The first half of 2011 was a promising period for high-yield bankers and investors. There was a record $150bn of issuance in the US dollar-denominated market. Euro deals, which totalled about €40bn, were also being churned out faster than ever. Spreads were tightening and junk bond buyers were making big gains.
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But from mid-June, the market took a severe turn for the worse amid renewed fears over the state of eurozone banks and a slowdown of economic growth in the Western world. Only nine euro-denominated high-yield bonds, totalling just €3.5bn, were priced in the third quarter. Spreads for European BB corporate paper widened by 386 basis points (bps) – almost 100% – between June 1 and September 30, according to BNP Paribas. In mid-October, European high-yield funds experienced their 11th straight week of outflows and had lost 22% of their assets since early June, says research by Bank of America Merrill Lynch (BAML).
The sell-off in the US market was less acute, mostly thanks to the latest financial volatility having its roots in the eurozone. But US investors could hardly be smug. Dollar BB spreads gapped by 236bps in the three months from the start of June. Issuance in August and September was a paltry $7bn, down from $53bn in the same period of 2010. “The volatility in the wider markets has slowed down the pace of new high-yield issuance in the US,” says John Cokinos, head of leveraged finance capital markets at BAML. “Fears of a looming economic contraction have caused the secondary markets to sell off quite a bit.”
He adds that nervous investors have been shuffling their portfolios as a result. “Generally, there’s been a move towards risk reduction – out of CCC and B credits into BB; and out of higher beta, cyclical sectors into more defensive ones,” he says.
Better than 2008
Yet the situation is far from being as bad as it was in the six months following Lehman Brothers’ collapse in September 2008. Then, junk bond issuance all but ceased on both sides of the Atlantic and secondary market liquidity was non-existent.
The main reason for the brighter outlook this time around is that issuers’ credit profiles are healthy. Moody’s said in October that US non-financial companies are better positioned to withstand a mild recession than they were four years ago, thanks to the majority having deleveraged substantially and lengthened the average maturity of their debt since then. The rating agency predicts the US non-investment grade default rate to be 2.3% in a year, compared with a peak in 2009 of 14.5%. In Europe, it expects default rates to decrease from 2.6% to 2.1% in the next 12 months.
This view is broadly shared by bankers. Most point to borrowers’ strong balance sheets and say that third-quarter earnings should be robust.
John Cokinos, head of leveraged finance capital markets, Bank of America Merrill Lynch
No surprises
Nonetheless, few are surprised that the junk bond market has suffered. At times of widespread volatility in bond and equity markets, the asset classes traditionally perceived to be the riskiest are almost always the first to be sold. “All the negative news has come from outside of our market,” says Mathew Cestar, head of leveraged finance in Europe, the Middle East and Africa at Credit Suisse. “High-yield credit fundamentals and default rates are very attractive. But the risk premiums in all asset classes have gone up very sharply. That’s why there’s been a lack of activity in the primary high-yield market.”
That investors are nervous despite issuers’ underlying strengths is clear from high-yield bond indices. The iTraxx Crossover, an index comprising the 40 most liquid credit default swaps of European sub-investment grade borrowers, and a widely used barometer of sentiment in the market, hit a peak of 874bps in early October, implying an expected default rate of well above the current level over the next five years.
Few investors think that is realistic, however, and the iTraxx Crossover had tightened to 755bps by mid-October. Nonetheless, they are reluctant to start buying again. This is partly because they need to hold cash to cushion themselves against further redemptions – a big problem in an environment this volatile. But it is also due to them not being convinced that junk bond prices have troughed. “High-yield investors have higher than average cash levels,” says Eric Capp, global head of high-yield syndicate at Royal Bank of Scotland. “They are being cautious in case the market drops further, but they want to be in a position to buy debt quickly if the market suddenly recovers.”
Prolonged weakness?
