors find themselves in a world in which enhanced yield is increasingly hard to find - given European governments' reduced borrowing requirements and the spread convergence which was a by-product of EMU. With government issues offering lower returns, the corporate bond market is an obvious place to turn for investors starved of yield.
Within the corporate bond market, however, developments in the last year or so have demonstrated to investors that the high yield segment of the market may be an altogether safer place to be than the higher rated area of the curve. This is because one of the most prominent themes of the European credit market in the last 12 months has been the emergence of event risk as a formidable threat to secondary market performance.
"Although the economic environment for credit still looks quite healthy," says Gary Jenkins, head of high yield strategy at Barclays Capital, "event risk has come to the fore, and it is clear that this has changed over the last year from being neutral or even positive to being very negative." That, says Jenkins, is in part a by-product of the intense volatility in the equity market, which is making it more difficult for companies to use their equity as an acquisition currency. In turn, this is encouraging them to raise more debt.
Those credits that are the most exposed to event risk, say bankers, are the weak single-A names vulnerable to a downgrade to triple-B or worse. A downgrade of this kind is especially serious because of the weight of investors unable to buy credits below the single-A level.
As an example of how dramatically spreads can be impacted by event risk of this kind, Jenkins says that investors need look no further than a company such as train and bus operator Stagecoach. "Its euro-denominated bonds were trading at 150bp over," he says, "but at one stage they widened out to 495bp on the back of Moody's downgrading the company from Baa2 to Baa3 with a negative outlook. That left Stagecoach on the cusp of being non-investment grade."
In this climate, high yield bonds perhaps offer a safer alternative to investors hunting for elusive yield because they are much less subject to event risk than their higher rated counterparts. It was for this reason that in a strategy update published in March 2000, analysts at Barclays advised that "in this environment, a barbell strategy would appear appropriate. That is government and short dated triple-As combined with high yield. However, the potential performance of the US high yield market precludes us from such a recommendation, although investors may wish to consider the European high yield market as an alternative."
Those that are taking this advice recognise that they need to channel substantial resources into establishing dedicated in-house corporate high yield investment teams focusing exclusively on the asset class. This is a relatively recent phenomenon. Among continental European investors in particular, it used to be common practice to bundle European corporate high yielding bonds together with emerging market sovereign issues.
This may have been a helpful way of adding yield kickers to underperforming portfolios dominated by, for example, government bonds and Pfandbriefe. But according to an analysis published earlier this year by JP Morgan's New York based portfolio research team, the similarities between the two asset classes are almost nil.
"Emerging market sovereign paper and speculative grade US corporate bonds are both used by investors to achieve significant credit exposure," note JP Morgan's analysts. "This is practically the only feature the two asset classes have in common. Sovereigns and corporates involve very different packages of credit fundamentals: exposure to changes in credit quality, default and subsequent recovery. These differences make it very difficult to compare their value and, consequently, to make high credit risk investment decisions."
"For example, spreads on comparable high-yield corporate and emerging market sovereign indices are 451bp and 587bp respectively. Is this 136bp difference sufficient to compensate for the lower diversity and lower recovery rates of sovereigns among other differences? Is it too much, given sovereigns' higher average credit quality? Without explicitly valuing credit fundamentals, we simply cannot say."
With the logic of bundling emerging market sovereign issuers and developed market corporate high yield bonds together open to question, a number of the more advanced institutions in Europe are clearly committed to developing their in-house research capabilities in the high yield market.
In Germany, for example, by far the largest high yield investor is DWS, the mutual fund arm of Deutsche Bank, which established a dedicated "junk" fund at the start of the 1990s. Today, according to Peter Walburg, head of DWS's in-house credit research team, the group has some Eu350m invested in the European corporate high yield market, although as DWS is on the verge of launching a collateralised debt obligation (CDO) issue this will soon rise substantially. In order to support this increasing allocation to corporate high yield, DWS has a highly sophisticated in-house credit research group made up of four dedicated analysts who, according to a recent promotional brochure published by the group, cover some 130 corporate high yield issuers.
Another German institutional investor that is clearly committed to moving further into credit products in general and the high yield market in particular is Allianz. The Munich based insurance giant has recently formalised the acquisition of a majority stake in Pimco, the Californian investment management company, and some of Pimco's top staff are now in the process of relocating from Newport Beach, California to Munich. As several of these are credit analysts with substantial expertise in the US high yield and high grade market, this will make Allianz something of a rarity in continental Europe - an institutional investor with extensive in-house credit research capabilities.
