Ian Gilday, European head of high-yield and loan capital markets at Goldman Sachs

High-yield bond issuance rocketed at the end of 2009 as the thirst for yield returned, leading investors lower down the risk spectrum. As yields dropped in response, this opened up the market to even the riskiest credits. Then, in mid-February, there was a huge sell-off. What is in store for the high-yield market? Writer Joanne Hart

In January 2009, the high-yield market was in deep hibernation. Worse, it was virtually comatose. Investors were not even interested in high-grade corporate credit. High-yield - or junk - was out of the question.

Fast-forward a year and the picture could hardly have been more different. In one week alone in mid-January, more than $11.5bn of high-yield bonds were issued globally, a record for the market.

"We are seeing a fundamental shift on both sides of the table" says Mark Walsh, head of European high-yield at Morgan Stanley. "On the one hand, banks are continuing to deleverage and reduce their balance sheets. On the other hand, more and more investors are becoming interested in credit. The convergence of these two factors has led to a resurgence in activity in the European high-yield market."

New lease of life

The resurgence began in the second half of last year and soon picked up steam. In 2008, for example, total high-yield issuance amounted to $78bn worldwide; in 2009, issuance more than doubled to $178.9bn, according to Dealogic.

"The market was in significant disarray for nearly two years from late 2007 to late 2009," says Roger Thomson, European head of debt capital markets at HSBC.

Sentiment reached its nadir in December 2008. In the US, at that time, the average high-grade spread over Treasuries was 1007 basis points (bps). By January 2010, that had fallen to 616bps. In addition, central bank interest rates were falling so the absolute cost of borrowing fell dramatically. The reduction reflects growing risk appetite among investors for high-yield credit.

"AMG funds-flow data showed 21 weeks of positive inflows to sub-investment grade funds from September 2009 to January 2010," says Ian Gilday, European head of high-yield and loan capital markets at Goldman Sachs.

The intensity of this trend prompted fears that 'irrational exuberance' was about to return to the market. But as January came to an end - and the Greek crisis erupted - investors began to flex their muscles. In early February, the market was hit by a serious attack of the jitters. In one week alone, nearly $1bn was withdrawn from US funds holding high-yield corporate bonds, the largest outflow since 2005. Spreads also widened by an extraordinary 100bps from mid-January to mid-February, reflecting growing concerns about the impact of sovereign risk on the wider corporate market.

It revealed that while corporate fundamentals are quickly improving, credit is not immune from sovereign risks. Nonetheless, bankers maintain that there are real differences between the high-yield market before the financial crisis and today.

Refinancing push

"Activity has been driven by refinancing. Companies are exhibiting prudent capital management. They are taking advantage of low underlying rates and the demand profile," says Mr Walsh.

In the past, many of these companies would have used the bank market to access finance. But this option is almost impossible now. Even investment-grade credits are not flooded with offers from the syndicated loan sector. For sub-investment grade companies, the banks are either completely unwilling to lend or pricing is prohibitive.

"The growth in the high-yield space is a natural evolution. Companies need to be financed. The vast majority have some form of debt and when they need to refinance, they look to see where the weight of money is. Commercial banks' appetite to lend has reduced and the capital markets are where the weight of money is. As a start, in investment grade last year, bond issuance exceeded bank issuance in Europe for the first time," says Mr Gilday.

Measured investment

Despite this trend, investors are discerning when it comes to high-yield issues: they are attracted to the rates on offer, but not just at any price.

"Investors are extremely focused on the structure of bond transactions. They want comfort around the enforceability of guarantees and the jurisdiction of the underlying business, and they want a fair seat at the table in the event of a debt restructuring," says Mr Walsh.

This means investors asking more questions of issuers and book-runners, and doing their own analysis before, during and after roadshows.

"Risk appetite has moderated," says Jean-Marc Mercier, European head of syndicate at HSBC. "People are comfortable with well-known names, such as Pernod Ricard or Rémy Cointreau - classic BB or B credits selling well-known products. Investors are also comfortable with 'fallen angels', credits that were once investment grade, but no longer are. Companies such as Ford or Heidelberg Cement, for instance."

