After several false starts dating back to the dot-com boom and bust of 2000, high-yield underwriters are hopeful that the European market is now set for a prolonged period of steady growth, writes Michael Marray.

By early October this year, the European high-yield market had already set an all-time annual issuance record of €36bn and, with a busy fourth-quarter expected, could end the year in the €40bn to €45bn range.

On the demand side, volatile equity markets and a low-interest-rate environment have sent investors searching for new opportunities and, with a tentative economic recovery and corporate default rates falling, they are willing to bet on B or BB rated corporates in return for juicy 6% or 7% coupons.

Institutional investors such as insurance companies and pension funds have increased their allocations to high yield, often managed by third-party credit fund specialists. Hedge funds are active buyers of high yield, and inflows into retail funds need to be put to work in an environment where holding cash balances will quickly depress overall returns.

For household names such as Renault, Continental or Hapag Lloyd, there is a strong retail bid in their home countries, with sizeable volumes placed via private banks and the wealth management arms of the major investment banks.

Upheaval in banking

The critical driver of all this activity is the upheaval in the bank market. Many corporates have decided to diversify their sources of funding to include both bank debt and high-yield bonds in the mix, after failing to get bank finance in 2008 and 2009. And the banks themselves are under pressure to set aside more regulatory capital, which has a disproportionate effect on lending to non-investment grade companies.

"Historically, banks in Europe were very willing to provide inexpensive long-term funding to corporate borrowers, often at pricing levels below that of the high-yield market," says Eric Capp, global head of the high-yield syndicate at RBS Global Banking & Markets in London. "But since the credit crunch, banks have scaled back the riskier portions of their loan books and are having to hold more capital, all of which is putting pressure on non-investment bank lending. At the same time, corporates have become concerned about relying too heavily on the banks as a single source of funding," he adds.

One example of this trend is automotive supplier Continental, which has tapped the high-yield market no fewer than three times in 2010, having previously been almost wholly funded by bank debt.

In late September, RBS acted as bookrunner and global coordinator on a dual-tranche offering from Conti-Gummi Finance BV, an entity wholly owned by Hanover-based Continental. It sold €625m worth of six-year (non-call three) bonds and €625m worth of eight-year (non-call three ) bonds.

"European companies want to diversify their sources of financing away from traditional bank lending, while on the demand side there have been sizeable new inflows of cash into high-yield mutual funds during 2010, as well as strong interest from institutional buyers and hedge funds," says Doug Clarisse, head of European high-yield capital markets at HSBC in London.

In January, HSBC acted as joint bookrunner on a dual-tranche offering of eight-year (non-call four) notes from UK cable company Virgin Media. Due to strong investor demand, both the sterling and dollar tranches were upsized: £875m worth of notes were priced at gilts plus 340 basis points (bps) and $1bn worth of notes at US treasuries plus 325bps.

Open for business again

Refinancing in a more accommodating market has underpinned much of the high-yield issuance. "A lot of the activity during 2010 has been straight refinancings, given that the European high-yield market had effectively shut for 18 months during the crisis," says Bruce Mackenzie, head of Europe, Middle East and Africa high-yield capital markets at Bank of America Merrill Lynch. "And some European corporates that had only relied on the bank market for capital are now diversifying into the bonds markets."

However, despite all the positive drivers, the high-yield market remains choppy, and the timing of an approach to the market is all-important. "During the course of 2010 we have had periods of negative newsflow, such as in February and May when the iTraxx [credit default swap index] widened out and issuance dropped off," says Mr Clarisse.

Mr Clarisse's comment suggests that underlying investor demand for high yield remains somewhat fragile, and that sustained negative newsflow will drive investors to temporarily sell assets, resulting in periods when primary issuance is very difficult. Many believe that this cycle will probably not be broken until there is a sustained economic recovery.

Doug Clarisse, head of European high-yield capital markets at HSBC in London

Doug Clarisse

Doug Clarisse, head of European high-yield capital markets at HSBC in London

M&A drives activity

However, the notable pickup in merger-and-acquisition activity across Europe in the second half of 2010 is now adding to the volume of high-yield offerings coming to market. Mr Mackenzie says there is a growing shift towards more event-driven transactions, such as the buyout of Sunrise (a Swiss mobile phone company) by CVC Capital Partners, and an offering by Ardagh Glass (a European bottle and jar manufacturer) to raise cash for an acquisition. The high-yield offering associated with the Sunrise deal in early October was heavily oversubscribed.

Sponsors are looking for an exit on companies that they acquired between 2005 and 2007, and in the initial public offering market there have been a number of attempted deals where the bid-ask spread on valuations has been too wide with regard to what the public markets are willing to pay and what sponsors are looking to achieve.

"In some cases, sponsors are looking for alternative exit opportunities, either selling to a strategic buyer or another buyout firm," says Mr Mackenzie.

Mark Walsh, co-head of European leveraged and acquisition finance at Morgan Stanley in London, also sees high yield being used as a financing tool in the leveraged-buyout (LBO) market. "The high-yield product is likely to become a mainstream financing tool for sponsors in Europe, so that will be another source of growth alongside refinancings," he says. "We are seeing a good pipeline of deals at the moment, so there is good momentum for high-yield issuance for the fourth quarter."

In June, Lion Capital announced an agreement to buy French frozen food company Picard Surgelés from BC Partners, and Morgan Stanley was one of three bookrunners on €975m worth of debt facilities to support the acquisition, with the capital structure comprising a combination of senior credit facilities and a subordinated high-yield bond.

The Lion/Picard deal was the largest European LBO financing of the year, and the first underwritten bridge to a high-yield bond taken out in 2010. In September, an offering of €300m of senior notes due in 2018 was completed, with the order book several times oversubscribed.

So has the European high-yield market finally come of age, or will it suffer another setback? There were high hopes about 2000, but these were dashed by the bankruptcies of some of the technology, media and telecoms (TMT) issues during the dot-com bust. High-yield issuance grew again in 2005 and 2006, but it relied too heavily on the fortunes of the LBO market.

"Back in 2005 and 2006, LBO-related issuance made up 60% to 70% of the European high-yield market, so the high-yield bond market was at the mercy of the LBO market," says Tanneguy de Carne, head of loan syndication and high yield at Société Générale Corporate & Investment Banking. "The big transformational change is the experience of chief financial officers and chief executive officers at European corporates during the financial crisis, when banks were struggling and sometimes refused to make new loans."

The shift in attitudes means that this time around there is a better mix of high-yield issuers. "Over the past decade, we have had periods of high concentration in single sectors, such as TMT or chemicals," says Mr de Carne. "But today we are seeing a much more diverse group of corporates wanting to access the market on a regular basis, much more like the well-diversified US high-yield bond market, as well as growing LBO-related activity."

There are already alarm bells ringing about the massive liquidity running into funds, which needs to be put to work quickly. This means that, although investors often complain about the rapid tightening of spreads, they still come in on the next transaction. The oversubscription levels on some recent deals are described by one analyst as a "mad scramble" for primary assets and as "a riot" by another.

"I came to London in 1998 because the European high-yield market was about to go gangbusters," says one US banker, who is cautious about predicting plain sailing ahead for the development of the market, given past experiences.

But in spite of fears of some individual corporate bankruptcy, or broader market events that might scare off investors yet again, the European high-yield market may have moved decisively ahead during the course of 2010, and may have put in place the foundations for long-term sustained growth.

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