Nowhere has the growing innovation and diversity of the UK capital market been more evident in recent months than in the emergence of a viable high yield sterling bond market. The deal flow is picking up speed and bankers believe it is destined become one of the most vibrant high yield corporate debt sectors in Europe.
Investors are increasingly keen on the sector, eager to deploy their growing credit analysis skills and earn enhanced returns on their fixed income portfolios as a result. Issuers -- M&A buyers seeking finance for acquisitions, or small and medium-sized companies keen to develop an alternative to bank debt -- are attracted by the new opportunities on offer.
Investment banks -- particularly the leading Wall Street firms -- are plugging the market for all it is worth, believing it to be a major growth area and a welcome source of high-margin business at a time of declining returns from other areas of their debt capital market activities.
And the authorities have given their blessing to the market, with the Bank of England coming out strongly in favour of the creation a high yield sterling bond market that would create an alternative for UK issuers to the much more developed US high yield market.
But all are agreed that the market's development will need to chart its own course. It is not going to be simply a replica of the US junk bond market.
Towards the end of last year, the London office of ABN Amro canvassed 44 UK fund managers on their views about the European high yield bond market -- and was delighted by the survey's findings. According to Brian Lawson, head of global syndicate at ABN Amro, more than 10 of the respondents indicated that they were already active buyers of high yield bonds, while more than 20 suggested that they would become active buyers in 1998.
Sadly, because the survey was a proprietary one, that is as much as ABN Amro is prepared to divulge about its findings. It is not, for example, prepared to go into detail about respondents' replies to questions aimed at discovering what are the "main drivers for the development of the European high yield market" and the "biggest impediments" to its development.
Nevertheless, the trend is not easy to miss. Flush with liquidity and under intense pressure to deliver performance on the one hand, and increasingly starved of their staple supply of Gilts on the other, UK institutional investors are warming to the concept of higher yielding bonds which sit somewhere between top rated corporate names and US style "junk".
Conservative UK-based investors with reservations about the concept of anything remotely resembling the US junk bond market would also have been comforted last year by a Bank of England report, which appeared to give its wholehearted approval to the development of a high yielding market in the UK.
Indeed, the bank's report began with a strong suggestion that as long as the UK high yield market remained underdeveloped relative to its US equivalent, the UK capital market would be passing up a very important potential source of growth and would be pushing would-be UK issuers overseas.
"Swapping the proceeds of a US dollar issue into the borrower's domestic currency can be costly," the report noted. "So this recourse to a foreign market suggests strongly that there are deficiencies in the UK market. Certainly most UK companies which have issued in the US agrees that a sterling issue in the UK, were it possible, would have been preferable. Indeed, the lack of an effective UK market may be restricting UK firms' access to capital."
Investors will also have been encouraged in 1997 and the early weeks of 1998 by the increasing number of investment banks which have put their weight behind leading new high yielding issues.
In the early days of the market, high yielding sterling-denominated bonds seemed to be the almost exclusive domain of Bankers Trust, which put its full weight behind the evolution of the market and which, as a result, today earns the generous praise of many of its competitors.
"Full credit must go to Bankers Trust," says one, "for pushing the development of the market very aggressively in 1996 when there was still quite a bit of scepticism around regarding high yield in Europe."
Bankers Trust continued to lead the way in 1997 with, for example, the launch in June of a £65m 10 year deal for Eco-Bat.
Co-led by HSBC and Chase Manhattan, this transaction for Europe's largest recycler and producer of lead was priced at 200bp over the 2007 Gilt and was more than two times oversubscribed.
But Bankers Trust was by no means alone in propelling the UK high yield market forward in 1997. When Castle Transmission Services launched its £125m deal via Credit Suisse First Boston in May -- which was upped from an original £100m -- it was at the time the largest high yield transaction Europe had seen.
This 10 year transaction was priced at 195bp over the December 2007 Gilt, which was seen as exceptionally good value -- not least because Castle enjoys a guaranteed 10 year contract to broadcast all programmes transmitted by the UK's state owned television and radio broadcaster, the BBC, which hardly made the credit untouchably risky.
At CSFB in London, managing director Simon Meadows accepts that the risk profile of Castle was scarcely on a par with traditional US-style junk.
"It was a very important deal both for our sterling franchise and for our high yield franchise," he says. "But in many ways you could argue that Castle Transmission was almost too good a name to be our first sterling high yield deal because it was such a good story. There was never really a shadow of a doubt that at the right price UK institutions were going to buy it."
