Dead in the water. That about sums up the state of the European high-yield bond market last year. Issuance of "junk" bonds slowed to a trickle. Moody's Investors Service downgraded a total of 71 issues, compared with 56 the previous year. And defaults soared to a record, with total default volume in 2002 surpassing $45 billion, more than for the entire period from 1985 to 2001, Moody's says. "There was a general feeling that when you invested in corporate debt, you didn't know what you were getting," recalls Gordon Wright, director at Standard & Poor's Investment Services in London. Indeed, after edging higher as 2002 began, junk bond prices fell 12% last May through October, according to the Goldman Sachs High Yield Index. "The market kept running into bad news," Wright says.
Not so this year. With corporate scandals out of the headlines and European interest rates on the decline, high-yield bonds are back with a vengeance. According to Credit Suisse First Boston, total European junk-bond issuance as of July 30 of this year was $8 billion, nearly triple the paltry $3 billion for all of 2002. By the time the year is through, bankers expect that figure to rise to $12 billion, beating the $10 billion record racked up in 1999. Behind the optimism: More companies want to restructure their balance sheets by stretching out the maturity of debts, which relieves short-term pressure to pay.
Among the big players in the new Europe junk market are the so-called fallen angels. These companies used to carry investment-grade ratings, but were demoted after they became enmeshed in scandal or ran into management and cash flow problems. By coming to market, they hope to bolster their balance sheets and eventually boost their ratings. In separate April and July bond floats, French conglomerate Vivendi Universal raised nearly $3 billion total to extend its debt maturity. Likewise, German manufacturer HeidelbergCement tapped the market for more than $800 million in July. That such big names were willing to take the plunge encouraged others.
That's a big shift from previous years, when sub-investment-grade bonds carried a stigma. "In Europe, there's been this fear of the junk-bond label," says Tim Flynn, head of European high-yield capital markets at Goldman, Sachs & Co. in London. "But now companies are much less sensitive."
Many high-yield borrowers have been enticed by the fact they can raise money at lower rates, with coupons averaging 9.35% this year versus 9.70% in 2002, according to Dealogic Ltd., an investment banking research firm in London. But the market has risen so far, so fast that some wonder whether the tidal wave of junk is in danger of cresting. In a recent report, Moody's warned that investors were exposing themselves to "significant risks" by plowing into high-yield, since much of the activity was coming from leveraged buyouts with mandatory debt amortization. One red flag: U.S. Treasury yields have risen in recent weeks. That's not expected to derail the European junk bond market -- since it's less sensitive to rising U.S. rates than its investment-grade counterpart -- but it may result in slightly higher yields.
Those yields, however, are still low by historical standards, and few investors have been scared off. Indeed, they have participated eagerly in the market, given the diversity of issues and the relatively sweet returns. The CSFB Western European High Yield Index had shot up 19% as of July 31, outperforming the major stock indexes in France, Britain, and Germany -- not to mention the U.S. That's broadened the type of money flowing in. Market players say there's even been some demand from U.S. institutions, along with European investors of all stripes. "There's been a convergence of the investor base in Europe," says Brian Bassett, head of European high-yield capital markets at Deutsche Bank in London. "You now see numerous investment-grade accounts investing in high-yield."
The shifting economic outlook has helped. "Junk bonds usually gain during a recovery," notes Michael Heise, chief economist at Allianz Group in Frankfurt. Of course, an unexpected shock could chill the market. The spread of deflation, for instance, would raise the real cost of debt. But bankers aren't worried, noting several large deals in the pipeline. The biggest: a $1.4 billion issue by Italian yellow-pages company Seat Pagine Gialle, expected later this year or early 2004. The smart money seems to be saying: Don't bet against junk just yet.
By Laura Cohn in London