Article 6.3 European junk bonds hit a sweet spot
By Andrew Bolger
Financial Times October 31, 2013
Record issuance levels and a wall of money rushing into Europe’s high-yield bond market suggests ‘junk’ is the place to be.
Will it last?More than $46bn of euro-denominated high-yield bonds - also labelled ‘sub investment grade’ or ‘junk’ - have already been issued this year. This is 50% more than in the whole of 2012, and almost double the amount issued by the same stage last year, according to Dealogic.
Christine Johnson, London-based head of fixed income at Old Mutual’s corporate bond fund, says ‘Europe is in a sweet spot, growth is flat, or only gradually recovering, so there is a “lower for longer” feeling about interest rates. Where is the place in the world where you least expect interest rates to rise? It has got to be Europe.' The high-yield market is also being driven by more fundamental shifts, such as the need for European corporates to tap the bond markets for finance as capital- constrained banks shrink their balance sheets by refusing to renew loans to traditional customers.
Fraser Lundie, of Hermes Credit's global high-yield bond fund, says 33% of European high-yield bonds have come over the past year from companies that were first-time issuers, whereas in the US the comparable figure was 5%.
‘It shows you where the US market is, and where the European market is going,' he says.
Mitch Reznick, at Hermes Credit, says that the size of the European high-yield sector has trebled since 2008. The sector has also been boosted by ‘fallen angels' - companies that have slipped below investment grade - and a recent influx of small companies.
Moody's, the rating agency, says there has also been a flurry of small companies issuing high-yield bonds for the first time, with six companies, each with core annual earnings (earnings before interest, tax, depreciation and amortisation) of less than $50m, raising a total of about $2bn.
Moody's adds: ‘It is encouraging to see the success of these small companies in issuing bonds at the bottom of the ratings spectrum. However, it remains to be seen if this is a temporary consequence of investors' search for yield, that will diminish as interest rates rise.'
Increasingly, corporates are borrowing more, for longer and cheaper, which can often mean poor value for the bond investor on the other side of that trade.
Paul Smith, corporate bond fund manager at Premier Asset Management, believes that ‘For corporate issuers this can be an opportunity to lock in fixed-rate, longterm capital before rates start to rise... which can often mean poor value for the bond investor on the other side of that trade, although defaults will remain low for the near-term.'
Ms Johnson sees potential dangers in bonds rated BB or Bal - the top end of the high-yield market.
‘BB looks overbought, since it has been backed by investors who are not really high- yield people, and could exit quickly. But single B and CCC bonds still offer 9% yields. You've got to do your homework, but selectively there are still good opportunities.' At Hermes, Mr Lundie argues that any shift in sentiment that spooks investors in BB-rated bonds will also hit lower-rated issues. Part of his strategy is to focus on bonds that have been issued in the past 12 months and now trade below face value. He says: ‘High-yield bonds usually offer change-of-control put options that allow investors to redeem at more than face value. This “optionality” further improves the potential for returns from investing in bonds below face value.'
FT
Source: Bolger, A. (2013) European bonds hit a sweet spot, Financial Times, 31 October.
Covenant light and payment-in-kind notes
These are extreme forms of high-yield bonds. Covenant light (cov-lite, covenant-lite) means that the covenants imposed on issuers are less onerous than normal. Issuers can get away with eliminating the restrictiveness of many of the usual covenants because investors are particularly keen to lend.
This may be because they are yield-hungry due to alternative investments offering low yields relative to the covenant lights. Private equity houses often use such bonds when they are taking over a company through a leveraged buyout, that is, buying a company or part of a company using a large amount of debt and little equity in the capital structure.For bonds higher up the rating ladder the normal covenants are often put in place to provide early warning signs of distress or threats to the collateral backing, for example:
• the property assets of the issuer must remain greater than the debt
• the profits/cash flow must be a minimum multiple of the interest payments
• the piling on of more debt is prohibited
• no/low payouts to shareholders when debt is high.
If these are breached the lenders can request cash or a debt restructuring, where they gain a powerful negotiating position. Covenant light legal structures eliminate many of these safeguards. A further erosion of the lender's position is the shrinkage of the call protection: while there is typically a six-year noncall period on standard bonds, this can be reduced to three years or less on covenant light bonds. Critics point out that the absence of key covenants makes them dangerous for the lenders - the lack of meaningful covenants results in prudence going out of the window - see Article 6.4.
Companies have also increasingly been making use of payment in kind (PIK) toggle notes where payments due to lenders can, at the option of the issuer, be rolled over into a further debt; lenders can be paid with more debt (more PIK toggle notes or other payments in kind such as equity) rather than cash. The interest paid in additional notes is set at a higher rate than the cash interest rate. During boom times for bonds when lenders are searching for higher yield, which usually happens following a period of subdued default levels, these instruments become a popular way for companies to finance leveraged buyouts. This exuberance was present in the run-up to the 2008 crisis and again in