Besides Bankers Trust and Credit Suisse First Boston, a number of other banks had a successful time promoting the high yield sterling market in 1997.
In November, Morgan Stanley led a two-tranche offering for COLT (formerly City of London Telecoms) which comprised a DM150m 10 years tranche priced at 362.5bp over Bunds alongside a £50m tranche for the same maturity and at the same spread to Bunds.
This deal incorporated a 144A clause, with 60% of both tranches placed with US accounts.
SBC Warburg, which co-led one of the first sterling high yield issues alongside Bankers Trust in 1996 -- the £80m deal for Fitzwilton Finance -- has also been an enthusiastic backer of the high yield market in the UK.
Last November it co-led a £100m 10 year issue for Frogmore Estates alongside NatWest Markets at 135bp over the Gilt, and the following month joined forces with Mees Pierson to lead a highly unusual £75m 10 year Eurobond for Chelsea Village, the owner of Chelsea Football Club.
Priced at 225bp over the 10 year Gilt, this was the first ever bond to have been issued by a company listed on the UK's Alternative Investment Market (AIM), and was described by Mees Pierson at the time as "a remarkable transaction" and a "landmark deal which demonstrates the appetite and willingness of the City to provide imaginative long term solutions to the demands of leisure groups which could be for the benefit of football and sport in general."
The first few weeks of 1998 have also seen a broadening of the sterling high yield market, which was most visible at the start of February when Goldman Sachs launched a two tranche sterling/dollar transaction for the telecom and cable TV company, Diamond Holdings.
The Diamond deal was notable for a number of reasons. First, it was the largest high yield corporate bond deal yet launched in the UK, with both tranches on the 10 year offering increased from their originally planned totals of £100m and $100m, which were raised by £35m and $10m respectively.
Second, the pricing of the issue pushed the sterling high yield market closer towards levels more normally associated with the US junk bond market. While the original cluster of higher yielding transactions in the UK had been priced at between 100bp and 200bp over the government benchmark, the Diamond deal offered juicy levels of 395bp over the Gilt (for the sterling tranche) and 375bp over Treasuries (for the dollar bond).
In early March, the nascent UK high yield debt market took a quantum leap forward with the launch of the two largest transactions yet -- a two tranche offering for IPC Magazines via Goldman Sachs which raised some £180m; and a three tranche sterling/dollar financing for telecoms company NTL by Morgan Stanley and DLJ.
The transaction for IPC, recently bought by investment group Cinven, comprised £120m of 10 year senior notes and £102m of zero coupon senior discount notes -- which raised proceeds of £60m, and which pay a 10.75% coupon after 2002.
Goldman Sachs said both tranches, which pay spreads of 358.5bp and 471bp over Gilts respectively, had been oversubscribed by more than three times by a wide range of investors in Europe and the US including insurance companies, money managers, pension funds and mutual funds.
Just four days later, NTL went one better with the largest financing yet in the sterling high yield market -- raising £300m as part of a three-pronged capital-raising exercise in the UK and US markets.
The 10 year issue, which is callable after five years, comprised three tranches: £125m of senior notes at a spread of 350bp over Gilts; £300m face value of senior deferred coupon notes (raising proceeds of £175m) at a spread of 375bp over Gilts; and $1.3bn face value of senior deferred coupon notes (raising proceeds of $800m) at a spread of 400bp over US Treasuries.
Other deals are on the way, including a number of acquisition-related financings. Bankers Trust is due to lead an issue for William Hill of around £200m as part of the financing to support Nomura's purchase of the UK betting business.
And Merrill Lynch and SBC Warburg Dillon Read are considering a high yield bond issue of £100m-£150m as part of the financing package for the merger of Waterstone's booksellers with fellow bookstore Dillons and the HMV record store chain.
With merger and acquisition activity running at high levels, bankers say the emergence of a viable high yield bond market in the UK is creating a whole new range of financing opportunities for acquirers -- as well as for small and medium-sized companies requiring working capital.
Bankers who have supported the evolution of the UK and European high yield market over the course of its short life are plainly delighted with the way in which it has evolved and are hungry for more deals. They are also convinced that opportunities in the high yield market will proliferate, for any number of reasons.
