Good reaction: Chemical company Ineos raised €870m on the high-yield market

The European high-yield market was, for years, driven by leveraged buyout activity. Now corporates are accessing the market in their own right. So, is European high yield coming of age? Writer Joanne Hart

These days, sub-investment grade companies issue 'high-yield paper'. But, back when the market first opened, they issued 'junk', and bankers in Europe struggled to persuade clients that they could access this market and still stand tall. The battle has been long and hard but there are signs that European corporates are beginning to come round.

"There appears to be less of a stigma associated with being a non-investment grade corporate in Europe, so corporates are less reluctant to tap the high-yield markets for funding," says Jim Yu, managing director in European high yield and leveraged finance at Morgan Stanley.

The numbers speak for themselves. In 2006, high-yield transactions valued at €35bn were issued in Europe in euro and sterling, of which about 70% were leveraged buyouts (LBOs). In 2009, 44 deals worth €30.3bn came to market and a full 60% of them were for European corporates. In the first five months of this year alone, 42 deals were issued, with a value of more than €20bn - the vast majority of which were for companies, not LBOs.

"Before the recent market volatility, 2010 high-yield new issue volumes were running at record levels in the UK and continental Europe, driven by the strength of corporate demand rather than LBO-related issuance," says Michael Moravec, head of European high-yield syndicate at Barclays Capital.

Most of these issuers have traditionally used the bank loan market. Having built up relationships over a number of years, they simply borrowed directly from a coterie of banks, which knew the company and the people working in it. This approach was particularly straightforward between 2004 and 2007, when banks were only too happy to dole out loan capital to well-known clients.

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Mathew Cestar, head of leveraged finance at Credit Suisse

Change of heart

Now, they cannot and they will not. Suffering from the aftermath of the financial crisis, most banks have been forced to rebuild their balance sheets, a process that could take many years. In the meantime, the capital requirements as set out by Basel III make lending to sub-investment grade companies increasingly unattractive.

"Banks are now saying it is uneconomical for them to lend to 'single B' corporates, thanks to Basel III," says Tanneguy de Carné, co-head of European loan syndicate and high-yield capital markets at Société Générale.

"Banks are scaling back lending. This affects the amounts and terms on which they are prepared to lend and the names they are prepared to lend to," adds Mr Yu.

As a result, companies are having to be more broadminded in their approach to fundraising.

"In the past, with very few exceptions, European companies did not want to be 'tainted' with the high-yield brush. Now, there is a growing acceptance that bond deals are not necessarily a bad thing and that relying on bank liquidity is not necessarily a good thing," says Douglas Clarisse, European head of high-yield capital markets at HSBC.

The names that are coming to this realisation include a number of well-known, well-respected companies, such as UK-listed International Power and Thomas Cook, French chemicals group Rhodia and Dutch cable operator Ziggo.

"A broad array of companies have been coming to the market. In the past, they might have stayed in the loan market, but there is more liquidity in the bond market these days," says Mathew Cestar, head of leveraged finance at Credit Suisse.

High-yield enthusiasts point out not only that bank loans are hard to come by these days, but also that the covenants attached to them are far more burdensome than those attached to high-yield bonds.

"Companies may have to pay more in the high-yield market, but the gap between loan interest and coupons has narrowed from historical levels and is now competitive with loans. The covenants on bonds are also much less restrictive," says Kenton Jernigan, head of European high yield and distressed at Jefferies International.

"Banks tend to insist on maintenance covenants too, which are tested on a periodic basis. If a company breaches them, they have to enter into renegotiation discussions with the banks - or risk default. High-yield bonds have incurrence covenants, which come into force if the borrower incurs more debt. For example, a company with high-yield bond debt would be able to weather a downturn in trading without having its covenants tested, while a company with bank debt would be tested," he adds.

A few years ago, this distinction did not seem terribly important. But the economic downturn has made borrowers think twice. Many of them have produced volatile earnings over the past two years and were forced to renegotiate bank debt as a result, often with painful consequences. For some, this has highlighted the attractions of the high-yield sector.

"We expect the number of corporate issuers to double over the next two to three years. I have never seen so many companies wanting to access the high-yield market," says Mr de Carné. The majority of these companies are using the bond market to refinance bank debt. "About 60% of new high-yield issues are refinancing bank debt and this will fuel the market's growth going forward," he explains.

