High-yield Bonds & Loans: Revolution from above and below
Few markets outside the emerging world have changed to the extent that European high-yield has over recent years. Joseph Mariathasan and Martin Steward find transformation coming from the massive to the micro, from above and below
The European high-yield market has come to play an increasingly important role for issuers, investors and the European economy as a whole since the financial crisis. Outstanding debt has grown from around €100bn in 2007 to well over €300bn today, and the number of investable credits has doubled in the past five years as many smaller issuers have come to the market for the first time.
There have also been dramatic changes in both the credit composition of the market and the sector composition. A market once dominated by the telecoms sector, which alone accounted for 57% in 1998, has matured into a much more diverse investment class, with telecoms and cable together now accounting for just 26% and autos and other industrials, the other major source of issuance, accounting for the same again.
“Idiosyncratic risks aside, one benefit to the convergence of bond and loan markets in Europe is that, with the surge in the number of issuers into the high-yield market, we now have many more names and risk profiles to choose from,” observes Mitch Reznick, co-head of credit at Hermes Fund Managers. “It also means that sectors such as retail, consumer, gaming, for example, have really filled out, allowing investors to more precisely look at relative value within a sector. There are even enough French retailers having issued bonds that it’s almost like its own sub-sector now. Healthcare and services have seen the same thing: services used to be just ISS out of Denmark and maybe one or two others, but now we have a plethora of names in that and other sectors.”
And the story of change goes further still. Prior to the financial crisis, European high-yield was dominated by single-B issuance, which accounted for over 50% of the market, whereas today, 62% is BB and only 30% is single-B. This is not a story of better-quality companies issuing debt for the first time, but of sovereign and related corporate downgrades that have pushed huge swathes of once investment grade borrowers into high-yield – the so-called ‘fallen angels’. The huge growth of the European high-yield market has been a combination of the impact of a small number of large fallen angels, and a large number of smaller new issuers.
At a glance
• A combination of a lot of small new issuers and a few big ‘fallen angels’ has brought profound change in the size, composition and diversity of the European high-yield market.
• Fallen angels have temporarily boosted credit ratings in Europe relative to the US, and reduced the market’s diversification benefits – but the longer-term trend is for new issuance to bring the average rating down.
• Smaller borrowers, peripheral euro-zone borrowers, and borrowers refinancing bank loans in the bond market look set to change the face of European high yield.
Fallen angels can, of course, present great opportunities for high-yield portfolio managers, as their more constrained investment-grade brethren and investment banks keeping an eye on their regulatory capital charges become forced sellers.
“A company is a fallen angel for a reason,” says Wei Romualdo, portfolio manager at Stone Harbor Investment Partners. “Their operating performance may be deteriorating and you have to judge whether they will continue to fall and how that fits into the valuation. Companies could also be subject to positive-event risk, like Lafarge which is in merger talks with the Swiss company Holcim, which would result in its debt becoming investment grade, with a corresponding reduction in spreads.”
Darrin Smith, fund manager at Principal Global Investors, is also keen on some of these names. “We don’t like Telecom Italia, but we do like others like ArcelorMittal, for example,” he says. “It had been investment grade but dropped down to high-yield, following the financial crisis. Such names have a passion to clean up their balance sheet and get back to investment grade. When they do move back to investment grade, they typically have quite a bit of spread compression.”
But as well as presenting opportunities, the sheer size of some fallen angels can cause headaches by distorting the sector composition of high-yield indices at a stroke. Kevin Corrigan, head of credit at Lombard Odier Investment Managers, estimates that the 10 largest bonds in the high-yield universe now account for 43% of the overall spread – even once financials are stripped out.
“There has never been so much idiosyncratic risk and at the same time so much concentration. That will come back to bite you,” he warns. “This happened in 2005 when General Motors and Ford were on their way to bankruptcy and there was an incredible amount of hand-wringing over what would happen when such enormous borrowers fell into a small market. There have been similar worries with Telecom Italia and its €26bn of debt. Investors tracking indices can get log-jammed into such debt – so they get more BB, but not because the rating quality of new issuers has improved.”
Downgrades in the telecoms sector during the last year, such as those of Portugal Telecom and Telecom Italia, increased the telecoms weighting in the high-yield index from 7% to 10%. The first half of 2014 also saw €10bn of new debt from the French cable company Altice Numericable to help finance the acquisition of Vivendi’s mobile unit, SFR, which was the largest European high-yield issuance to date.