Elsewhere in Europe, bankers point to Dutch institutions as those in the vanguard of developing research capabilities in the high yield market. "I remember visiting Holland a couple of years ago and discussing the potential for the growth of the European corporate bond market," says Barclays' Jenkins, "and their response was to hire new credit analysts. They saw the growth in the market coming and they prepared for it professionally."
In terms of being able to draw on extensive in-house credit research, European investors such as DWS, Allianz and the handful of the Dutch pension funds are clear exceptions, with most institutional investors in Europe and even in the UK continuing to rely heavily on the research regularly published and distributed by the investment banks.
"Research is viewed as being fairly critical by investors in the high yield market," says Tom Mitchell at JP Morgan, who follows more than 20 European industrial issuers in the market. "Few of the funds split their resources between portfolio managers and credit analysts, although some of the more sophisticated funds in the UK are looking to hire analysts pretty rapidly. But it is fair to say that the majority still depend heavily on research to guide them."
Even if institutional investors start building up their own in-house credit analysis teams, it is unlikely that they will be able to keep up to speed with the evolution of the high yield market, meaning that external research will continue to be critical. "It is clear that we will be going into a riskier credit environment over the next few years and that European corporates will be issuing more debt," says Richard Fletcher, head of credit research at Gartmore in London. "It follows that credit analysis in the investment grade and the high yield market will have added relevance."
This is self-evident from the amount of resources that the leading banks in the market are prepared to channel into the development of quality research. For example, when it became apparent that Dresdner Kleinwort Benson's team had had much of its morale beaten out of it by the Deutsche Bank approach, predators were quick to contact Dresdner's top analysts. The highest profile example of the fall-out was the move by its head of high yield research, Peter Morris, to Goldman Sachs. But Goldman is by no means alone in seeking to bolster its research capabilities. Mitchell at JP Morgan reports that his team will be expanded from three to four analysts in June, while at WestLB Panmure in London, head of high yield Jay Nawrocki says that his bank's credit research team is also looking to add to its head count.
For investment banks casting around for high quality credit analysts, equity departments may be fertile ground. Many analysts of the high yield bond market argue that, as an asset class, it sits somewhere between high grade fixed income and equity. A number of companies in Europe, especially in the telecoms sector, have not viewed either product in isolation, but as component parts of an overall funding strategy. Colt in the UK and Spain's Jazztel are two examples often referred to by analysts of companies that have made highly successful use of equity and high yield funding in tandem with one another. As a result, high yield analysts tend to work much more closely with their colleagues in equity research than do their counterparts on the high grade fixed income desks.
Investors say that over the course of the last year, credit research on the high yield market has improved beyond recognition. Nevertheless, they will doubtless be hoping that as the size of banks' research teams expands, the process will be accompanied by qualitative rather than quantitative improvements in the analysis they distribute.
"Most of the investors I talk to say this is already an overbroked market," says Mitchell at JP Morgan. "In other words, they are overwhelmed with the volume of research they receive. One of the portfolio managers I speak to at one of the largest UK funds claims to be sent 20 European market updates every Monday morning, of which he has the time to read maybe two."
A result of this, say investors and bankers, is that there is an increasing intolerance towards glossy 50 or 60 page reports on individual issuers in the market that institutions simply do not have the time to read.
"Investors are focusing more on the sort of research that is user friendly," says Mitchell. "So what we are trying to do at JP Morgan is to supplement very detailed and comprehensive reviews on certain credits with regular and disciplined shorter reports. When earnings are reported, for example, or when ratings are changed arising from M&A activity, we will write a five or six paragraph update the same day that goes out to investors immediately. Judging by the high proportion of people who read these Bloombergs, they seem to appreciate the strategy."
Aside from demanding more pithy information, investors say that they need to be given good ideas by banks' bond traders - preferably by telephone rather than via e-mails, faxes or research reports. "I just do not have time to play the relative value game," says a Scottish fund manager who is among the largest UK based institutional investors in the non-Gilts market. "That means it is essential that traders come to me with ideas."
Sometimes, of course, those ideas can be more valuable from an academic standpoint than as practical suggestions that can be rapidly turned into trading strategies. This is because although investors report that trading volumes in the market are much improved, liquidity can still be patchy in the extreme.
"The high yield market is so illiquid that recommendations can be quite notional," says John Pattullo, a corporate bond fund manager at Henderson Investors in London. "You may be given a buy recommendation but find that you cannot get hold of the paper, or conversely it may be a sell recommendation but there will be no buyers out there."
