What's driving high yield?

“European high yield is a good place to be at the moment. It's a lot better than 12 months ago and probably a better place than it has ever been.” So says Martin Reeves, Director of European Credit Research at Alliance Capital. Returns, comfortably north of 20 per cent for the year to date, have been nothing short of spectacular (see charts), outperforming all other asset classes.

At last, senior lenders in LBO transactions have opened the door a little, showing a chink of light that promises more in the way of structural protection for those lower down the financing hierarchy. “Real” companies, household names almost, are issuing significant volumes of new sub-investment grade paper. Investors are participating in a live market for the product rather than the patchy, and volatile, trading patterns that have previously typified its behaviour. For the first time in what seems like an age, new money is flowing into the coffers of those investing.

So is European high yield heading into a new era, a golden age even? Is it exhibiting signs of the genuine maturity that “serious” funds, in other words those with serious amounts of money to deploy, require? Or is this just another false start on the lengthy road European high yield has thus far travelled? So far this journey can be characterised by the many bumps and potholes encountered as much as the (occasional) smooth, straight stretches. The best answer is probably: maybe. As one investor with over €1bn of funds committed to the asset class put it: “I would really like to be optimistic, but I can't help being sceptical”. So what is the current situation?

The telecom legacy
It is, not surprisingly perhaps, a little more complex than it might first appear. The European high yield market exhibits a number of different facets. Firstly, there is the legacy of the market's roots: the telecommunications issuers. During 1999 and 2000, they represented the vast majority of the market. Even as recently as the end of 2001, according to the Merrill Lynch Euro 3% Constrained Index, they still accounted for around 20 per cent of the market by value despite the depths to which many of them had sunk. Today, the sector accounts for less than 10 per cent.

However, those that have survived still have an enduring influence on the market. Ironically, this is due to their performance. If one breaks down the performance data, it is possible to see that, for the year to date, the telecommunications sector has been a consistently strong performer, generating total returns above the wider market for most of the period. Indeed, the proportion of the total represented by their market value has begun to increase, despite the rise in issuance levels from other sectors. Some are even predicting the return of meaningful new issuance from telecom companies.

“It's likely that we'll see the cable sector re-enter the market, together with the broader TMT space too,” observes Nicholas Street, director of high yield capital markets at Royal Bank of Scotland. “Such financings will take place for companies that are now on solid ground, provided the structure and the leverage are right,” he says, adding a note of caution. The inference here is that for the once distressed issuers, if the “fixing” of the capital structure is considered robust and the business model makes sense, the market will welcome them back.

Indeed, there is already evidence of this in the shape of the recent transaction for IFCO Systems, the transport packaging logistics company, even though it is a credit from a different industry sector. “This was a big thing,” comments Alliance Capital's Reeves, “and probably shows that the market is now acting more rationally.” The €110m 7-year issue for the transport packaging firm was, according to sole lead manager Deutsche Bank, three times oversubscribed, with around a third of those investing returning to the name, though a significant number overall were distressed investors.

Distressed
This leads to the second facet of the market, one that is closely related, though not exclusively, to the first: distressed issues. These were, of course, very much the hallmark of the market during 2002 in particular, when ratings agency Moody's Investors Service reported default volumes of over $45bn, effectively representing more fallen angels than had defaulted during the entire prior history of the market.

Looking at a wider definition of the term “distressed”, to include everything rated below single-B, then CCC-rated issuers, according to the Merrill Lynch Euro 3% Constrained Index, have actually shown the strongest returns of any rating category during 2003, and are the only segment to have generated consistently positive month-on-month returns since the end of last year. Spreads (OAS) at the end of September were down to 1284 basis points (12.84 per cent) from 2191 only a year earlier.

