Dire straits

In the first six months of this year, just $2 billion in new European high-yield deals were priced, down some 60 percent from last year, an anemic showing that pretty much assures that 2002 will be the slowest since the market got under way in 1997.

As recently as a year ago, European high-yield bond investors and underwriters were still talking about the good times ahead. The prospect of more mergers and buyout deals, less stringent competition from bank lenders and a general corporate embrace of leverage were all expected to boost annual high-yield issuance sharply -- possibly rivaling volume in the older, more established U.S. market within a few years.

So much for the future.

In the first six months of this year, just $2 billion in new European high-yield deals were priced, down some 60 percent from last year, an anemic showing that pretty much assures that 2002 will be the slowest since the market got under way in 1997. Worse, 2002 will also be the third successive annual decline from 1999’s $18 billion peak. By contrast, in the mature U.S. market $41 billion in offerings were priced despite the rash of corporate scandals and record numbers of defaults and downgradings.

Matters are so bad that Tyco International’s June slide to non-investment-grade meant that about 25 percent of some leading European high-yield indexes (which have been borrowing U.S. names to help enlarge and diversify thin local benchmarks) are now composed of the debt of the Bermuda-based company, whose recently deposed chairman is under indictment in the U.S. In July troubled French telecommunications equipment maker Alcatel followed Tyco into the junk realm. Its debt now constitutes more than 10 percent of the indexes -- equally unnerving. That means index-based European high-yield investors’ future performance will depend on whether Tyco and Alcatel can right themselves.

Closely tied to the deal drought is the massive hit taken by telecom and cable companies, whose debt made up 65 percent of the market just two years ago. Since then half of that debt has gone into default. Companies like Bermuda-based Flag Telecom Holdings, Britain’s NTL Group and the U.S.'s WorldCom have all failed to meet their obligations. Meanwhile, market forces are taking an ax to outstanding asset values: Through midyear Merrill Lynch & Co.'s global high-yield European issuers index had posted a 12.62 percent return, far worse than last year’s 6.9 percent drop. The last time investors had anything to smile about was in 1999, when they took home 9.72 percent returns.


“It’s worse than the beginning of the market in 1998 because at least in the beginning there was hope,” says Joe Biernat, head of investment research at asset manager European Credit Management in London. “Quite frankly, it could be a number of years before the market can develop to become a real market.”

Also frowning are many of the big investment banks, especially U.S. firms that staffed up in anticipation of a telecom-led boom in Europe. Underwriting fees make up as much as 85 percent of a firm’s high-yield revenue. With so little new issuance, they cannot cover their expensive overhead. Like a number of firms, Merrill Lynch has folded its high-yield group in with the rest of fixed income, letting go several people from its 28-person staff in the process. The department’s well-known head of European high-yield research, Frank Knowles, took early retirement in May. Goldman, Sachs & Co. officials confirm it has reduced the high-yield group head count to 30 from more than 40 a year ago, and Varkki Chacko, Goldman’s global credit strategist, who spent much of his time on high yield, left the firm in May without a new job. Société Générale let five professionals go last year, when it merged high yield into fixed income. The firm later jettisoned its three remaining high-yield specialists. And ABN Amro, which attached high yield to its leveraged finance group, dropped as many as a dozen staffers in 2001, according to sources outside the firm.

Perhaps most troubling is that investors, starved for deals, have pretty much abandoned their fight for the longer-term protections that the market needs to succeed. “There’s been a food fight over the few deals issued,” says an investor. “If you get 5 million bonds in an allocation, it’s a home run -- it’s that bad.”

To get even those morsels, investors have had to take lesser terms: just three years of call protection (versus the traditional five-year minimum) and virtually no bargaining rights in a bankruptcy proceeding -- all of which makes their investments that much riskier. European investors are “nuts” to accept such threadbare terms and risk being marginalized by stronger market participants, such as LBO sponsors and bank lenders, says a U.S.-based high-yield professional.

