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Clearing away the confusion

The practical and lucrative benefits of the burgeoning European high yield bond market are explained by William Healey of Merrill Lynch Mercury Asset Management
Over the last few years, European investors have experienced a tectonic shift in financial markets which has left them with a very different investment landscape than they had over the past decade. Interest rates across Europe are near the lowest level in memory. Rates between countries – whether inside the Euro-zone or not – have converged and relative volatility declined significantly. Eleven distinct currencies are combining into one. Equity markets have defied traditional valuation gravity to reach new highs.
Yet, at the same time, investors still face many of the same day-to-day requirements on the other side of their investment ledgers – such as meeting high pension payouts or guaranteed annuity obligations. So where do we go from here? Listening carefully to our UK and European bond clients over the last year or so, we have heard them consistently state the following broad investment ‘mission statement’ for the start of the new millennium:

p Higher yields – but without assuming dramatically greater risks
p Portfolio diversification
p Protection against downward price moves in equities or increases in interest rates
p Maintain flexibility and liquidity

Challenging indeed! Yet, in the course of our research we discovered one relatively new, rapidly growing asset class in Europe which we feel is uniquely suited to helping our clients achieve these future investment goals: European High Yield Bonds.

What are European high yield bonds?
What are ‘European high yield bonds’ and what characteristics do they have which makes them so uniquely suited to the ‘brave new world’ of investing at the start of the new millennium? Since the initial launch of this market some six years ago, it has been shrouded in a fog of questions, scepticism, and confusion among traditional European bond investors who are not familiar with this decidedly non-traditional asset class. But in the comments which follow, we hope to clear away some of the fog and share our observations about this exciting and rapidly growing asset class.
First, let’s be clear what we mean when we talk about European high yield bonds - and likewise what we are not talking about.
For us, European high yield bonds are promissory obligations issued by relatively small, sometimes new companies who do their business mainly in Europe. That is, we mean bonds whose yields and creditworthiness are linked directly to the fundamental performance and financial health of an operating company, where the sovereign credit risk of the corporate’s home country itself is neither in question nor is a significant factor in valuation. European high yield bonds are usually longer maturity, fixed rate debt obligations used by these companies to fund the rapid growth in their operations, refinance expensive and restrictive bank borrowings, or to fund the significant capital expenditure many of these companies have in building out their networks. Many of these instruments are callable before maturity – but at a considerable premium to the investors. This feature gives issuing companies who prove their viability a strong incentive to issue equity or otherwise de-lever their balance sheets and to re-issue debt at lower funding costs later.
To be clear, we are not talking about emerging market bonds - that is, we are not talking about bonds issued by governments or companies in Russia, Thailand or Brazil.
Interestingly, nearly two-thirds of the companies who have issued European high yield bonds are in industries which, for the most part, are not very sensitive to cyclical economic factors. Many have rapidly advancing technologies like fibre-optic telecommunications (Jazztel, Tele 1, KPN, Qwest, Hermes), cable television, (NTL, CableEuropa), mobile phones (Orange, Dolphin), as well as healthcare (Fresenius Medical Care, Sirona Dental Systems). The universe also includes older, mature companies whose cash flows have been ‘rock-solid’ across all points in the economic cycle, like gaming (William Hill, Coral), insurance (Willis Corroon), and specialist technologies (Leica Geosystems).
European high yield bond issuers are generally rated ‘non-investment grade’ by the main rating agencies, which means rated double B plus or lower. We believe the rating agencies tend to view many of these bond issuers as non-investment grade for three key reasons:

1) because they are new and have no track record of performance across cycles;
2) they are growing very rapidly, often by acquisition which can be unpredictable; and/or
3) because they require large amounts of capital expenditures – often debt-financed - to build out their networks before their impressive cash generating engines can reach full steam.

Clearly, these are important risk factors – and should be taken seriously. However, in our opinion the rating agencies tend to be overly conservative in that they focus on historical facts rather than on the longer term prospects for these companies.
In contrast, many of these companies have listed equities whose valuation is driven by their future earnings, cash flow and dividend prospects. A prime example of the difference in perspective between debt and equity markets is the UK mobile phone company Orange. Orange has one of the largest market capitalisations on the London Stock Exchange at nearly £12bn, but its public bonds (which are senior in payment priority to equity!) were rated only single B+ by Standard & Poor’s – quite far down the non-investment grade scale - when issued for the first time last summer.
Investors in European high yield bonds are, in effect, ‘arbitraging’ this difference in perspective and valuation between the credit rating agencies and the equity markets. We believe that combining a detailed credit analysis of the operating and financial risks of each company with a forward-looking assessment of their earnings and growth prospects allows prudent investors to capture higher yields and upside gains while aggressively managing and controlling downside risks.

