Europe charges down the credit curve

Global Finance, Mar 2000 by Brandman, James

Last year was an extraordinary period for Europe's high-yield debt market. The first quarter of 1999 was spent recovering from the effects of the Russian economic fallout of the previous year, with investors retreating to less risky investments, forcing spreads to widen. Even in the second quarter the market remained cautious with precious few new issues. The turnaround came in the third quarter-the most prolific and fruitful period for European issuers ever, with several benchmark issues coming to market at tight prices. As the year drew to a close, a record number of issues flooded the market in November and December, with investors seemingly unperturbed by the threat of the Y2K computer bug.

Tony Assender, director of corporate credit ratings at Standard & Poor's in London, says: "Last year was really stimulated by the hangover of 1998. Perhaps the market had overreacted after the financial crisis by lowering the credit ratings of many companies, and the rebalance came in 1999."

Now that high-yield investors have had a taste of market volatility, the outlook for the junk-bond market is bright. Despite a lull in the first six months of 1999, last year's total issuance reached $17.2 billion, up from $14.2 billion in 1998. Europe now makes up 18% of the global high-yield market.

Says Geoffrey Sherry, head of European trading and capital markets at Chase Manhattan in London: "When I came to London in October of 1998, there were about 15 accounts in Europe that could buy below-investment-grade bonds; now there are about 115. It's part of the credit culture birth that's happened in Europe."

Adds Shiva Dustdar, director and head of high-yield at Fitch IBCA in London:"It's opening up the capital markets to a wider issuer base. Smaller companies or companies with a less sexy credit rating have traditionally had to rely on the bank market. Commercial banks will now face pressure internally and externally from their own shareholders to lend less to those companies because of the very low margins they have typically lent at." Dustdar says that tapping the high-yield market can be a first step by a small or medium-size company toward coming to the equity market. "The high-yield market in a way will help these companies open themselves up to a wider shareholding away from having family or bank ownership as has been the case so far," she says. "It plays quite an important role in changing the whole scene."

The performance of Europe's high-yield market has confounded critics. "Over the last two years, when prophesying the growth of the market, people were always worried about demand," says Sherry. "A lot of people thought you'd never see a true high-yield investor base develop in Europe.The naysayers have been proven dramatically wrong."

But despite newfound optimism, the European market has a long way to go to catch up with its US counterpart. The E18 billion of European issuance is dwarfed by the $94 billion issued in the United States last year. Although the gap is not as pronounced as it was 12 months ago, the wellbeing of the European market is still dependent on its American older brother. Despite some decoupling in 1999, European capital markets remain sensitive to the US equity market and US interest rates. "There's always the trap of the US equity market; if the United States coughs, the rest of the world could catch a cold;' says Dustdar. "That certainly applies to the European high-yield market."

Europe needs to attract dedicated high-yield investors as well as the occasional buyers to ensure long-term prosperity. US investors still make up about 50% of the market, driven to Europe by the lack of growth -in high-yield back home. "Significant portions of most deals done today are still placed in the United States," says a high-yield analyst in London. "Upwards of 80% of the recent UPC [United Pan Europe Communications] deal was placed in the States," he says.

Europe has youth on its side.The state of European high-yield is similar to the US market of 1988-1989. But the two markets have developed differently. In the United States, highyield was born in the late 1970s as a new financing tool for downgraded companies. It only hit Europe in the mid-1990s with the growth of the telecommunications market and the greater financing needs of European telcos.

The size of high-yield issues also varies across the Atlantic. Last year the value of eurodenominated tranches overtook dollar-denominated tranches in Europe. "It's easier to get a $200 million euro deal done than a $200 milhon dollar deal because the technicals here are better than they are in the States," says Sherry at Chase."In the United States there tends to be a penalty for small deals.You have to pay a very big liquidity premium. There's probably less liquidity risk in Europe's marketplace.The days when the US market dictated pricing on a European deal have ended."

Issues by telecommunications and media companies make up about 70% of the European high-yield market. The remaining 30% comprises leveraged buyout (LBO) financing and industrial companies, a portion that is expected to increase as the market matures over time. Dutch cable company United Pan Europe Communications issued the largest European junk bond ever in January this year, worth $1.6 billion. But UK-based cable company NTL remains the largest European issuer of high-yield bonds to date, with more than $7 billion of paper in the market. It also launched the largest euro-denominated junk bond-a E700 million offering done last November.