Europe’s high yield bond market is stable, well-functioning, with a wide base of issuers and credit quality as good as ever. Pricing is so tight investors are smarting. There is one problem: not enough issuance.
The market enjoyed six years of continuous growth in Europe’s crisis years of 2009 to 2014, breaching its pre-crisis record as early as 2010. It has grown to be about 45% as big as the US market, by annual issuance. That was driven partly by companies and private equity firms turning to the bonds as a readier source of funds than the stressed banking sector.
But in the last couple of years this growth has gone into reverse. In 2015, issuance fell 16% from its 2014 peak of €117bn, according to Dealogic, and last year it contracted by another quarter, to €75bn.
High yield investors and bankers agree that there is one principal cause: banks, now restored to health, and leveraged loan investors, are eating their lunch.
“There’s a substitution effect taking place, with single-B leveraged loans up and bonds down,” says Colm D’Rosario, senior portfolio manager, high yield, at Pioneer Investments in London, which has a high yield credit portfolio of $27.5bn. “Loan investors have been willing to accept lower yields and take weaker covenants. This time last year, 45% were covenant-lite, and now it’s in the high 60s.”
Fixed income investors have tried to stay strong about bond terms in the face of an increasingly attractive loan market.
“While more issuer-friendly [i.e. weaker] call protection would make bonds more competitive with term loans, it is considered sacrosanct for most HY investors,” says a syndicate banker. “They need the upside that call protection provides in a performing credit for taking on the risk in the first place.”
One of the biggest benefits of bonds over loans, for issuers and investors, remains the long maturities they can offer. Debt longer than five years is still widely unavailable from the loan market at palatable interest rates, except in one-off instances where relationship banks are sweetening a deal for a prized client.
In the bond market, eight year money and sometimes longer tenors can readily be obtained — often at very low yields. “A yield of 3% or below can be achieved for double-B issuers in high yield,” says the banker. “It’s hard for loans to do that for any meaningful size.”
Price tussle
High yield investors are not happy about where pricing has headed, thanks to the European Central Bank’s special refinancing operations and quantitative easing including its Corporate Sector Purchase Programme, which has flooded the corporate bond market with demand.
“When looking at low absolute yields, there probably is a floor where the yield should go,” says D’Rosario. “The problem is central bank action has made the floor a moving target.”
Since CSPP started in June 2016, the spread between single-B and double-B credits has been around 150bp to 250bp, “which is about right,” says D’Rosario.
The problem for investors is that the spread has remained in that corridor even while double-B spreads have tightened and benchmark yields have fallen, creating eye-wateringly low single-B yields.
“Talking inside 5% yield for many single-B bonds would be tough,” says D’Rosario. “We are being more cautious in general in the portfolio as we try to avoid risks that we aren’t being paid for.”
But there are signs that high yield investors are giving up, inch by inch, what were once considered absolute certainties of the market.
“Changes in bond terms over the past 12-18 months have favoured issuers,” says Michael Masters, managing director, leveraged finance syndicate, at Barclays in London. “We are in a world that has excess liquidity and the hunt for assets is competitive throughout the capital structure.”
Refugees from the ECB-warped investment grade market have headed to junk bonds in search of yield.
“Investors that like the low investment grade space may have been squeezed out by the excess liquidity supplied by the central banks, encouraging them to move into the double-B space,” says Masters.
This has pushed yields down even further at the most creditworthy end of the European high yield market. “The high yield index, which is heavily weighted towards double-B and is yielding around 2.4%, is at near-record lows,” says Masters.
Investor momentum into double-B has trickled through the ratings spectrum, leaving the single-B index offering a yield of about 3.6%, also near historic lows.
But this is still not cheap enough for borrowers to favour bonds over leveraged loans. Loans for single-B issuers can be signed at around 375bp, give or take 25bp, over three month Euribor. That rate is now -0.33%, and on the tightest priced loans it is floored at 0%, meaning the borrower only has to pay the margin. Loans are generally signing at, or close to, par and without call premiums.
Bond investors will find it hard to get issuers to pay higher yields or offer more covenants, as by many yardsticks, European high yield firms are in rude health.
The default rate for high yield borrowers in Europe fell from 3.4% in 2015 to a historic low of 2.1% in 2016 and is expected to stay around this level through 2017, according to Amundi Asset Management.
This is possible even though euro area GDP growth is only set to reach 1.6% in 2017 and 1.8% in 2018, according to the European Commission, as the low growth is offset by cheap debt. This means borrowers can continue coasting at low growth rates and not miss debt payments.
“The European high yield sector has been stable and had low defaults in a low growth environment,” says Shilen Shah, bond strategist at Investec Wealth & Investment in London. “They do not seem to be as geared as in the US market.”
The rise in European bourses and lack of share buybacks has also strengthened the hand of Europe’s high yield investors.
“We have not seen debt-to-equity ratios come under strain in Europe, and European corporates have not been as equity-friendly as their US peers,” says Shah. “They are in quite a good place.”
The first test of whether investors can lure issuance back from bank finance will come this year, when a swathe of callable single-B bonds are due to be refinanced.
“A decent chunk of bonds are callable, with 35% callable in 2017, and 80% of those are single-B,” says D’Rosario. “So the trend could reverse if we saw a flurry of issuance refinancing those bonds in the high yield market.”
But there is no guarantee that issuers will refinance like with like. “It is hard to know now whether they will go to levloans or bonds and on what terms,” he says.
Show me the yield
In the hunt for returns in a world working under massive central bank intervention, investors have two main choices — go further down the credit curve, or take on ever more maturity risk.
Taking more duration is becoming riskier, as the ECB has said it will only continue its €60bn-a-month bond purchases
until December, when a more aggressive tapering is expected. This is likely to make yield curves steepen, meaning investors that lock in higher yields at long duration will face mark-to-market losses.
“When we see some of the technical support from central banks being reduced, that will have a widening effect,” says D’Rosario. “Investors are reluctant to go too long risk because of this.”
That means investors will have to head down the credit curve in search of higher returns. “We haven’t seen a lot of triple-C paper,” says Masters at Barclays, who reckons there would be supply at that credit level. “If your high yield portfolio is heavily weighted toward double-B and yielding in the mid-2s, you may want to add some higher risk/higher return paper.” l