Not that European CFOs and CEOs, still comfortable with bank loan pricing, are in any rush to take advantage. Only 11 new issues have come to market this year. “Many European boards still associate a non-investment-grade rating with a one-way ticket to bankruptcy,” says Tim Flynn, head of European high-yield capital markets at Goldman Sachs International in London. “This perception has been exacerbated recently with Marconi, Enron and others in the headlines.”

Despite the headaches, market participants by and large believe that they are going through a painful stage in the market’s maturation. They see hope, for example, in the recent influx of fallen angels, companies like Tyco whose credit ratings have plunged from investment- to non-investment-grade. Since the beginning of the year, U.K. diversified manufacturing group Invensys and two U.S. issuers with big European operations, paper producer Fort James Corp. and chemicals maker Solutia, among others, have all “crossed over” to junk. A year ago fallen angels’ debt made up just 8 percent of the market. Now it comprises about half of the $35 billion marketplace. By year-end an additional $6 billion to $10 billion of fallen angels’ debt could arrive in the market.

FOR DEALERS THEIR ARRIVAL IS A GODSEND, providing liquidity and ample trading opportunities. It’s not uncommon for a fallen angel’s bond price to plunge 20 to 50 points on entering junk status and then whipsaw higher on any whiff of recovery. “In the trading business the opportunities have shifted,” says Thomas Connolly, group head of European high yield at Goldman. One high-yield professional puts it more bluntly: “If you lost money trading -- well then, you lost money in the last year because there were so few other opportunities.”

The onetime investment-grade companies offer the prospect of a deeper, more diversified high-yield marketplace. Some traditional investment-grade buyers, familiar with many of these credits, have begun to chase them down the credit curve. The phenomenon reminds Anton Simon, chief investment officer at the European high-yield fund New Flag Asset Management, which was purchased by Putnam Investments last month, of the U.S. market a decade ago. Then, new kinds of investors sought the higher yields available among troubled junk bond issuers.

“In Europe, just as in the U.S., the investment-grade funds that have been crossing over and down the credit spectrum are becoming addicted to the yield that lower investment grade can offer,” says Simon. “Once they get the triple-B taste in their mouth, that tells you what’s going to happen next. The European high-yield market will be broadened by investors coming south, first to lower investment-grade and then to high yield as securities are downgraded.”

Because they weren’t originally junk bond issuers, the fallen angels also don’t include structural subordination clauses in their bonds and therefore offer at least some prospect of recovery in a bankruptcy. U.K. cable operator Marconi, for example, was downgraded to junk last September, and its bank loans don’t have any seniority to the company’s bonds.

Perhaps most important, fallen angels like Invensys and Tyco offer the market an opportunity to diversify away from overleveraged telecom and cable companies and into a broader array of industries. The telecom and cable companies’ market share has dropped from nearly two thirds two years ago to about half that today. Other sectors, such as industrials and consumer products, are about the same size as telecom.

What’s more, some of these onetime blue chips are large, viable businesses that have decent prospects for recovery. “From one perspective there are stressed names like Xerox Corp. and the Gap, where problems could be solved in time,” says William Healey, head of European high-yield portfolio management at Merrill Lynch Investment Managers, whose E1.2 billion ($1.2 billion) in junk assets is among the largest in Europe. “These are names representing the highest quality of the high-yield market, so if you want to upgrade your portfolio, fallen angels represent a chance to diversify.” They ultimately will supplement issuers like William Hill, HMV Group and Yell, lower-rated companies that have performed well for investors.

To be sure, fallen angels present their own risks. Although he champions diversification, Healey also thinks they represent “an extremely treacherous space.” Why? “There’s typically a minimal requirement for reporting, disclosure and leverage targets.” Because these were once investment-grade issuers, most were permitted to provide investors with less information than companies that have always been high yield. The risk, Healey explains, is that the new high-yield entrants can hide problems other junk issuers can’t.

