European high yield matures

People say that product differentiation is a sign of a market reaching maturity. If that is true, there may be signs that the European high yield market is finally coming of age, as highly leveraged companies and their sponsors are benefiting from a new trend away from the one-size-fits-all approach to structuring high yield debt. It is well worth taking a look at what this means, even if cynics will say that what has been happening recently is simply a sign that the market is desperate to sell product at any cost in order to evidence that, yes, it still has a pulse. The cynics may well find that they have got it wrong. Issuers raising money have been looking at ways to pay it back when it suits them rather than the investor ? which arguably is a sign of strength rather than weakness. And sure enough, during the first half of this year, a number of high yield issues have been successfully sold with an increasing variety of maturities and more flexible prepayment terms or ?non-call periods.?

For example, there have been a number of deals recently with three to five year maturities, most notably in Italy where there is interest in such paper from retail investors, provided the name is right. On the more traditional transaction-driven front, where deals tend to be highly leveraged, Britax came to market with a long-awaited nine-year, non-call four issue (i.e. a nine-year maturity prepayable from the fourth anniversary of issue), even though the opening yield required was a generous 11.5 per cent. In a similar vain, Deutsche Bank is currently marketing a seven-year, non-call 3.5 transaction for Kronos International.

Even more interestingly, bathroom maker Sanitec, successfully priced a ten-year, non-call three bond with a nine per cent yield. This matters primarily because it suggests that issuers and their sponsors are getting more say in the way that their bonds work, which in turn suggests that demand for high yield product remains healthier than those cynics would suggest. That news is most certainly not just a spurious detail. But are borrowers having to pay up in order to achieve a structure more conducive to their timing, and what if anything are the investors giving up in return? A closer look at the recent Sanitec and Britax issues offers some clues as to what is happening.

If a short non-call period is introduced into the issue structure, the minimum contractual period during which the bond is outstanding is also potentially shorter. Doesn't this mean that either the price of the bond goes down, unless it pays a higher return? The simple answer is yes, though the amount of extra cost varies.

If one calculates the yield, based on the issue price, on each of the above securities on the assumption that they are called at the earliest opportunity (the so-called yield to worst), then the Britax bond provides a gross return of 12.475 per cent per annum, while the Sanitec issue yields 11.594 per cent, a spread of just over 88 basis points. Comparing that with the marketed gross yield (assuming redemption at maturity) of 11.5 per cent and 9 per cent respectively gives a spread of 250 bps. The reason for the difference in spread is primarily due to the varying premium at which the bond has to be redeemed prior to maturity ? the earlier the call, the greater the premium to compensate investors. And from the issuers' perspective, both bonds provide a valuable element of flexibility, although the most issuer-friendly terms are going to be more expensive.

single-B rated company, in the words of the song, ?the only way is up? – at least in credit quality terms. If this proves to be the case, or a successful exit is achieved by the sponsor, then wider access to cheaper funding will probably ensure that any such outstanding bond does indeed not exist for very long (as it can be refinanced). Conversely, if this does not happen, the issuer has at least secured long term funding. A ?winwin? situation then? Possibly, although many would still say that the investor remains the first among equals.