Added incentive

Investor appetite provides another incentive for corporates considering the high-yield market. With interest rates at historically low levels, investors are hungry for yield - and nowhere is this more on offer than in the sub-investment grade sector.

"Government debt is yielding very little and investment-grade yields are low, so if you want to earn more than 4.5% to 5%, you have to look at sub-investment grade," says Dominic Ashcroft, executive director at Goldman Sachs.

Over the past 18 months, looking at sub-investment grade has proved extremely rewarding. In 2009, total returns from this sector were 70% in Europe, compared with 54% in the US and 19.6% from investment-grade bonds.

In the first five months of this year, total returns from European high yield were 5.2% - rather a comedown but still higher than the US (3.5%) or investment-grade bonds (4.8%).

"Last year was an aberrant year; the returns were unusual. Between 8% and 10% is more normal and I believe the outlook for this year is reasonably good," says Mr Cestar.

Investor demand has had a notable impact on yields. The average yield in April and May of this year was 8.54%. The average yield from 2000 to 2010 was 10.72%.

"Yields are 225 basis points below their long-term average. Obviously, they are flattered by low base rates but current levels still highlight the strength of investor demand and show issuers that now is an attractive time to come to market," says Mr Cestar.

The high-yield investor base in Europe has traditionally been quite small, but there are signs this is beginning to change.

"Liquidity in the European high-yield market is still dominated by a relatively limited number of investors compared to the US market. But in certain specific cases, such as strong BB credits, we're seeing investment-grade investors subscribing for paper, because they are looking for yield," says Mr Yu.

Peter Aspbury, head of high-yield research at European Credit Management, agrees that yield plays a crucial part in the investment process.

"We are primarily attracted to yield," he says, but adds: "We also want to ensure that a business is appropriately leveraged and that it intends to manage the balance sheet in a way that does not compromise its rating. The rating itself is not so important - what matters is that a company is aware of the factors that affect its credit quality, which it should be seeking to maintain or enhance if we are to invest."

Put another way, investors are far less likely than in the past to subscribe to a deal without investigating the credit thoroughly. A rating provides helpful clues but it is not sufficient in itself.

"The boundaries between investment grade, non-investment grade and unrated are much more blurred than they used to be. If investors believe a credit has the right characteristics and it is being offered at the right price, they will take it," says Martin Egan, global head of syndicate at BNP Paribas.

The Greek debt crisis - and its overspill into Spain, Portugal and beyond - tested the high-yield market, as it did many others. Issuance has been sparse but deals have been done. UK-based chemical company Ineos, for example, raised €870m in the market and the deal was priced on May 5. The two-tranche, five-year deal was priced at 9% and 9.25%, respectively, and the paper was bought by investors.

Now, many issuers are waiting in the wings but banks, perhaps not surprisingly, are confident conditions will improve and the second half of the year will be characterised by robust issuance, driven by corporate names.

"Stability will return, value will be seen and the market will pick up," says Mr Clarisse. "I have so many issuers wanting to get in before the summer that I am really quite hopeful."

Positive trend

The pattern so far this year lends weight to Mr Clarisse's optimism. In February, for example, Czech mining group New World Resources (NWR) tried to access the market with a €600m senior secured deal offering a coupon of 8%. Concerns about Greece had just surfaced and the deal was pulled. A month later, when the market was more stable, NWR returned, paying 7 7/8.

"If a business is sound and its prospects are good, it will still be able to tap the market, even if the timing of its first attempt is affected by adverse external market conditions," says Mr Moravec.

Of course, LBO activity is likely to return, once buy-out conditions become more stable. Nonetheless, the structure of the high-yield market has almost certainly changed for good. Corporates need capital to refinance existing debt and invest in the future. Banks are no longer willing or able to lend on the terms that they used to but bond investors seem increasingly keen to take up the slack. Events of recent weeks have affected all financial markets but high-yield investors are still looking for quality issuance. For companies with interesting prospects and reasonable leverage, the appetite is there.

"This is going to remain an attractive asset class over the long term. There may be volatile periods along the way, but over time these will prove to be some of the best buying opportunities," says Mr Aspbury.

Breakdown of high-yield bond issuance (2010/11)

Breakdown of high-yield bond issuance (2010/11)

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