High yield has arrived in Europe and it's here to stay, says Bankers Trust
The advent of the single currency, the euro, will be the biggest event in the development of the European high yield bond market. At a stroke, one of the most important investment management decisions - what currency to buy and whether to hedge or not - will largely disappear from the European bond markets. Within a European context there will still be some limited opportunity to take currency risk against the euro (whether it be in sterling, drachma or Danish or Swedish krona); however the relative size of these trades will pale into insignificance compared to those against the yen and the US dollar. On a pan-European basis the ability to take distinguishing currency risk will almost completely have gone; there will only be credit as the main means of setting one's investment management track record apart from the competition.
It used to be said that if, as a fund manager, you got the currency right, nine times out of 10 you made money. However, one of the salutary lessons learned by investors who failed to spot the potential in convergence trades, was that there was money to be made from putting on the most basic of credit trades - involving both currencies and countries - into practice. As countries and their currencies approached economic and monetary union, the belief was that the weaker nations would be pulled up by the bootstraps by the stronger nations. If you foresaw Italy making a successful entry into the single currency with all its trappings (notably a central bank with a credible monetary policy), then it made a fair bet that Italy post-EMU would probably be a more palatable option than Italy pre-EMU. Italy, as a credit, saw its benchmark yield curve 'converge' towards that of Germany.
This was a credit trade at its most basic - using sovereign credits - and the skill and judgement used here do not differ from many of the credit trades already being put on in high yield corporate bonds today.
Before developing this theme much further it may be necessary to make one or two definitions and a distinction. The European high yield bond market is based solidly in and around the western European econ-omies; it encompasses small and medium sized companies, typically seeking longer dated fixed rate finance. Many of these companies may be new and growing rapidly and may not even be cash flow positive; many of the new telecoms carriers fall into this category. A few high yield bonds may come unrated where they are 'crossover' credits, ie sitting between investment grade and sub-investment grade; the vast majority though are rated sub-investment grade and carry 'BB' or 'B' ratings. They carry substantial coupons and on a cumulative basis can provide equity type returns for bond funds; in recent years it has been possible to create reasonably well-diversified portfolios giving compound annual returns in excess of 20% per annum.
The important distinction to make is that, though higher yielding, these assets are categorically not 'emerging market', which more typically take sovereign risk in the Far East, South America or Eastern Europe.
With currency considerations largely removed from the equation in Europe, investment managers will still need to perform. Any assessment of the impact of the single currency needs to focus on the 'prime movers' in this market, investment managers being just part of the picture, Issuers and intermediaries making up the balance. In a (relatively) low inflation and interest rate environment across Europe, achieving headline returns is more and more difficult to do; the desire for yield is growing as marketing men set higher target rates and out-performance of a benchmark gets harder to achieve. As the number and size of third party fund management organisations grows, so the competition for funds to manage will grow and with it the need to outperform.
Trustees of pension funds are coming under increased pressure to make sure that the assets they oversee at the very least perform creditably and that the relative maturity of the fund under management is adequately reflected in the returns generated.
In reality, EMU will be the catalyst for the high yield market. The key driver is the search for yield by European investors. The flow of funds into the market has pushed down and will continue to push down yields, making 'good returns' ever more difficult to achieve. The driver in the development of the market is the search for yield by European investors. EMU makes cross-border investing a real possibility and broadens peoples' minds to the possibilities, but it is not the underlying driver.
The single currency will enable fund managers to focus on the key credit considerations in any one transaction; in its purest form this can mean the comparison of one sovereign against another. At a deeper level this can mean the comparison of one corporate credit against another. This is by far and away the fastest expanding area of the fixed interest market in Europe at the moment. At its most elemental, this is basic corporate valuation (as is used daily in the analysis of equities and investment grade bonds)- the risks of which UK fund managers and trustees are already very familiar with - it is just that the analysis is being applied to the bond markets. Using basic tools of credit analysis and cashflow forecasting, UK and European fund managers can already compare a Swiss sanitary-ware maker with one of Britain's leading bookmakers ; they can compare a UK chain of book and music retailers with a Belgium-based chemicals company or a European telecoms company. Investors can compare all of these with a whole raft of new and growing Western European telecoms carriers, already financed in the high yield bond market in Europe.
In this new corporate credit market, the point is that where currency takes any part in this decision-making process, it already takes a relatively small part. Come the single currency, that consideration will almost entirely disappear.
There is a slightly more subtle point here and that is from a borrower's perspective: not having to factor in swap cost or depth of market issues opens the market up even further because of the ease (the speed and cost) with which money can be raised. One further point is that in a single currency area, it is not just the currency base that is broader but the investor base as well.