The Market
Currently, the market for European high yield bonds is relatively small - but growing rapidly. Having recently celebrated its sixth birthday, the European high yield bond market is now nearly E40bn in size with over 100 different bonds issued by more than 50 different companies across a diverse spectrum of industries. Although still only a fraction the size of its much older cousin in the US, the European market has nearly doubled in size in each of the last three years, as shown in Fig 1. It is quickly becoming more diverse in terms of issuer types and much more efficient in terms of market makers and investors.
We expect the rapid growth in this market to continue as it benefits from profound, longer term, structural changes which are reshaping the European marketplace. One key change fuelling rapid growth in this market is deregulation of historically protected industries such as telecommunications. This allows a new group of competitors to emerge who require longer term, fixed rate capital to fund high speed, high capacity, fiber optic networks for businesses and home users across the Continent. Another example of these profound changes is ‘disintermediation’. The long standing role of banks as primary receivers of capital (ie deposits) from European investors and savers and as primary lenders of capital to European borrowers is breaking down. Instead, investors are looking to broaden their investment options by investing directly in capital markets, while small- to medium-sized corporate borrowers seek to diversify their funding sources by accessing public debt markets directly (such as the European high yield bond market).

Why invest in European high yield bonds?
As mentioned above, we believe European investors are seeking to increase and stabilise returns on their investments, diversify risks, and provide protection to their capital against potential downside price movements. We believe European high yield bonds offer many important advantages to the European investor to help meet these challenges:

a. Increase investment yields:
Currently, European high yield bonds offer an average yield (in euros) of about 10.4%, which is over 5.5% (550 basis points) greater than that offered by comparable German government bonds – or more than double the absolute yield!

b. Relatively consistent total returns:
The European market has only a limited history, so we must look to the US high yield market for some rough indication of how this asset class might behave over longer time periods. Firstly, over longer time horizons (eg three, five, or 10 years), the total returns on high yield bonds has proven to be surprisingly stable at between 10% and 12% on average. Secondly, most of the return comes from the very high and consistent running yield on these instruments!

c. Diversify portfolio risks:
US high yield market history also suggests that the performance of high yield bonds bears some of the characteristics of government bonds and equities – in effect, a ‘hybrid’ asset class. Over time, however, such bonds perform in a manner which is unlike either equities or government bonds. This is indicated by low levels of correlation between the performance of high yield bonds and either government bonds (0.43) or equities (0.55). Therefore, we believe European high yield bonds over time could provide an excellent way for investors to diversify the overall performance risk of their portfolios.

d. Downside protection:
High yield bonds generally yield between 10% and 11%. This provides excellent protection for investors’ capital during periods of market illiquidity or credit crisis such as that experienced last autumn. In fact, using the US high yield bond market as a proxy, only once in the last 10 years has investors’ capital been at significant risk of loss on a total return basis (see fig 2). In the same way, we believe the high and consistent running yields on European high yield bonds could also provide excellent downside protection for investors’ capital – with considerable upside potential.
What are the risks?
Of course, high yield bonds incorporate a number of risks not normally found in EU government debt. Among the most important of these risks is that of credit-related losses.
Data from Standard & Poor’s show that over the last 10 years the default rate for non-investment grade corporate bonds worldwide has averaged approximately 4.3% per annum. However, during the last five years, the actual default rate has been considerably lower at around 2.7% per annum, due to the strong economic environment, declining interests rates, and easy access to equity and debt capital (see fig 3).
We should note, however, that these global default figures represent a broad definition of ‘default’, including not only the complete collapse of a company but also temporary delays in payments and breaches of other covenant provisions not related to payments. Also, these figures represent the percentage occurrence of default – not the default losses incurred by investors, which history has shown to be significantly lower.
It is also important to note that in the six year life of the European high yield bond market, there has been only one default – a UK telecommunications company named Ionica. There is no way of telling at this early stage what the default experience will be for European high yield – whether it will over time approach the experience in the US or whether there will prove to be a different credit and default paradigm in Europe.
We believe prudent investors in European high yield will be best served by designing a conservative investment philosophy – and sticking to it! - employing a team of experienced portfolio managers, who apply rigorous in-house credit, markets and equity research to this asset class, and monitor carefully all positions and holdings.
In this way, investors should be able to capture higher and consistent yields, diversify portfolio risks, and gain downside protection from the exciting, rapidly-growing asset class of European high yield bonds as we enter the brave investment world of the new millennium!
William Healey is director of spread markets research & head of European high yield bond products at Merrill Lynch Mercury Asset Management in London
Merrill Lynch Mercury Asset Management in London now manages a total of E125m in European high yield bond assets, making it one of the leading investors in this market in Europe. The team includes three dedicated portfolio managers with average experience of 10 years each backed by two full-time credit analysts. In addition, the team leverages Mercury’s extensive equity research group, which includes 71 analysts who cover most of the companies and industries represented in the European high yield bond market. Merrill Lynch Mercury has two ‘flagship’ funds investing in this market - one in euros and another in sterling.
The views expressed do not constitute investment or any other advice and are subject to change.

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