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Credit: Signs of exuberance

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More high yield, more security, more hybrids. Joseph Mariathasan surveys the changing European credit markets and asks, are they changing for better or worse?

There is a feeling of déjà vu pervading credit markets. A flood of oversubscribed new issues in both high-yield and investment-grade bonds has led to looser covenants and tighter spreads.

“Credit markets go through cycles,” as Gaurav Chatley, portfolio manager at M&G Investments, puts it. “What we are going through now is reminiscent of what we lived through seven or eight years ago when credit spreads were extremely low in the high-grade market.”

But in other ways, the world looks very different. “Post-Lehman, the market changed – and what borrowers are doing has changed,” says Martin Horne a managing director at Babson Capital Europe.

A driving factor behind post-Lehman developments is the fact that capital markets have been effectively closed twice during this period – in the immediate aftermath, and again in summer 2011. That exposed the risk in the pre-crisis practice of relying on single sources of capital – whether US loans or European bonds – and pushed issuers, particularly large multi-nationals, to diversify their sources of funds.

“Both those events made treasurers and finance directors far more aware of the need to source capital from multiple areas to give them the opportunity to tap different pricing points as they come along, and to make sure they have access to capital when they need it,” says Horne. “So now we get companies issuing fixed and floating loans and bonds next to each other, and US and Europe issuance, none of which we saw in significant volume pre-Lehman. It is all about diversification, driven to a great extent by banks not being able to lend so freely.”

But it is not only global US companies like Microsoft, Caterpillar and Procter & Gamble issuing in euros and sterling. Even purely domestic US companies such as the cable operator DTV, which issued in sterling, have sought finance in Europe.

“They do this for two reasons,” says Chatley. “Firstly, it gives them diversification and insurance in case the US debt markets close down again – and the spread [investors] would need for a second sterling issue is lower than for a first-time issue. Secondly, they may want to expand in Europe. In neither case is it really price driven.”

Add to this the fact that European companies are now able to source more of their financing from their own capital markets before heading across the Atlantic, and that larger corporates in the euro-zone periphery that typically relied on bank finance are now also turning more and more to the capital markets, and a picture builds of companies scrambling to borrow from investors who are scrambling to lend.

But that picture, too, might be misleading if one takes it to resemble 2006-07. Now many issuers are choosing to come to the bond markets, whereas before issuers of senior high yield, for example, did so because they were unable to get bank financing or were looking for specific project finance.

Particularly in the immediate aftermath of the financial crisis, these quality new issuers were offering great spreads and very favourable covenants. Moreover, they continued the practice of offering security that they brought with them from the bank loan market. Europe’s high-yield bond market, excluding financials, has grown from less than 200 issues worth about €100bn in 2009 to 400 issues worth €200bn – and 40% of issuance in 2012 was senior secured. The share in the US last year was more like 25%.

“The cinema operator Odeon, for example, historically went to the loan market when it wanted funding, but in the first half of 2011 it actually issued senior secured bonds,” says Kam Tugnait, managing director at Babson Capital Europe. “We have companies like Priory Healthcare issuing both senior secured and unsecured bonds. These are well-known issuers who would have previously gone to the loan market for funding.”
David Newman, head of global high yield at Rogge Global Partners, sees structural changes that have benefited bondholders.

“In some cases, bondholders are now being treated close to pari passu with banks – ‘one dollar one vote’ – and they have access to the inter-creditor agreements,” he says, “although that has led to recent bond prospectus, like that of French catering services firm Elior, being 500 pages long.”

However, he also warns that in many cases bondholders are senior-structured in name only, and points to some slippage occurring in the core covenants. He identifies four of these: restricted payments, which limit the cash that can be sent upstream to holding companies; minimum interest cover; change-of-control clauses, which stipulate that bonds can be put back at a price of 101 at the bondholders’ request in the event of a takeover; and the make-whole provision if bonds are called early.

“What has already happened is a slippage in the latter, with borrowers able to call back 5-10% of bonds at a set price,” he says. “That reduces the potential upside for investors. Portability has also been introduced to the change-of-control covenant – if a company is taken over but leverage remains below a certain level, then it would not trigger the option. Banks have taken away the upside on behalf of the sponsors.”

Still, while the huge appetite for debt was almost inevitably going to affect the quality of covenants in high yield, these slippages are nothing like what was accepted during the boom-time excesses. “We are now at the stage of perhaps 2003 or 2004,” reckons Chatley. “There has been a loosening of bond holder protection, but not to the levels seen in 2006-07.”

So much for overall credit quality. At the sector level, the two credit cycles look very different indeed.

A decade ago, European debt issuance was dominated by financials at a ratio of two-to-one. In 2012, net financial debt issuance became negative to the tune of €202bn, while net non-financial debt issuance was still running at €92bn. Banks have been de-leveraging, and have sucked up cheap financing from central banks, rather than tapping capital markets. By contrast, non-financials have been taking advantage of falling yields and meeting other, more specific pressures, such as utility companies seeking finance for the capex associated with requirements arising from climate change considerations.

And where banks are issuing, the de-leveraging cycle is changing the nature of that issuance. Hybrid debt – lower rated paper from mostly investment-grade issuers which has riskier, equity characteristics – has suddenly become a big and important part of the market.

It has been issued by a range of corporates such as RWE, KPN, Tele Austria, EDF, National Grid and Tele Italia as well as insurance companies such as AXA, Generali, and Zurich, and is often seen as the one way to get decent spreads from super-safe trophy issuers – but the real movement has been from the banks.

Absent for some time after the financial crisis, as balance sheets have been repaired and the regulatory environment has become clearer with the implementation of CRD4/Basel III, banks have returned to the hybrid-debt market. Regulators are particularly open to banks issuing contingent convertible securities (CoCos), which may be written off or converted to equity should a capital-deficiency trigger be breached. In return, investors have been rewarded with yields of 6-8% from recent transactions, such as Barclays’ April $1bn issue in April 2013.

“This is seen as attractive for some bond investors, but they are taking on equity-type risk and could lose their capital even if the company is not bankrupt,” warns Steve Sahara, the former head of hybrids at Credit Agricole CIB. “The demand for hybrid regulatory capital may be healthy for the financial system, but we have all seen periods in the past where there has been a surge in the volume of issuance at ever tighter spreads fuelled by bull market sentiment that eventually collapses.

“Since hybrids are high beta, they also exhibit high downside potential and additional liquidity risk if there is no bid from the Street for such capital intensive inventory when a sell-off occurs,” Sahara concludes.

For those looking for reasons to be sceptical, the hot market in hybrids is yet another warning sign. “Investors are not thinking about it, and banks are using a hot market to come up with structures that are bad for investors,” as Newman puts it.

In 2006-07, it was the CDO-squared at tight spreads. Today, it is slowly-loosening covenants and hybrids at tight spreads. Investors may feel more comfortable that the risks are more transparent this time around – but that doesn’t necessarily mean that they are being properly compensated.
“We may not see the launch of CDO-squared and those kinds of crazy deals,” as Chatley puts it. “But you can never say never as the hunger for yield drives investors to riskier or exotic structures.”

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