The European high-yield bond market has come a long way from its infancy in the late 1990s to record issuance in 2012 and 2013. But with interest rates threatening to rise, can the market stay on track for another bumper year in 2014?

Bigger, better, longer and riskier – that was the motto of Europe’s high-yield bond market in 2013. The region saw its highest ever issuance of speculative grade-rated bonds at €87bn, more than €26bn ahead of the previous record year. Volumes were boosted by debut issuers refinancing their bank loans in the capital markets, as well as by investor appetite for higher yields and thus more aggressive structures and lower products.

More than 60 first-time issuers graced the market in 2013 from a host of new sectors and countries. For many the move to the bond market has been accelerated because of historically low yields, which helped the European market move closer to its US counterpart. But with the end of quantitative easing in the US, the artificially created rate environment is set to end. How will the market react?

Refinancing deadline

“In Europe, there is €340bn of refinancing [activity] that needs to happen in the next four years,” says Mathew Cestar, head of leveraged finance in Europe, the Middle East and Africa at Credit Suisse in London. “This so-called structural shift to the capital markets away from the private lending model, is happening almost irrespective of the rate cycle. It matters less if the rates are 4.5%, 5.5% or 6.5%; there are still companies needing to refinance.”

And that is why Credit Suisse expects 2014 to be yet another record year for high-yield issuance in Europe, with forecasts of €110bn equivalent of bonds sold by European issuers, irrespective of currency. So far economists forecast no rate hikes in the eurozone as the region’s economies are lagging behind their inflation targets of close to 2%. A fall in the inflation figure from 1.1% to 0.7% in October 2013 even caused the European Central Bank to lower its rates from 0.5% to 0.25% in November.

The UK seems closer to an upward correction of its 0.5% rate level after a drastic fall in unemployment from 7.8% in January 2013 to 7.1% in August. Still, the governor of the Bank of England, Mark Carney, was quick to assure the market that interest rate decisions would not be based solely on unemployment, creating new uncertainty over what would trigger a rate rise.

“People are pretty sanguine about [a rising interest environment] in euros, while in sterling it is already priced in,” says Henrik Johnsson, head of European high-yield and loan capital markets at Deutsche Bank in London. “Rate rises are part of the risk that people take and most are defending themselves against it by having relatively short-duration bonds.”

Expecting the unexpected

Even if a rate hike in the eurozone is nowhere near imminent, investors need to analyse what such a development could mean for their portfolios. In 2008 and 2009, the market's default panic triggered a flight to quality, with treasury yields falling sharply and high-yield spreads shooting up, according to Georg Grodzki, head of credit research at UK financial services company Legal & General. “But it would be naive to assume the opposite would happen and spreads would tighten automatically when yields rise,” he says.

The European high-yield market used to be inversely correlated to government bonds, but quantitative easing has brought all asset classes closer together. Between May and July 2013, the market even saw high-yield bonds react in line with government bonds.

“This high and positive correlation should be a warning that in a rate-rise panic and government bond sell-off scenario, high-yield bonds can sell off even more,” says Mr Grodzki. “However, if government bond yields rise moderately, high-yield bonds are well positioned to perform, provided rate rise expectations remain benign. A gradually improving economic environment is very favourable for risky corporate bonds.”

European high-yield vs 10-year bunds

Spreads matter

High-yield bonds are typically a yield-driven product, especially in Europe, but spreads are becoming ever more important as they show investors the cushion available compared with other asset classes. Deutsche Bank sees European high-yield spreads tightening to a meagre 320 basis points (bps) by the end of 2014, which is still far ahead of the bank’s forecast for corporate investment-grade bonds at 95bps.

At the moment, investors in European high-yield bonds can pick up 382bps over benchmark or an average 4.5% yield, according to Credit Suisse data of February 14, while US spreads are wider at 444bps and yields at 5.5%. However, the European index, reflecting the market, has more BB rated bonds in its selection than the US.

European B rated bonds trade significantly wider, offering investors more pick-up – Deutsche Bank research of February 7 quoted the spread at 572bps. Also, in 2013, the ratings category returned investors 2% more than the entire Barclays Pan European High Yield Index’s 9.1%.

Returns for 2014, while higher than in most asset classes, are deemed to be much lower. Barclays forecasts between 4.5% and 5.5%, and JPMorgan research expects as little as 3.4%.

A tale of two regions

While recovery in Europe is slow, the US is on track for tapering, even though the new chair of the Federal Reserve, Janet Yellen, is seen as more cautious than her predecessor. Yet in December, the Fed announced a $10bn reduction to its $85bn monthly bond-buying stimulus.

In his last appearance as chairman on January 29, Ben Bernanke stuck with his stance on tapering, announcing a further $10bn cut to the programme to $65bn. These moves, paired with uncertainty over the political stability of certain emerging-market countries, caused a sell-off.

“In the US, expectations are for rates to rise,” says Mr Johnsson at Deutsche. “Obviously, the market has repriced but now new issuance is carrying on as before.”

Should Europe follow the US example, once rate increases become a more imminent possibility, a systemic shock could be averted. So far, the technicals are speaking for this: European high-yield funds have seen net inflows in 12 of the past 13 months worth a total of €9.6bn, according to JPMorgan research. The money has to be invested in something.

Floating-rate bonds

“We think 2014 is the year of the loan but also, more generally, the year of the floating-rate instrument,” says Mr Cestar at Credit Suisse, “because if the global economy is getting back on a more normalised path and rates are going up, it gives you some interest rate protection.”

One large financing of the year already opted for a floating-rate product. The €10bn takeover of Dutch cable operator Ziggo by US telecoms investor Liberty Global avoided high-yield bonds but financed its €3.7bn of new capital raising with €2bn and $2.35bn of first-lien loans.

But a meaningful percentage of the investors were still high-yield bond-type buyers, says Mr Cestar. “The psychology of these investors, who have been buying record amounts of fixed-rate product over the years is: ‘it makes sense for me to start hedging that with floating-rate product’,” says Mr Cestar.

The European high-yield market sold its highest portion of nearly €6bn of floating-rate bonds ever in 2013. By mid-February 2014, the first €445m equivalent were priced and issuance is expected to stay strong.

“When you go back four years, people were questioning whether high yield was here to stay or if it was going to be a fad,” says Kevin Muzilla, partner at Allen & Overy in London. “Now everybody agrees it will stay really important in the funding mix in Europe.”

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