In some cases, the very fact that these companies can now access the capital markets helps to create a positive momentum.

"In the middle of last year, the market worried about a redemption wall, but many issuers have extended maturities, so we are seeing a virtuous circle developing. Companies refinance on favourable terms, they become stronger and the next time they need money, they can access it more favourably still," says Mr Mercier.

Changing playing field

The market has changed in certain key respects, however. Before the financial crisis, leveraged buy-outs were responsible for a substantial proportion of high-yield bond activity. And in the US in particular, sub-investment grade companies issued bonds to pay dividends. These types of deals remain few and far between.

"Investors want yield and they want diversification, so activity has been brisk in the high-yield market, but the deals are being done for real companies doing real business. Credits tend to be at the higher end of the speculative-grade spectrum, with a genuine rationale for raising money," says Martin Egan, global head of syndicate at BNP Paribas.

Recent evidence lends weight to the thesis that investors have become more discriminating. Italian yellow pages group Seat Pagine Gialle was forced to scale back a bond issue from €650m to €550m after weak demand from investors. Whispers in the market before launch suggested a 9.5% yield at issue, but in the event, the bonds were priced to yield 11%.

Italy's biggest gaming company postponed a €350m bond issue altogether in February and saw its credit rating downgraded from B+ to B as a direct result. At the same time, Manchester United football club bonds slumped in price within a fortnight of launch. A £250m (€286.9m) tranche tumbled in price from 98% at launch to 93%, while the price of $425m tranche slipped back to 94.5%. But chemicals company Kerling issued a €785m bond within days of Manchester United's deal and its price rose in the secondary market.

"Investors are beginning to price credit with a real degree of differential," says Mr Gilday.

In the second week of January, Virgin Media issued $1bn of dollar-denominated bonds, yielding 325bps over Treasuries and £875m of sterling paper at a spread over gilts of 340bps. Initially, Virgin intended to issue the equivalent of £500m in total (dollars and sterling), but demand was so intense that the amount raised more than doubled. The sterling tranche was the largest amount ever raised in that market.

Investor appetite was stimulated partly by a belief in Virgin Media's business model, but also because the deal was structured in such a way that the bonds offered investors the same protection as bank lenders. Manchester United bonds were secured against the same assets as the bank debt they were replacing, but concerns about the underlying creditworthiness of the company hit secondary-market trading hard.

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Jean-Marc Mercier, European head of syndicate at HSBC

Analytical approach

"Investors are doing in-depth credit analysis. There is no momentum buying," says Mr Gilday. Mr Egan says that the high-yield market is very different from what it was in the past. "Before, it was highly leveraged. Now, issuance is much more positive from a credit perspective and this works for investors," he says.

Looking ahead, optimists believe that acquisition and leveraged buyout funding will return to the market as economic conditions improve. Whether this occurs in 2010 or beyond is a moot point, however. Investors have given the market graphic proof that they will not buy whatever is on offer. The price has to be right, the structure has to be right and the name has to be right.

"Highest rated high-yield credits should be able to clear the market pretty effortlessly this year. But the more speculative companies may have trouble refinancing, particularly in certain industries, such as property or consumer discretionary," says Diane Vazza, head of global fixed-income research at Standard & Poor's.

However, she adds that high-risk investment behaviour is on the increase, at least in the US. "The return of questionable practices in some recent deals, such as raising bond funds to pay out shareholder dividends or sponsors, raised consternation that recent optimism may have been overdone," says Ms Vazza.

The future

Far-sighted observers are concerned too about prospects for high-yield issuance in the years to come. Between 2012 and 2014, more than $850bn of speculative-grade debt is set to mature, including loans and other credit facilities.

Much of this will need to be refinanced and, if the loan market remains subdued, pressure on the high-yield bond market will be immense. By that stage, global interest rates are almost bound to be higher, so the absolute cost of borrowing may well have increased.

The response from investors will undoubtedly depend on external economic conditions and the identity and rating of each individual issuer. February's sell-off underlines that a return to the search for yield at any price seems highly unlikely.

And from an issuer's perspective, there is more of a need to be responsible now than ever before. Sources of finance have narrowed considerably, so they simply have to make sure they treat the capital markets with respect.

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