High yield bounces back

After a dismal few years for Europe’s high-yield market, there have been recent signs of a revivalin 2002. Is this a sign that the high-yield market is on its way to recovery or just a blip on anotherwise downward trend?

The high-yield market has had a bumpy ride over the first half of 2002 marked by continued volatility. But this is set to change in the second half of the year as analysts expect European leveraged buyouts to rejuvenate the market.

“Supply has been weak all year,” says Chris Mohler, member of the high-yield capital markets team at Bank of America, “but the pipeline for the remainder of the year is robust, comprised primarily of leveraged buyout deals but also of corporate refinancings.”

Katherine McCormick, high-yield analyst at JP Morgan, says that there is a light at the end of the tunnel and the market is poised to take off. “The market will be boosted by the LBO and private equity investment rather than M&A activity.”

Investors may have no cause for concern, as the pipeline seems to be straining under the weight of deals just bursting to be launched. Just looking at the official calendar gives you some idea of how important LBO financing in the high-yield market is set to be.

Upwards of €3 billion is expected, led by Jefferson Smurfit, the Irish packaging firm, which plans to launch a possible €1 billion bond via Deutsche Bank and Merrill Lynch.
Other deals are a €600 million transaction for Legrand, the French plug and switch maker, lead-managed by Credit Suisse First Boston, Lehman Brothers and Royal Bank of Scotland; Gate Gourmet, the Swiss airline caterer, with a €400 million deal via CSFB and Salomon Schroder Smith Barney; Haarmann & Reimer, a German flavours and fragrances business, with a €250 million deal via JP Morgan and Commerzbank; and Brake Brothers, the British wholesale food distributor, which mandated JP Morgan and CSFB for a £175 million deal.

Net issuance of €3.2 billion in the European high-yield market over the last six months has been a disaster, agree the majority of fund managers. But one high-yield portfolio manager at a large UK fund says that at least it will not be hard to beat first-half issuance figures. “I see the market developing reasonably strongly, but at a conservative cleft. Issuance will at least double and I see €2 billion to €3 billion there and perhaps some pleasant surprises.”

“Of course,” he adds, “the fallen angels brigade will bolster inventories and the asset class.” JP Morgan statistics show that the $89.6 billion high-yield market has been dominated by the fallen angels to the tune of $12.1 billion since the start of 2002.

“We have already seen €6-€7 billion coming from fallen angels,” says Simon, “and that will continue – €5-€8 billion of new material by Christmas. In a way that will give us interesting growth over the next year.”

These statistics would seem to be a fillip for eager high-yield investors, but some asset managers are concerned about the state of the market after Big Food Group posted poor results. “It will be tougher for some of the LBO food retail deals now,” says Toby Nangle, high-yield analyst at Baring Asset Management. “Borrowers need to tell a really good story if they want their deals to succeed.”

Energis also curbed positive sentiment and shook a lot of people after the company went bankrupt. It had been looked upon as one of the rare survivors in the telco world, adds Nangle. Another high-yield fund manager says: “Combined with the energy horrors of February and the WorldCom horrors of June, it seemed we were in a force ten gale.”

More troubles for the sector surfaced when rating agencies Moody’s and Fitch outlined their concerns about the rising number of defaults in the market. Fitch reported that about 21% of the European high-yield bonds, $12 billion in total, defaulted in the first half of 2002.

Baring Asset Management’s Toby Nangle says: “Default rates are extreme but I think they have touched their highest point in this cycle. The market is currently expecting default rates to stay at cyclical highs for the next five years. We think that is very unlikely and Moody’s, which has a model for high-yield defaults, also thinks they will come down. When the light at the end of the tunnel is seen then the market will rally and the asset will outperform.”

The market does seem to be going through a cleansing process, adds JP Morgan’s McCormick, and she believes that there are already tangible signs that the market is improving.
“The indices all reflect lower yields, narrowing spreads and negative returns,” says McCormick. “Negative returns are a result of a change in the composition of the index; many of the TMT names have dropped out of the indices upon default and new issues, of better quality, have been added.”

McCormick believes that most of the weaker names in the TMT sector have defaulted or that their prices reflect the probability of default. By year-end the company expects the effect of these weaker credits to have dissipated.

On a positive note and despite a weak environment, Baring Asset Management’s head of credit, Marino Valensise says: “We are buyers of high yield at these levels. Lots of high-yield companies have not bought into the recovery so they are now using their free cashflow to pay off their debts.”

When the market reopens, European high yield is forecast to become even more diverse as new industries start to tap the sector. “Investors are looking to diversify their portfolios,” says JP Morgan’s McCormick, “and there is a lot of cash available to invest in better-rated European industrials credits.”