Fallen angels also have a higher incidence of default than other high-yield issuers. Goldman Sachs analysts have estimated that 3.6 percent of fallen angels with first-time high-yield ratings in the double-B range will default within a year. That’s well above the 1.6 percent average annual default rate for a straight double B. These are, after all, companies whose creditworthiness is declining and may fall even further.

As the Tyco example highlights, there’s also the inundation factor. Healey points out that downgrades of companies with prodigious debt loads can wreak havoc on secondary market prices. When Tyco’s $10 billion of debt turned into junk, investors were forced to decide whether they were going to give a full market weighting to a foreign company many had never tracked before. If Tyco recovers and a portfolio manager doesn’t own it, he could fall well behind his benchmark. If he keeps a market weighting and it doesn’t rebound, he may face the wrath of investors. “It’s thrown people into a quandary on how to manage these fallen angel situations,” says ECM’s Biernat. “It’s a tough call, too, because many portfolio managers are limited to 5 percent of any given name.”

EVEN A MORE DIVERSE GROUP OF ISSUERS AND investors won’t help, however, if basic structural shortcomings in the market aren’t addressed. Limited bargaining rights in bankruptcy, scanty call protection and poor disclosure continue to undermine investors’ confidence. More powerful entities like bank lenders and LBO sponsors -- which together provide an estimated 80 to 85 percent of the financing for buyouts, a key source of new issues -- have taken advantage of high yield’s current predicament to strip still more protections away. With the new-issue market so weak, investors have had little clout to fight back.

So-called structural subordination basically assures that high-yield investors get little or nothing in a bankruptcy or restructuring. High-yield bonds are usually issued through a holding company that has no claim on assets, cash or bank debt. Under normal business conditions cash is funneled up from the operating company to pay bondholders at the holding level. But if the company runs into trouble, it can easily turn off the cash spigot to bondholders to ensure that other creditors -- namely, bank lenders -- get paid. In most European countries bankruptcy laws give banks the right to oversee a large part of any restructuring.

“In the U.K., secured lenders control the bankruptcy process, and this process doesn’t favor unsecured lenders. I would have thought we would have seen more progress in addressing this issue because it’s a major issue for capital market growth in general,” says Tim Grell, head of credit products in Europe at Merrill Lynch.

Call protection, which prevents an issuer from redeeming its bonds before an agreed-upon date, has pitted high-yield investors against another formidable interest: private equity firms. In the U.S. five years of call protection is the norm. That was the case in Europe for a couple of years as well, but more recently, it has shrunk to three years.

Bondholders typically don’t want their issues called early because they depend on the steady high-income stream from the coupon. That income disappears once a bond is refinanced and leaves investors scrambling to find another bond with a comparable yield, which can be difficult. The trouble is that buyout firms want the freedom to exit their investment once a portfolio company has tapped the high-yield market for funding. To them five years is too long. Because they often have a major say in the investment banking firms selected to underwrite deals for their portfolio companies, the buyout firms have successfully pushed their underwriters for better terms.

One example of how the recent markets have operated was a E260 million offering from Finnish bathroom products maker Sanitec Corp. launched April 29. Lead managers Goldman Sachs, HypoVereinsbank and Merrill Lynch priced the ten-year deal at par to yield 9 percent, and investor appetite for a sound credit pushed the price up 3 points on the first day of trading. The fact that the deal was structurally subordinated and had three years’ call protection didn’t prevent it from being a blowout success. The underwriters concede that the offering was structured this way to meet the needs of an equity sponsor, Germany’s BC Partners Funds, and a variety of banks.

“Things have gotten worse for investors because there’s such huge demand for high yield, so terms of the issues have moved against the investors,” says one portfolio manager. “Equity sponsors in the LBOs are able to withdraw cash, meaning their dividend is ahead of the high-yield bonds. I’d say the structure and positioning of high yield has not improved at all.”