Junk bond investors’ main concern is that the wider debt markets remain weak for a prolonged period. In that case, default rates will probably spike, regardless of borrowers’ underlying strengths, as they will struggle to refinance their debt as it matures. “High-yield companies will suffer if there’s no financing for a while,” says Yannick Naud, a portfolio manager at Glendevon King Asset Management. “People are pricing in the risk that they might run out of money before the market reopens.”
Refinancing needs loom large, particularly between 2013 and 2015. European companies alone are estimated to have about €200bn of leveraged loans and high-yield notes maturing in the past two years of that period. Bankers were unconcerned about this at the start of the year, but the fallout from the eurozone crisis is making them increasingly nervous. Many are advising clients to bring forward their refinancing plans.
Of more immediate concern for banks, however, are the bridge loans underwritten before the summer to finance leveraged buyouts (LBOs) and which were meant to be sold down in the bond and loan markets soon afterwards. In Europe, there was an estimated €4.5bn of debt destined for the bond market but still sitting on banks’ balance sheets by the middle of October. In the US, the figure was roughly $50bn to $60bn.
Taking a hit
The amount of so-called ‘hung debt’ is far smaller than was the case four years ago, when the credit crunch began, says Arnaud Tresca, head of high-yield capital markets at BNP Paribas. But the underwriters of these deals are still expected to have to make writedowns or sell them with hefty discounts. “The banks holding these bridges will take a hit,” says Mr Tresca.
Most have been trying to change the structure of the deals they hold to make them more appealing to the market. But establishing what pricing and leverage levels investors will accept has proved tricky. The lenders arranging SKr13.2bn ($1.95bn) of financing backing BC Partners’ LBO of Com Hem, a Swedish cable television company, had to restructure the debt twice after the first attempt to make it more conservative failed to entice investors.
As Com Hem’s difficulties make clear, the LBO market will suffer from a weakened high-yield market. Bankers say private equity houses have already delayed or pulled new buyouts because of the increased cost of funding them.
The volatility in the wider markets has slowed down the pace of new high-yield issuance in the US
The situation is made worse by equity valuations not having dropped as much as credit markets. “The cost of financing LBOs has sky-rocketed, growth prospects are weaker and sellers are yet to adjust their price expectations down,” says the head of leveraged finance at a US bank. “So you have a recipe for inaction in the private equity market.”
Long-term bliss
Whether the junk bond market recovers before the end of the year hinges on the eurozone crisis. Investors will remain risk averse until there is a resolution, say bankers. Until then, all but the strongest credits – such as borrowers rated BB and those from defensive, non-cyclical sectors such as utilities and healthcare – are likely to be shunned. This will particularly be the case in Europe. But the US is also being cautious. In mid-October, for example, the unsecured CCC tranche of a $2.55bn debt package backing the LBO of Kinetic, a US wound care company, had to be scrapped, the arrangers instead opting only to sell down the higher-rated secured tranches.
Yet bankers and investors are confident that the junk bond market’s long-term future is rosy, despite the current problems. The European market, still far smaller than that in the US, is only set to get bigger, they say. This is being driven by banks’ increasing reluctance to hold leveraged loans on their balance sheets amid higher capital requirements and an absence of new collateralised loan obligations, which have been a mainstay of the loan investor base in Europe for almost a decade. “Companies are diversifying away from bank debt,” says RBS’s Mr Capp. “That’s a long-term trend that won’t change because of the recent volatility.
“In addition, the regulators are making it more expensive for banks to hold lower-rated corporate debt on their balance sheets. That will inevitably cause high-grade and high-yield bond issuance to increase over time.”
Moreover, a prolonged period of slow economic growth and low interest rates in the developed world – which many are predicting – might play into the hands of the market. “Low rates and sluggish growth are generally positive for the high-yield market,” says Mr Tresca of BNP Paribas. “In such an environment, investors looking for yield will prefer buying high-yield bonds to highly rated fixed-income products or equities.”