Admittedly, this segment represents a relatively small overall proportion of the market, but the turnaround in performance is nevertheless dramatic. “There has been a phenomenally good run in distressed with some dropping out of this category, though not all,” says Sara Halbard, portfolio manager at London-based Intermediate Capital Group. However, this performance is not necessarily evidence that the issuers of this paper have come out of the doldrums. “The more worrying aspect is that if one looks at fundamental earnings levels, they don't appear to support current price levels. Prices are currently technically driven rather than reflecting a fundamental belief that such companies are out of trouble,” says Halbard.

Though the market has rebounded this year with European primary issuance increasing by over 130 per cent and high yield, as an asset class, outperforming others, there still seems to be an imbalance between supply and demand: the primary “technical” factor. AMG year-to-date fund flows, a proxy for investor liquidity, have increased in the US by more than 400 per cent over last year and European investors have also experienced significant inflows.

The consequences of this can be seen in European secondary market prices. In the absence of sufficient new issue volumes, European investors have had to put their cash balances to work in the secondary market, causing the market to be well bid.

Since the August break, there have only been a few new issues. “Supply is quite tight and there is not a huge visible pipeline from now to the end of the year, though there's always the possibility that a big fallen angel will enter the market,” states RBS' Street. This is a widely held view: fallen angels have, in effect, saved European high yield. “Fallen angels have really moved the market along. These are proper companies with access to other financial markets. They've added credibility,” says Halbard.

Fallen angels
Such issuers, including ABB, Ericsson, Alcatel, Ahold and others, constitute the third facet of European high yield, and this is probably the most important at the moment. They have brought what the market has, in effect, been looking for from the start: publicly listed entities with large outstandings, but most importantly, BB-category ratings. By value, even within the constrained index, BB-rated companies now represent 35 to 40 per cent of market value, and probably a larger proportion of new issuance, a fundamental change from the early days.

It is better to have long term investors in good deals rather than just shovelling crap at them

Such new issuance, including significant volumes of paper from Vivendi Universal, HeidelbergCement, Rhodia and EMI, has underpinned the credibility of the market. These issues have helped to evidence that the market can digest a sizeable number of bonds from a variety of industries. Anecdotally, market participants suggest that it is also this segment that accounts for the bulk of the performance of the indices, though it is harder to establish this in fact.

What is also causing excitement is the change in perception by European corporate issuers about the high yield product. More corporate managers are becoming attuned to high yield's benefits for the first time, such as extending maturities and diversifying funding sources. This trend should continue down into the mid-market and Continental Europe which is full of medium-sized companies who have traditionally financed themselves through the bank market. If sufficient numbers of them can be persuaded, or even obliged, to seek funding away from these traditional providers, the European high yield market will grow, bringing it more into line with its older and bigger North American brother.

There are, according to some, signs that this may be beginning to happen. “The biggest change of all in the last five years is that today one can definitely see [that] banks are less willing to lend on uneconomic terms,” says Street at RBS. He, and others, all report swelling high yield issuance pipelines for 2004, some of it being ‘corporate’. “This is very exciting because as more types and sizes of issuers tap the high yield market, the product will be perceived as more of a conventional corporate finance tool,” he says. For everyone involved, this will be an important point in the development and maturity of the European high yield market.

Do equity sponsors like high yield?
Given the preceding three drivers of today's European high yield market, what about that other traditional issuer and the fourth and last, facet to the ‘new’ market: private equity backed businesses?

A year ago issuance from this group ground to a halt amid unresolved problems relating to structural subordination and claims of inflexibility on all sides. Since then, there has been considerable movement towards addressing these issues, resulting in the market opening up for such transactions once again.

What may yet prove to be a new type of staple security has also emerged from this process: the mezzanine note. This instrument, issued by UK DIY chain Focus Wickes in an increased £290m equivalent transaction, is essentially a hybrid: a mixture of some of the best from the high yield and mezzanine markets combined. Curiously, though, this innovation did not feature prominently in conversations with either buy or sell-side representatives.

