Watching the mighty fall
“High Yield Walloped Treasuries” – the headline on a recent Merrill Lynch research paper describing the huge outperformance enjoyed by the US High Yield sector over 10-year US Treasury bonds during the month of March. Sadly for the European counterpart, there have been no such headlines over here. In fact this year has already begun badly, continuing an 18-month long story of turbulence and anguish.
Pictet launched their Euro High Yield Bond Fund back in September 2001 and, according to fund manager Guillaume Bucaille in Geneva, it has been a baptism of fire, flood, pestilence and plague. “After the attack on the US on September 11th and the high volatility in stock markets, our market was then hit by the bursting of its TMT bubble, which caused havoc and severely damaged investor sentiment.”
Bucaille is referring to the financial woes of the likes of Energis and NTL, both big names in the telecoms and cable sector. He explains, “After recovering in the last two months of 2001, the market was badly hit by the news that Energis couldn’t meet financial covenants that had been agreed less than a month before and would thus be going into voluntary default. Bearing in mind that the telecom and cable sector still accounted for almost 40% of the European high yield universe, when these two issuers took a bath they dragged down even the best names in the sector. And it is obviously very frustrating to see the positions held in better names with clear shareholder support being massively repriced because of big lame ducks. But that is part of the perils of the European high yield sector, as there is just not yet the depth of credit expertise and market liquidity for the wheat to be separated from the chaff.”
Eighteen months of pain, is how London-based New Flag’s Anthony Robertson describes the European high yield market. “But the TMT shakeout is good news. At the height of the bull market bubble, TMT represented 65% of Europe’s high yield index which was utterly unsustainable and had to change,” he comments. “Some debt securities had no right to be issued, as in effect they were equities dressed up as debt, but in the euphoria of the bull market they got away with it. Investor hopes were unrealistically high when this market was getting underway. It is not unnatural for any new body to experience growing pains, although it is fair to say that this one has suffered more than most.”
Both high yield managers are agreed that the demise of the TMT sector’s overbearing domination of Europe’s fledgling high yield market must be seen as good news for investors. “High yield TMT bonds in the US have also suffered huge losses, but because that market at around $750bn is over 10 times the size of our market, it can withstand the shocks. Today we are seeing a much better diversity of industries represented,” argues Robertson.
“To have the likes of NTL, or UPC ejected from the universe – companies whose issues added up to as much as 7% of the index – creates a unique opportunity for a positive ‘rebalancing’ of the high yield universe in Europe,” adds Bucaille. “It is happening via the ‘fallen angels’ and new issues from industrial names in the chemicals, autos, and packaging sectors.” He suggests that the new issues coming to the market have a more competitive structure than their predecessors during 1998-2000. They are also much leaner and meaner than many of their investment grade competitors, and thus have a greater upside potential on their operating margins as western economies rebound from the poor performance of 2001.
‘Fallen angels’ are companies whose debt used to be investment grade but who have suffered downgrades into the sub-investment grade categories, and their arrival in the high yield market is welcomed by many. “Former investment grade fallen angels have swollen the ranks of ‘BB’-rated securities and the domination of single ‘B’ issues has waned which has benefited diversification,” says New Flag.
Looking forward, Bucaille remains undaunted by the last bruising 18 months, and is enthusiastic about his market. “We have had two years of bull market in government bonds, and it seems unlikely that equity markets will offer double digit returns. Yields are historically very high. We know they are high because they are pricing existing rates of default but we expect fewer names to go bankrupt than their credit ratings are suggesting. We believe that, as telecom and cable names disappear, the default rate in Europe is going to slow down markedly. With risks coming down, I think we should excpect low double digit returns in 2002.’
Robertson is similarly positive, arguing that the economic conditions of low growth are pretty much ideal for high yield. He also highlights the fact that the M & A calendar is re-establishing itself, and for the first time there are four deals in the pipeline over the next weeks. “There is also the prospect of better quality names coming to the IPO market. High yield IPO candidates have been few and far between in recent years in Europe and to now have four or five in the offing is very encouraging indeed.”