First, there is now a tangible and very solid investor base supporting the market, both in the UK and Europe. "I would say that at any point in time when we launch a high yield transaction we can reach between 50 and 100 mainstream institutional investors in Europe alone," says Youssef Khlat, managing director of the European debt syndicate at Bankers Trust in London.
"Most of these institutions will have attended seminars organised by ourselves and others on cashflow models and on understanding credit, so the level of sophistication is higher than it ever has been before."
While institutions investing in the market are spread across most of Europe, it is UK investors who appear to be leading the way. "In the Eco-Bat transaction we attracted 33 institutions, of which 21 or 22 were from the UK," says Khlat, "and we understand from the market that CSFB had much the same experience with Castle Transmission.
"I would argue that if you look at a list of the top 20 insurance companies in the UK, several are already active players in the high yield market. Of course they're not allocating anything like the bulk of their portfolio to high yielding bonds, but momentum is growing and in many instances we have seen UK insurance companies acting as anchor orders -- subscribing, say, for 10% of the transaction early on and providing the basis upon which to build the total book."
A second reason for optimism on the growth of the high yield market is that with the onset of Emu, the European capital market will increasingly look like a mirror image of its US counterpart, with currency considerations evaporating almost overnight and being replaced purely by credit analysis.
"The US is a very mature market for high yield bonds," says Gopal Menon, managing director of debt capital markets at Bankers Trust. "Issuance levels in the US is about $2bn per week and the total outstanding stock is around $400bn. The entire European market is worth about 1% of that."
The obvious conclusion is that Europe has a great deal of catching-up to do, and that if the European market could expand to a degree which is perhaps 10% of the size of the US market, the growth achieved would be colossal.
Given that so many more investment banks are now putting their weight behind the growth of the market -- competition which Bankers Trust says it warmly welcomes as it can only enhance liquidity and broaden origination opportunities -- the prospects of this happening seem bright. "We would much rather be in the top three of a very large and liquid market than to be top of the league table in a tiny one," says Khlat.
A further encouraging signal for the longer term viability of the high yield market, adds Menon, was the way in which the fledgling sector responded to the volatility in the world's capital markets in the last quarter of 1997.
"We took great comfort from the way spreads behaved in October," he says. "In general high yield bonds showed themselves to be a lot less volatile than emerging market issues."
For Bankers Trust itself, the imminent acquisition of the cash equities department of NatWest Markets provides an ideal springboard from which to add depth and breadth to the UK high yield market in terms of origination.
"At a strategic level the acquisition gives us a perfect platform," says Menon, "because about 60% of NatWest's clients on the broking side are small or medium sized companies which would be rated double-B or thereabouts. These are growth companies which have probably never considered raising debt in the high yield market."
While generally bankers in London applaud the development of the high yield market and are thankful for its growth, they have two minor reservations about the trends which have been established.
The first is a concern whispered in some quarters that much of the high yield paper raised in the European market has found its way not into the traditional European institutions for which it was intended -- but across the Atlantic and into the accounts of dedicated and seasoned US high yield investors.
The second reservation, which is more specific to the UK market, is a sense of surprise that Germany, populated in the main by investors stereotyped as being highly conservative, has also seen very strong growth in the sector.
The Deutschmark sector is jostling for position with sterling as a leader in the high growth area, and some UK issuers have surprised bankers by electing to issue in Deutschmarks rather than sterling.
One example of this early in 1998 was the launch by the UK shoe materials manufacturer, Texon, of a 10 year DM245m bond priced at a gigantic 495bp spread over Bunds, which was led by Chase.
"Logically the UK ought to be the European home of the high yield market," says one London banker, "because it is the most developed corporate bond market in Europe, and by extension it is the market where investors have more credit expertise than elsewhere in Europe.
"As a result," says the same banker, "you would have expected sterling to take a clear leadership role in terms of high yield. I think the reason why the Deutschmark market has been so strong is that German investors tend to take a barbell approach to asset allocation.
"They're very happy to buy Pfandbriefe at 20bp over Bunds, but don't seem at all interested in anything at between 30bp and 100bp. In a generally low yielding environment they've obviously been enticed by things offering a 300bp pick up." EW
Opinion divided over prospects for emerging market borrowers
PROBABLY less successful to date than the corporate high yield bonds in the sterling market have been issues from emerging market borrowers, principally but not solely from Latin American sovereigns.
The first of these in 1997 was a five year £300m issue from Mexico via BZW and SBC Warburg priced at 175bp over Gilts, which met with a muted response given the shortness of a maturity scarcely likely to appeal to UK institutions.