Obviously the notes for Focus were just one of a variety of structures used during the past year. Although most issues now include upstream guarantees of some sort, the benefit that has resulted has varied considerably due to the dependence on local laws, which frequently constrain the availability of such measures. In short, and as many old high yield hands will point out: a good structure won't change a poor credit.

“The much more interesting thing in the context of LBOs is the non-call provisions. This is the reason why British private equity funds don't like high yield,” says Stephen Mostyn-Williams, current chairman of the European High Yield Association in London, and a broadly experienced advisor to the private equity sector.

The sponsors' dislike for non-call provisions attached to high yield paper has historical reasons. During the period from the mid-1990s to the end of the decade, their argument goes, the private equity community, at least its UK-based constituency, grew accustomed to exiting transactions, and generating impressive returns, within a comparatively short time frame, and one completely at odds with the structure of a traditional “non-call five” high yield structure. In this arbitrage-like approach to buying and selling companies, what counts most was the availability and flexibility of finance – not necessarily its cost.

This still holds true for many today. “I value flexibility very highly,” says Lyndon Lea, a partner at the London office of LBO investors Hicks, Muse, Tate and Furst. “Deals are not made or broken on the cost of debt alone.”

Sponsors also continue to view high yield simply as a way of increasing leverage: “We have always operated on the basis that it's better to be conservative on leverage on the way in – and to releverage or refinance in a year or two if the deal has gone well,” says Charlie Green of Candover.

Green's comment might be seen as going to the heart of the inability of high yield to completely meet the needs of the Europe-based private equity community, despite the view amongst many that high yield, in economic even if not in straightforward cash terms, is generally cheaper than mezzanine, its principal rival.

The mezzanine juxtaposition
So what are the key issues around which this rivalry crystallises? Most private equity practitioners would point to the restrictive call language contained within high yield indentures and the standard “make-whole” provisions required as part of the tender process (assuming an exit during the non-call period) as the main obstacles in the way of high yield grabbing more market share. Yet are these really significantly different from the back-ended return provisions of mezzanine instruments?

Most mezzanine providers target an IRR of 15 per cent-plus for their investments. This will typically be structured assuming an exit within a 3-year timeframe, and be received in the form of warrants. If the realisation occurs earlier, everyone accepts that the return is likely to be higher – at least in the high teens.

Compare this with a high yield bond. Coupons today for Brated private equity backed transactions are in the range of 9 to 10 per cent. Assuming traditional terms, a tender for the bonds at some point prior to the third anniversary of issuance within a non-call five structure and with a makewhole premium based on today's low risk-free yields would probably be at around the 115 to 120 basis points price level, but could well be lower. This is even assuming that holding from issue would generate an IRR of the same order as for the traditional mezzanine instrument referenced above and hence a similar total cost to the sponsor.

Both returns are in effect contractual, the only difference being that the mezzanine provider is entitled to a sum defined as a share of a company rather than a specific amount in relation to future cash flows. Perhaps this is the key: mezzanine providers are still regarded as having interests aligned with the equity sponsor, whilst bondholders are not. As long as this perception, let alone the actual market structure of mezzanine as delivered by its relatively few providers, is common among the private equity community, then high yield will remain a poor relation.

So where does this leave the overall market? Besides the four facets examined here, many practitioners also feel they are witnessing the establishment of two main market groups: the corporate market, which may well become the mainstream (as in the US), and the sponsor-driven market. Ultimately, what will really count for the success of either of these will be the appetite of the investor. The draw of impressive yield is irresistible at the moment and that is delivering short-term demand for high yield product.

Longer term, the willingness of at least a sizeable core of investors to stick with the market as it develops further will be required. For that to happen many foresee the need for “three C's”: confidence, commitment, and, above all, a continuation of the quality and variety of issuance seen of late.

There's something else needed too: discipline, neatly summarised in the following comment from a seasoned member of the buyside: “I really hope that the sellside recognise the fact that it is better to have long term investors in good deals rather than just shovelling crap at them.” For both sides, the next 12 to 24 months should be very interesting indeed.