While for the research and trading arms of investment banks the growth of the high yield market has provided substantial new opportunities, the rating agencies have also been very clear beneficiaries of the process. At Standard & Poor's in London, Tony Assender says that of the new ratings assigned by the agency in 1999, 13.5% were in the double-B category, with 18.9% single-Bs, and between 4% and 5% in the triple-C and below range. As a result, within S&P's European universe, made up of 333 companies, some 37% of issuers now fall into the sub-investment grade category.
While a rating is clearly a bonus for an issuer in the high yield market, it is not necessarily a sine qua non. This year's deal from southern European competitive local exchange carrier (CLEC) Grapes, for instance, was an unrated transaction, which inevitably limited the number of investors able to come into the issue - but which did not stop the offering being well received, especially by investors from southern Europe familiar with the name.
According to Assender, while there is little in the way of fundamental differences to the way in which his agency will approach rating a high yield and an investment grade borrower, there are inevitably subtle differences in the process. "When we are talking about high yield issuance, the process becomes more qualitative in terms of assessing the financing capacity of the overall debt in the capital structure," he says. "Many of the companies in the high yield universe have been formed by way of a leveraged buy-out, which means that it is very important for us to get a good idea of the quality of the management, what the management's plans are, and how sound and realistic their projections are."
Assender adds that in general S&P has found that there is sufficient information available about companies in the high yield market. "Many of the issuers are quoted companies that have their accounts audited to a decent international standard," he says.
"For some of the privately owned companies it is true that the information flow is less robust, which makes it all the more important that we stay in regular contact with the management. But there is no doubt that if we felt we were not being given enough information at the outset we would refuse to assign a rating, and there have been a few occasions on which we have withdrawn ratings where we have not been given sufficiently detailed information."
A hot subject for research departments and for rating agencies is the capital structure of an issuer in the high yield market. Analysts say that in several instances the structural subordination of a high yield bond can be as important - and sometimes more important - than an issuer's basic credit quality. As a result, analysis of structural subordination plays a major role in S&P's approach to assigning ratings in the market.
"First, we would assign a corporate credit rating to an issuer," says Assender. "Then we would look at the overall debt structure of the company and at exactly where the individual bond instrument stands within the capital structure. In other words, is it senior secured, does it rank pari passu, or is it subordinated?"
The results of this analysis can be fairly dramatic in terms of ratings notches. "If a bond is deeply subordinated to the claims on a large secured facility," says Assender, "we may move the rating down by one, or more likely by two notches compared to the corporate credit rating."
Is this enough? Some observers think not. "I've heard from a number of investors that the agencies' ratings still do not fully reflect the magnitude of risk to bondholders arising from structural subordination," says one analyst. "I've heard the argument that two notches is not nearly enough to account for the difference between senior secured debt and, say, allegedly senior notes that are typically subordinated to bank debt both at a structural and at a contractual level."
Per Regnarsson, a high grade analyst at JP Morgan in London, is well qualified to comment on the degree to which ratings reflect added risk, given that he has sat on both sides of the fence - having previously been a high yield analyst at Moody's in London and New York, where he followed about 100 issuers in the US market. He says that sometimes a two to three notch differential between senior and high yield debt would be a more representative expression of the risk factors differentiating the two classes of debt instruments.
Whether or not research analysts should devote extensive resources to digging into issues of structural subordination is a subject of some debate. Some investors concede that analysts are by definition paid to comment on individual credits and sectors rather than to dive into details that should be the preserve of lawyers. Some analysts, for their part, argue that it depends largely on the credit.
"It's a fact that at the moment virtually all European high yield issues involve some element of structural subordination," says Mitchell at JP Morgan, "so when I comment on companies on a quarterly basis, the structure of the issue is generally taken for granted. It is when you start getting into discussions on the semi-distressed credits that you have to start evaluating what structural subordination means for recovery rates, which in Europe at the moment is an almost impossible exercise. Only once we have a default trackrecord in Europe will it become realistically possible to assess the implications of structure for recovery rates.
"When we publish a detailed piece of research, however, we will always try to flag instances in which the capital structure is more favourable for investors," he adds. "With the original Ineos, for example [before the recent issue for Ineos Acrylics], that was one of the few cases in which the bonds are not only structurally at the same level as bank debt but secured as well. So in that instance we highlighted the fact that irrespective of the credit itself, bondholders would automatically be in a more favourable position with this issue than with a structurally subordinated one."
The issue of structural subordination has given rise to an intriguing internal conflict among investors. On the one hand, as one analyst puts it, "investors absolutely loathe structural subordination in the high yield market", which is one reason why transactions that do not incorporate these features tend to be almost guaranteed flyers. A high yield bond from drinks company Rémy Cointreau, for instance, benefits from ranking pari passu with bank debt, which is an unusual phenomenon in the European high yield market.
