High yield is back in business in Europe
I used to be a European High Yield guy. I was there when the market first took off in the late 1990s on the back of telecom plays like NTL or Telewest. I was also there when the Russian devaluation and default shut down the market. And I remember how the market tanked when the Tech Bubble burst and those 7 and 8 times EBITDA and 0.9x coverage ratios were not met, defaults skyrocketed, and investors lost their shirts.
So I know what happens to markets when easy money comes to town and people are ready to leverage up. It’s called “reaching for yield.” And this is what is happening in European markets right now. The Guardian reports:
Investors are in turn flocking to the more risky high-yield market because of the low returns offered elsewhere with interest rates at historic lows. They are attracted to returns of about 7 or 8%, compared with the 3% they get from a more regular loan.
However, Standard & Poor’s, another ratings agency, warned that the rush back into junk products could be dangerous. "Are memories in the capital markets getting shorter? The global markets have just experienced one of the worst liquidity and credit dislocations since the Great Depression … We believe that investors might want to consider the benefits of maintaining discipline in structuring, pricing, and distributing high-yield bond transactions," the company said.
A high-yield conference in London last week saw about 200 bankers, investors and corporate treasurers gather to cheer the return of a market that still represents a small fraction of the funds raised by European companies.
Traditionally, businesses in Europe have relied more on bank loans built on longstanding relationships and local contacts. But banks are still shoring up their books in the wake of the credit crunch and have turned down some of their traditional clients. Slowly, the European high-yield market is turning more towards a US model, more reliant on institutional investors, such as pension or hedge funds. The US, with an economy similar to Europe’s, has a junk bond market which is about four times bigger.
Now, to be fair, the last comment about the European High Yield market is on the money. There is huge potential for Mittelstand companies in Germany, for example, whose loans are saddling bank balance sheets to use the high yield market as an alternative source of capital. I certainly expect Europe to be a key area for the expansion of the global high yield market.
Nevertheless, from the investing side, risks are now being taken that have as much to do with artificially low yields as with the attractiveness of high yield bonds. I can’t help but think I have seen this movie before and it does not have a happy end.