High Yield Déjà Vu? Not Quite Yet

It’s been quite a year to date for leveraged finance. Improving economic data, increased risk appetite and a supply/demand imbalance has driven valuations starkly higher. At the time of writing, the Merrill Lynch European High Yield Index is up a whopping 75%, the average bid for leveraged loans in Europe has risen by around 50% from its lows earlier in the year, and the high yield new issue market has reopened to all but the most speculative propositions printing approximately €20bn year to date.

Such a reversal in fortunes is bound to be met with raised eyebrows. Standard & Poors, in a report released last month asked ‘Is History Repeating Itself In The European High Yield Market?. The report identifies four areas where it claims the European high yield market is at risk of repeating past mistakes. I thought it would be worth taking a brief look at each.

The first area relates to pricing. ‘The lack of returns in money markets and investment grade bonds may be prompting new investors to enter the European high yield market, compressing spreads as volumes remain low’according to S&P.  I have some sympathy with this notion. The lack of supply in the earlier part of the year combined with a near zero interest rate policy has undoubtedly forced less traditional investors to consider high yield risk. The huge oversubscriptions that new high yield transactions have garnered in recent months are, in part, testament to the idea. There is evidence that suggests that this interest has broadly targeted the stronger high yield credits and in itself has not been the major driver of lower spreads. An improving default outlook and economic backdrop has likely played a greater part.

The second area of concern relates to the recent non-rated issuance. ‘Anecdotal evidence suggests that much of the demand of unrated deals comes from private banks and other relatively new players’according to the report.  I suppose we have to take this gripe with a pinch of salt. S&P are clearly incentivised to ensure the status quo of obtaining a rating prior to, or shortly after, coming to market. That said I don’t doubt that a number of  investors have bought recent unrated transactions without the skills to fully analyse these investments.

The third area relates to the structuring of transactions. This and S&P’s final point are those with which I have the most sympathy. ‘Bond covenants have not been particularly strong for unsecured high yield debt’according to S&P. The ability of bondholders to protect their interests (and interests in the event of distress) will largely come down to the covenants that are put in place at the time a deal is structured.  Indeed, a number of recent high yield transactions have come to market with the lack of covenant protection usually associated with investment grade rated transactions. This has been a major issue for us for a number of  years (we have blogged on the subject on numerous occasions) and this has been one of the most important determinants when deciding on new transactions. Furthermore, we have long been advocates of a move to a US style approach of disclosing bank debt covenants. These covenants remain ‘private’ in Europe despite the dangers that this presents to investors.

The fourth and final area relates to disclosure. Historically high yield lenders receive detailed quarterly company reporting, whereas bank debt investors receive monthly updates.  The more recent trend for certain high yield issuers has been for semi-annual reporting without an acceptable degree of detail.

Looking at the high risk end of the credit spectrum, it’s worth noting that CCC issuance has been notably absent so far this year. For example, a recent speculative transaction for Donington Park failed to get out of the pit-lane due to a lack of investor demand. Both are signs that we have yet to retest the heady heights of 2006 where credit was bountiful and there was a boon in speculative-grade bonds. That said, we are clearly trending back in that direction if spreads continue to compress for this type of debt. Such a trend will require close monitoring.