On the other hand, shortage of industrial issuance twinned with the cascade of money pouring into high yield funds means that investors have often had little choice but to buy structurally subordinated deals even when they abhor the structure of the bonds they are being offered. In a February review of issuance, analysts at Schroder Salomon Smith Barney detected this conflict in the market's response to transactions from Irish packaging and printing company Clondalkin, and Scandinavian transportation company Concordia Bus. "Both credits had complicated corporate structures with significant structural subordination," noted Salomon's analysts. "Concordia compounded this with a financial strategy that could effectively reduce recovery values for investors in the medium term. However, despite vociferous protests against these types of structures by investors at the end of 1999, both deals came at price talk and performed well. This was an excellent example of technical, rather than credit factors driving pricing. We expect this trend to continue until we reach equilibrium between supply and demand."
Although the range of services available to investors in the high yield debt market is impressively broad, institutional participants in the sector continue to be deeply uneasy about a number of structural deficiencies they feel still have the potential to jeopardise its long term development. So uneasy, in fact, that for the past 18 months they have been holding informal meetings in London to discuss these deficiencies and ways in which they can be addressed.
Originally the brainchild of heavyweight investors with a very substantial trackrecord in the US market - most notably Alliance Capital Management and Oak Tree - these regular meetings tend to last between 60 and 90 minutes and bring together many of the most influential institutions in the market. Typically between 20 and 30 firms will be represented, which, says one of the meetings' organisers, accounts for all the "significant firepower" in the market. Although most of these are inevitably from UK based institutions, the organisers have sought to engage European firms in the debate by scheduling meetings to coincide with industry conferences in London or roadshows likely to be attended by investors from the Continent.
For the benefit of some of these European participants, one topic sporadically raised at these meetings is the language of documentation in the high yield market. "Documentation is always in very technical English legalese," says one investor, "which is hard enough to understand even if English is your mother tongue."
Other issues discussed at these meetings range from liquidity in the market to the quality of banks' research, pricing practices in the primary market and the role of senior debt and venture capital in driving the market forward. But all these issues are sideshows compared with the ones that really bother the leading investors in the market.
One of these relates to transparency in the market and to the information flows that are provided to investors. "This market needs transparency," says Martin Reeves at Alliance Capital Management in London, one of the most vocal lobbyists when it comes to calling for change in the way market participants behave. "And transparency comes from proper reporting and accounting. It comes from making sure all investors have access to all the information at the same time.
"In Europe we have not been able to achieve that," says Reeves. "The only occasions in which we have achieved it have been with companies that are listed in the US, and, in certain deals for issuers like CompTel, Jazztel and Derby Cycles that are registered with the SEC, the reporting is fine."
For many others, Reeves says that disclosure of information has been feeble. "One of the great strengths of the US high yield market is that every quarter investors have access to every company's balance sheet, profit and loss, and cashflow details, all of which are very important when you are investing in a highly leveraged company. I cannot believe that in Europe, which in a couple of years will be a market worth $100bn, 30% or 40% of issuers are still not giving out accounts on a regular basis that can be assessed by anybody who wants to see them."
There appears to be a couple of reasons explaining why Europe is so hesitant about opening itself up to scrutiny from outside sources. One of these arises from a perception that if companies do provide more fluid information flows, these will have a deleterious effect on their competitive position. Reeves thinks this is an absurd excuse and one that does not stand up to a comparative analysis of the structure of the market on either side of the Atlantic.
"Look at the economy and the stock market that has generated more value for shareholders than any other in the world," says Reeves. "The US also has the best disclosure and accounting standards in the world as well as the largest and most vibrant high yield market. Issuers in the US have had very open reporting and accounting standards for the last 10 years and I have never met or heard of any chief executive officer of a high yield issuing company who has attributed poor commercial performance to the fact that his competitors can see his 10-K. It just doesn't happen."
Perhaps Europe's antipathy towards disclosure will go the same way in the high yield market that it has in the equity market. After all, not so long ago the idea of listing their shares on the New York Stock Exchange (NYSE) was viewed with revulsion by German blue chips, which deeply resented the requirement imposed upon them to draw up their accounts in accordance with US standards. Ever since the iconoclastic Daimler-Benz offended so many of its Dax-listed peers by stepping into US accounting line with its NYSE listing these objections have crumbled. So much so, that the listing of German companies on the NYSE is no longer headline material.
