The high yield bond market in Europe is currently in vogue as a benign macro-economic environment and historically low default rates combine to produce an abundance of liquidity for both investor and issuer.
New issuance reached a record €42bn in 2006, representing a 61 per cent increase on the €26bn raised 12 months earlier, according to research from Fitch Ratings.
Activity stemming from the leveraged buy-out (LBO) and emerging market space continues to fuel the majority of deals, with issuers warming to the favourably-priced conditions for refinancing or M&A.
On the buy-side, many institutional investors view exposure to high yield investments as crucial to their objective of gaining that extra yard of yield. For example, pension funds in the UK awarded seven times more specialist bond mandates in 2006 than in 2004, with high yield asset allocation an integral part of the investment brief.
Troubled history
However, this wasn’t always the situation. The rate of acceleration at which Europe’s market grew in the second half of the 1990s, once the dust had settled, slowed down dramatically as issuance fell from the highly-leveraged TMT sector and investors exited with haste.
By 2000-2001, it was not uncommon for one in four companies that had issued non-investment grade bonds a few years earlier to have defaulted on their debt repayments.
Nowadays the situation is more stable. Default rates for issuers of European high yield bonds, although forecast to creep a couple of percentage points higher this year, nevertheless remain historically flat at around 1-2 per cent.
From the sell-side, this makes life easier. Investors are more inclined to snap up high yield debt if they think the company issuing the bond will last the pace. Additionally, issuers can command cheaper repayments because the market is so liquid with spreads at their narrowest for some time, and this can determine pricing.
James Courtenay, global head of high yield at ABN Amro, underwrites and distributes high yield deals into the institutional investor market. He says the climate for high yield debt is currently slanted towards the issuer, with reducing returns for the investor.
“There is a huge demand for high yield investments, but a shortage in supply relative to the US market. This is putting coupons at close to all time lows for the corporate issuer but lower still of course for the investor.”
Mr Courtenay believes robust demand from institutional investors is down to a search for yield in a benign macro-environment, with default rates at historic lows.
“Investors are continuing to seek out yield, but with only a 2 per cent default rate in high yield bonds, there remains a material imbalance between demand and supply”, he says.
The Merrill Lynch Euro High Yield Bond Index supports Mr Courtenay’s view of a yield curve that is perhaps flattering to deceive. Last year, the annual total return in euros was 8.9 per cent, better than the 6.8 per cent generated a year earlier but a long way from the 14.7 per cent generated in 2004 and 26.4 per cent in 2003.
Strong demand for high yield investments and the consequent narrowing of spreads, presents bond managers with fresh challenges to maintain an attractive level of return.
“It is a yield hungry environment at the moment and any new issuance is easily absorbed,” says Kenny Watson, investment manager on the fixed income desk at Resolution Asset Management.
Resolution’s £60m (€89.3m) high yield bond fund is expected to return between 5-7 per cent to investors in 2007.
The message from the larger managers is similarly modest.
Paul Reed, head of high yield on the fixed income team at Aberdeen Asset Management expects the attraction of high yield to persist, despite tight spreads and, in his view, a lack of net issuance in early 2007.
“The start of this year witnessed spreads at an all time low, but we see a number of investors moving to high yield because of flat returns from investment grade bonds,” says Mr Reed. “We genuinely think there is appetite for the asset class, although we’ve not seen much in the way of pension fund money.”
Return disparity
Mr Reed is right to point out the disparity between low returns currently on offer from investment grade corporate bonds and those from high yield bonds. In 2006, there was a total return of 0.6 per cent on Merrill Lynch’s Euro Investment Grade Corporate Bond Index, compared to 8.9 per cent on its high yield bond equivalent.
Aberdeen’s €246m Global-European High Yield Bond returned 11.49 per cent in the 12-month period since February 2006 and accumulated 35 per cent since 2004. “The relatively short life of high yield bonds is attractive to investors, yet where demand is high, we are seeing little in the pipeline in terms of new issuance,” admits Mr Reed.