We can already see the development of a virtuous circle. Increasing numbers of issuers are realising the benefits of having a medium-to-long-term fixed rate piece of debt on their balance sheet. For many European companies, this part of the capital structure simply hasn't been made available to them and typically they have had to rely on bank debt or private equity. Where the private equity has dried up and a public quote has been deemed to be undesirable or too costly, the local banks themselves have historically stepped up to provide equity-type finance. Currently, approximately 70% of all financial assets in Italy, Spain, Germany and France are in the form of bank loans; in the US, this figure is only 22%, though one has to allow for substantially different corporate structures across these countries. Furthermore, issuers simply seeking refinancing are not just the only borrowers in this market - LBOs and MBOs, start-ups, high growth companies and acquisitive companies are all types of borrowers tapping this market and set to tap much more in the future.
On the other hand investors, ever hungry for yield and equipped (now) with the analytical tools necessary to assess these credits and the industries or sectors in which they are operating, are increasingly keen to lend money. Using the word 'lend' may sound slightly antiquated, but in essence that is all that bond fund managers are doing when they invest cash; in many ways they are simply replacing regional banks by lending in this manner. Interestingly, with the in-volvement of the big international investment banks as lead managers of many of these bond issues, the process of disintermediation is likely to strike further and harder amongst European regional banks than it has done already.
Any discussion of the European high yield corporate bond market and its prospects under the single currency inevitably draws on comparisons with the US. One of the biggest factors in facilitating the 'Junk' market in the 1980s was the US dollar. This is now a flourishing high yield bond market: approximately $125bn of sub-investment grade debt was issued in the US in 1997 taking the market through the $300bn mark; 1998 to-date issuance of $90bn moves the total nearer to $400bn. The fact that the US had one currency and not a variety of currencies all pulling in different directions was of fundamental significance. The US also had 250m people operating in a free market economy the like and size of which did not exist anywhere else in the world - until n ow. Economic and monetary union (still incorrectly called 'European' monetary union by some market participants) will leave a single currency area with a similar sized population of 260m and Euro5.5trn in GDP. (compared to US GDP of Euro5.8trn).
Perhaps the most interesting point to make is that, broadly speaking, the United States of Europe is demographically the same now as the US was in 1990. Europe's baby-boom happened approximately 10 years after that in the US. Just as the baby-boomers in the US were starting work in the 1960s and then piling into savings and savings products 20 years later, so Europe, about a decade later, will see an enormous rise in the demand for private sector financial products.
The explosive growth in long term investment via mutual funds, pension funds and savings plans in the US in the late 1980s and 1990s speaks for itself. If we factor in the likely difficulties facing European governments and their provision of state funded retirement schemes in the next 30 years, the direction seems clear for Europe. The drive towards higher levels of personal saving and self-provision for the future is going to be largely government-led .
It would be difficult to quantify just how big an impact the single currency will have on the high yield market in Europe; already the market has a good head of steam. From a market size of no more than $2bn by the end of 1996, this had probably grown to about $5bn by the end of 1997 and is approaching double that by the end of the first half of 1998. As the knowledge gap on behalf of investors and the information gap on behalf of issuers both narrow, so the gap between the two groups gets smaller as well. A close examination of the graph at the top of the page will reveal a vast array of credits already available in this market ahead of 1999; that list is set to grow far longer by year-end and far broader in the years ahead.
The key effects of the single currency include lower government bond yields and the disintermediation of banks as already mentioned. The development of a homogenous market is perhaps the most critical of all; credit analysis is already conducted on a pan-European basis and will be more so in the future under a single currency: comparison of credit in Europe will be cross-border and cross-market. The search for yield will lead to more issuance and more investor choice, made more possible by EMU. With choice comes the ability to diversify and with that come more and more market participants. With them comes liquidity, perhaps the key indicator of the maturity of any market. There are already pockets of liquidity, by sector and by bond issue; the Single Currency can only help in that regard.
Whilst the euro will be a big factor in the development of this market, it does highlight shortcomings elsewhere on the pan-European playing field and in economic and monetary union. Insolvency law and the lack of global or pan-European accounting standards are areas where reform or revision would be greatly beneficial to all market participants, both present and intended. The level of due diligence on behalf of both underwriters and investors is enormous and the provision of timely, accurate and comprehensible information, consistently and concisely presented, would be an enormous fillip to the market.
The single currency will force fund managers to re-appraise their asset allocation. The disappearance of multi-currency bonds (at least in Europe) and the arrival of a whole new higher-yielding fixed interest asset class will mean many senior fixed income fund managers face the prospect of having to learn credit as a new discipline. Indeed it is not too difficult to envisage a time when analysts and fund managers progress on to corporate credit after cutting their teeth in the government bond markets around the world.
As Europe moves towards a unified market, the impact of the euro on this particular asset class - the European high yield bond market - cannot be underestimated.It will make the raising of capital a cheaper, simpler and more efficient process for Europe's small and medium sized companies. It will also open up a whole universe of corporate credits that investment managers are increasingly ready, willing and able to invest in. Just as the US dollar proved to be a major, albeit implicit, prop in the long-run development of a US market, so the euro will prove to be a major factor in the development of the European version of a high yield corporate bond market.
For further information contact Sean Hunt, who is vice president, European high yield distribution at BTAlex.Brown International in London