A key difference between the equity and high yield market, however, is that investment banks advising the likes of Daimler-Benz and other German companies on their NYSE listings had a very clear, fee-based incentive for impressing on their clients the need to adapt their accounting standards. No adapting of accounting standards would have meant no listings. No listings would have meant no chunky fees.
In the European high yield market none of this applies. Bankers have little if any incentive to advise their clients to be more open in terms of reporting and accounting. Indeed, if anything they have a disincentive, because a bank giving a company advice that it does not want to hear is likely to weaken its case for acting as a lead manager at the beauty parade stage.
This approach, say disgruntled investors, is dangerously short sighted. "There is going to be about Eu1bn to be earned in investment bankers' fees in this market over the coming 10 years if it develops as we all hope it will," says one. "The investment banks that are going to earn those fees owe it to themselves as much as to everybody else to make sure the market grows from a stable base. And if Europe starts getting a reputation for being the Wild West of the high yield market that is going to put people off.
"What is absolutely clear at the moment is that investment banks that have launched deals have not been prepared to make the effort to go back and work with the company in question to persuade the issuer to give out proper financial statements. It is disappointing and annoying, and as things stand now, we feel we have been let down very badly by the investment banks."
Strong words. But surely if investors feel so sore about market practices their solution is glaringly obvious. They should vote with their feet and refuse to buy bonds from issuers that do not report properly. After all, surely market economics will out? Surely supply and demand patterns will guarantee that delinquent issuers pay prohibitively high spreads in the primary market and see their spreads widen horribly - and justifiably - at a secondary level?
In theory, yes. In practice, no. Two factors, at least, will ensure that for the time being demand will remain strong enough to provide a bedrock of support, even for issuers prepared to tell their investors little or nothing at a later stage of their bond's life.
"One of the problems," says an investor, "is that this market is growing so fast that there are enough investors who are very inexperienced in the high yield market, who have never bought a US issue and do not really understand what they are buying in the European market. Another is that supply of new bonds is still low. There is a massive amount of fundraising going on and institutions that have set up serious funds have to put their money to work. So they cannot afford to vote with their feet."
The result of this second factor, says one sell-side observer, is that "the loudest complainers are also the biggest buyers in the high yield market."
Alongside disclosure and reporting, the other very serious problem that high yield investors seek to grapple with when they gather at their informal meetings is the issue of documentation. "The problem we have is not one of structural subordination per se," says Reeves at Alliance Capital Management. "It is the lack of a clear bankruptcy code throughout Europe that can create some kind of certainty in the minds of investors."
The nub of the problem, says one investor, is that there is an essential mismatch between documentation and the legal regimes to which the documentation is being applied. "The documentation we are using in Europe is the same that was created for a US market that has an insolvency and bankruptcy code based on Chapter 11," he says. "Because there is no equivalent of Chapter 11 in Europe this means that there are certain clauses in the documentation that simply would not work in a European framework. These are very material issues."
Material, perhaps. But to date also hypothetical, because the euro denominated market has successfully steered clear of a major default of a high yield issuer that would, potentially, open up a huge can of worms. According to data published by Barclays, between 1997 and 1999 six issuers in the European market either defaulted or entered into negotiations with their bondholders. "Interestingly," Barclays points out, all of these companies "had issued dollar bonds rather than European currency bonds, so we have still not crossed the 'final frontier' of a European currency high yield bond defaulting, although a number of European currency bonds are now trading at impaired debt levels."
That does not mean that European investors should become blasé about the potential for defaults. Quite the reverse. "What we need to do," says one investor, "is to look very carefully at the documentation and ask, in advance, what would happen if an issuer went bust? How are we going to deal with a default in practical terms?
For example, getting consensual agreement on restructuring in Europe is complicated by the fact that we have unanimity clauses that say that every single bondholder has to agree not to take interest in the event of distress, clauses that say that every single bondholder has to agree that they will not petition for the winding up of a company, and so on.
"It is very important for us as investors to talk about this sort of topic," he adds. "Because if the opportunity is not open for us to try to resolve difficulties with corporates in distress among ourselves, the only route that would be left would be formal insolvency. That would take place either in the jurisdiction in which a single business operates, or, more alarmingly, across a number of jurisdictions across Europe. For obvious reasons, looking over that precipice is not very appealing to investors."
The same observer says that while a default would not kill off the market, it would cause "chaotic disruptions to investors' portfolio valuations". And, at Alliance Capital, Reeves does not believe that a single default in the European market need wreak havoc, but that the real problem would be if defaulting issues start to behave like London buses. "A single default will probably have been priced in by the market," he says. "The real concern is if three or four defaults come along at the same time."