Soeren Rytoft, portfolio director for the European & Nordic region at Payden & Rygel estimates that the Europe market is on the way up. “The market conditions are very similar to the US. We’ve had a quiet first two months, and spreads are very narrow, but investors are still willing to take on risk in their search for yield,” he says.
Payden & Rygel’s $5bn (€3.8bn) Global Fixed Income High Yield bond has a 20 per cent non-US exposure. “We view pension funds and hedge funds as the major buyers of high-yield debt at the moment and don’t anticipate the appetite for risk to stop,” adds Mr Rytoft.
Recently the US-based fund manager has used the barbell strategy in expectation of a flattened yield curve. Managers have now split institutional money between high yield bonds with average credit quality of BB-, and government/corporate AAA/AA rated bonds.
Axel Potthof, European head of high yield at Pimco, the bond specialist, has €18bn
under management in non-investment grade products.
He reckons the ‘high liquidity/high demand’ climate of today will continue and stability from the issuer side will persist. “It is highly unlikely the scenario of 2000-01 will be repeated,” says Mr Potthof. “There is some volatility in the market, including distress in the automotive industry, yet there remains a visible difference between today’s issuers compared to those at the start of the decade.”
He explains that sub-investment grade ratings are a lot tighter and the due diligence surrounding issuers tougher today than in 2000-2001.
With the rate of net issuance expected to tail off this year, certainly compared to high yield market growth rates in the US, Europe’s fund managers are hunting elsewhere for new investment opportunities.
The team behind Fidelity’s European High Yield Fund has been busy snapping up emerging bank debt in Eastern Europe, namely bond debt from Russia’s state-owned bank, VTB, and Kazakhstan’s Kazkommertsbank.
According to Oliver Szwarcberg, senior credit analyst at Fidelity, heading eastwards reflects the climate for high yield debt in Europe. “It is the best of times (strong demand), and the worst of times at the moment (narrow spreads) and we have to look deeper and travel further for opportunities,” explains Mr Szwarcberg.
The fund built up a small holding in bond debt issued by the BNP Paribas-owned Ukrainian bank, UkrSibbank and as a result picked up an extra 205 basis points (2.5 per cent) for its clients.
The Fidelity high yield fund has assets of around €1.6bn fund, making it the market’s largest player.
Similarly, managers of Newton’s £23m European High Yield Bond Fund say they are concentrating analysis on emerging market corporates, which are less well known and have higher growth potential.
Both Fidelity and Newton’s high yield funds maintain significant holdings in what are distressed debt staples like the automotive sector, with General Motors and Ford often delivering strong returns.
With managers searching high and low for those extra basis points, the industry body is busy educating and marketing to potential clients the pluses of high yield exposure.
Critical information
Representing both the issuer and investor sides of the market, the European High Yield Association (EHYA) recently made public its market practice recommendation for bond issuers to disclose their senior loan documents, in addition to amendments and waivers.
“This information is critical to investors, especially when more investors than ever before are investing across credit asset classes,” says Craig Abouchar, chairman of the EHYA, who is also bond manager at HBOS-owned Insight Investment.
The EHYA hopes this move will bring Europe more in line with the US where information is routinely disclosed and issuers do not regard it as a burden.
From the perspective of managing institutional money, Mr Abouchar, who oversees around £350m (?520m) in high yield for Insight, believes there is room for improvement in the local market if it is to catch up with trends across the Atlantic.
“The high yield market isn’t doing what it’s supposed to be doing at the moment and I’d like to see the euro market growing faster,” he says.
Mr Abouchar says strongest demand for high yield is coming from hedge funds and activity within the leveraged buy-out market.
But if issuance levels in the European market are growing at record rates why does it appear that there is not enough debt to go around?
“The fact that a doubling of issuance still resulted in insufficient supply is probably explained by the relative small size of the European market against the US market,” says ABN Amro’s Mr Courtenay.
According to research from Standard & Poor’s, US high yield issuance volume was twice as high in 2006. Although found the difference between the two markets has narrowed markedly in recent months.