When Argentina followed suit the next month with a £200m deal led by HSBC and UBS, it was altogether more popular -- reflecting its 10 year tenor and a spread over Gilts of 280bp.
Brazil, which came to the sterling market in July with a £150m euro-fungible bond arranged by BZW and Credit Suisse First Boston, also opted for the more institutionally friendly 10 year maturity, and priced its issue marginally inside the Argentina deal at a 275bp spread.
Offering some diversification away from sovereign issuers from Latin America in 1997 was a rare £150m 10 year deal for India's Reliance Industries in July, which was priced at 165bp over the Gilt.
But one geographical block which has yet to turn in any significant way to the Eurosterling market is eastern Europe, where borrowers appear to have been more comfortable with the Deutschmark sector.
The most recent of the emerging market issues in sterling was a £100m 10 year deal for Colombia in January which was co-led by Barclays Capital and Credit Suisse First Boston.
When this transaction eventually surfaced, having originally been a casualty of October's Asian crisis, it was smaller than many market participants had expected and more highly priced.
While spread talk had been focused on a range of between 300bp and 330bp over the government benchmark -- which would have dovetailed with Colombia's 10 year dollar deal trading at the time at 328bp over Treasuries -- the issue's final pricing came at 350bp over Gilts.
This, says Meadows at Credit Suisse First Boston, led to substantial retail take-up of the Colombian issue. "Just as there is in the Deutschmark market we saw tremendous retail interest in Colombia as well as in Brazil," he says.
"Investors could see that they were buying a triple-B sovereign with a 9.75% coupon which is pretty compelling when your average triple-A 10 year bond is going to yield 6.2% at best."
The relative failure of emerging market credits to have found widespread favour among UK institutions prompts an intriguing debate about the sophistication levels of local investors in the UK.
At times, UK institutions -- especially the pension funds and insurance companies -- can appear to be stunningly parochial in their willingness to accept far-flung credits.
As one major local investor says: "We did not buy Argentina or Brazil and we would only do so under exceptional circumstances. The fact of the matter is that we simply do not have the resources to send people to Peru or wherever at the drop of a hat."
This observation, say London-based bankers, highlights a curious paradox among UK institutions. Far from being unsophisticated investors, they say, it shows that UK institutions are possibly too sophisticated for their own good.
"Why was the sterling market not heavily tapped by the Koreans when they were rated AA-?" asks one London-based syndicate member rhetorically.
"The reason is that because of their sophistication as investors UK institutions do not always trust the ratings agencies. They have confidence in their own ability to assess risk, and they are not paid simply to take the word of Moody's or Standard & Poor's."
Pre-Asia, it would have been easy to say that by adopting this stance UK investors were collectively cutting off their noses to spite their faces. The Asian crisis, however, and more importantly the spectacular failure of ratings agencies and bank analysts to see the crisis coming, appears to have vindicated the UK institutional approach to emerging market credits.
As with the high yield corporate bond market, some bankers attribute the strength of the Deutschmark sector for emerging market names relative to sterling to the comparative lack of sophistication of German institutions, which seem happy to invest on the basis of ratings agencies' views rather than to conduct their own hands-on research.
Whether or not the Asian crisis has dealt a temporary blow to the potential of sterling as a currency for emerging market issuance, or whether the damage which was caused will be more long term, is a matter for speculation.
"Sterling has been a currency for emerging market issuance, and it has not been confined to sovereign borrowers," says one London-based banker.
"You've seen good enough deals as well from corporate names such as Pemex and Reliance Industries. But broadly speaking the experience of emerging market issues in sterling has not been a good one. They have tended to come too tight and have widened significantly as a result." He adds: "But it was doubly unfortunate that we had the Asian crisis at just the time when some UK institutions were starting to dip their toes into the emerging market water, which led to spreads ballooning out again. Confidence was lost at time when it was very fragile anyway, and it will take quite some time to rebuild that."
Another banker questions the intrinsic logic of emerging market issuers tapping UK institutions in any case if their aim is to diversify their investor base.
"There's no doubt in my mind that emerging market issuance is largely asset-swapped back into dollars and then sold to investors with a long history of buying emerging market credits," he says. "These bonds are not going to UK institutions buying and holding sterling assets, but to exactly the same investors that would buy in dollars. It's slightly fictitious to claim that there is now a sterling market for emerging market names." EW