Banks has been another, even more problematic sector crashing the high-yield party since 2008. Applying accounting and regulatory principles to balance sheets that bear little resemblance to that of the average corporate borrower, tends to get high-yield portfolio managers scratching their heads.
“With the financial crisis they fell into the index in a very significant and dramatic way,” says Romualdo. “At one point they were over 30% of the market. Bank debt is predominantly distressed paper or else perpetuals that form part of their risk capital, which is a fairly specialised group of instruments. Anecdotally, many fund managers are not including them in their portfolios at all and have switched their benchmarks from overall benchmarks to ones that exclude financials.”
Finally, because fallen angels tend to trade on their spread, and therefore follow government bonds much more closely than the genuine high-yield issuers that trade on price more like equities, they have caused the high-yield asset class to correlate closely with investment-grade, reducing its diversification benefits.
“Should you include split-rated borrowers? Should you include loans?” asks Corrigan. “These are dilemmas a lot of investors face as a result of the compositional changes in the high-yield market which has led to a convergence with investment grade.”
But while fallen angels are a big theme today, the future development of Europe’s market will be influenced by quite different factors. As Garland Hansmann, portfolio manager at Intermediate Capital Group (ICG) points out, the phenomenon of fallen angels has largely disappeared and, if anything, will turn around as rising stars move from high-yield to investment grade. The average credit rating in the European market is higher than that of the US – BB represents 61% of Europe’s index and just 41% in the US – but that is changing, as new issuance in the US tends to be evenly spread between credit ratings, whereas single-B and even CCC have been on the rise over the past couple of years in Europe. Adding to this effect is the fact that there has been little increase in the number US companies issuing into this growing European market, tilting it ever more decisively towards domestic borrowers.
Part of this has been due to a notable increase in high-yield bond issuance by companies domiciled in peripheral Europe.
“In the two-year period from 30 June 2012 to 30 June 2014, issuance by Italian companies increased from 10% [of the market] to 14%, and issuance by Spanish companies increased from 4% to 7%,” says Romualdo. “Issuance by French companies also increased, from 11% to 16%, but in contrast, issuance by Nordics diminished a lot as their domestic markets opened up.”
Some of the peripheral-Europe expansion has come from fallen angels like Telecom Italia, which now accounts for 4.5% of the index, but Wind Telecom, also Italian, has been a big issuer since the financial crisis – and this development is also part of the broader story of the influx of many smaller issuers, which have been turning to bonds as a result of the disintermediation banks from large section of Europe’s lending markets.
“The European market is becoming more like the US,” says Smith. “Over the past decade, European companies were borrowing through the bank loan market. But the banking regulatory environment in the form of Basel III is encouraging corporate borrowings to be undertaken through syndicated underwriting deals or high-yield senior unsecured transactions. This is increasing the size of the high-yield market and giving investors more names to choose from that would have been borrowing through leveraged loans in the past.”
Hansmann notes that the German Mittelstand and similar companies in the UK and France have become more comfortable about using the European high-yield market for debt finance rather than the banks. This marks a significant change as in the past there was stigma attached to mid-sized companies that had to issue bonds after failing to secure bank lending.
“The outstanding amounts could be as low as €500m and quite a few fall into the range €300-500m,” says Hansmann. “We love this market and what really helps us is the convergence of the high-yield and loan markets: we already know many of the new high-yield names from the loan market.”
Reznick at Hermes agrees. “If you are flexible you can look at these new issues and say, ‘No thanks’ if the value structure is not there, or take advantage where you see opportunities,” he says. “But flexibility – around geography, around credit rating, around whether it’s a bond or a loan or CDS – is essential in these new credit markets so that you are not compelled to invest in any one specific area.”
Just as Europe’s high-yield markets are evolving, so the strategies and capabilities of European portfolio managers must change with it. The combination of a few enormous credits and many much smaller ones churning in and out of the market will create concentration and liquidity problems for benchmark-focused managers with large asset inflows and outflows. However, for smaller managers and those with less constrained mandates – and especially expertise in both loans and bonds – some competitive advantages could begin to tell significantly, in terms of relative performance, over the coming years.