Still, investors are making some small gains. Early this year Goldman Sachs’ Connolly and Flynn hosted a dinner at their London office with four major high-yield investors and four private equity sponsors to hash out their differences. Connolly says the investors that evening made clear structural subordination was their “No. 1 issue,” while the buyout firms wanted call protection kept to three years or preferably less. “We’ve worked to address these points this year, and hopefully, we’ll be able to bring better-structured deals to market,” he says.

As a compromise, Goldman and co-manager J.P. Morgan Chase & Co. are working on a new issue that will have an unusual contractual subordination structure. The issuer is Germany’s Gerresheimer Glas, whose glass products are used in the pharmaceuticals and cosmetics industries. The deal is being used to refinance mezzanine debt created when the company was sold to Investcorp and Morgan affiliate J.P. Morgan Partners in 2000. The deal will give investors legal recognition as creditors should the company go into bankruptcy. But there are catches: The bonds are callable after three years, and investors would be constrained from any participation in a restructuring for 120 days should the company fail. That, in turn, would give bankers the opportunity to reorganize without them. Bondholders would have to be consulted about any sale, however. Still, since Goldman and J.P. Morgan happen to be running the books on a new term loan to Gerresheimer, they would have substantial incentive to make sure their own interests were taken care of.

“There is no charity in this world. Underwriters are doing nothing to assist investors. Let’s read the back of the prospectus before we say this is great,” grouses one hedge fund investor about the deal.

Even if Goldman’s and J.P. Morgan’s effort represents a very small first step toward a market-based solution to the problem, it’s unlikely companies are going to jump at the chance to save 25 to 50 basis points by tossing out structural subordination. Why? Regional banks in countries like France and Germany are racing to offer them low-priced loans. A company leveraged three or four times can still get a loan at 75 basis points over LIBOR. In the U.S. a similarly indebted company would be a prime candidate to issue high-yield bonds. But in Europe there’s little incentive for a CFO to pay a much larger spread over LIBOR to issue junk bonds and be required to make regular quarterly financial disclosures. Banks will lend at a lower rate and accept little additional financial information.

“Let’s say I visit a steel company in Bonn, Germany, which is four times leveraged,” says a U.S. investment banker. “I say, I know you’re getting LIBOR plus 75. Hey, I can get you money at 8 percent, noncallable with quarterly disclosure. Oh, and how does my American accent sound?” Another banker estimates that it will take three years or more for his cadre of high-yield professionals to address these issues and establish meaningful relationships with European borrowers.

MANY OTHER HIGH-YIELD PRACTITIONERS ARE taking a similarly long-term view of today’s marketplace. “No doubt 2001 was a very disappointing year. But I think in a historical context it will be seen as a year of catharsis with the comeuppance of telecommunications and cable, which has removed a hell of a lot of credit risk in a fast and brutal way,” says New Flag’s Simon. He adds that obituaries were written in America in the late 1980s, when Drexel Burnham Lambert junk bond king Michael Milken went to jail. The U.S. market, dominated by Drexel and its clients, stumbled badly afterward but ultimately grew bigger and stronger. “People had to reinvent themselves from being equity analysts of high-grade bonds to active managers of portfolios with bad credits,” Simon recalls.

In the meantime, market conditions are expected to become a little more forgiving. Merrill Lynch’s Healey has recently begun to put his cash back into the market because European corporate defaults appear to have peaked and economic growth has resumed. “In our opinion, over the next year to 18 months, the environment for high-yield performance is good,” he says. Healey is sufficiently encouraged to have added a new member to his ten-person staff and plans to create another position shortly.

If he’s right and the market does begin to improve, high-yield investors will no doubt be in a stronger position to press their claims. They can’t wait. “When there’s a buyers’ market, we will enjoy the revenge. We will demand all sorts of things, like no more structural subordination and better transparency,” says one frustrated London-based hedge fund manager. Until then, however, he and fellow junk bond investors have little choice but to keep a close watch on the trials and tribulations of Tyco and Alcatel.