Europe Races Into A World Of Junk
Across Europe, companies and investors are learning to love junk bonds, just as their U.S. counterparts did in the 1980s. Companies from Lisbon in Portugal to Lule, Sweden, are scrambling aboard the high-yield bondwagon to free themselves from short-term bank borrowing. And growing numbers of yield-hungry Continental investors are discovering a new source of juicy returns in a period of rock-bottom interest rates. "That's why [junk] is one of the fastest-growing asset classes there is for Europeans," says Frederic Rollin, a Paris-based fund manager with CCF Capital Management.
Indeed, analysts expect $18 billion worth of new issues this year, more than triple the 1997 level (chart). By the end of 2004, the amount of junk outstanding could soar sevenfold, to $280 billion, of which the bulk will be denominated in euros, figures London-based Global Research & Consulting. That's still well behind the huge $600 billion U.S. market, but it's manna to investment bankers, who are falling over each other in the rush to earn 1.5% to 3% underwriting fees. Rating agencies are doing a roaring business, too. Three in four ratings assigned by McGraw-Hill Standard & Poor's in Europe this year have been for high-yield issuers.
Spurring the market's growth is the frantic pace of European restructuring. With the introduction of the euro, companies can no longer hide behind their national currencies. They have to become price leaders to thrive and deliver shareholder value if they're to survive. As a result, companies have embarked on an unprecedented round of mergers, acquisitions, and divestments. "All that activity needs a huge amount of long-term capital," says Barrie Whitman, who manages high-yield investments at Threadneedle, a London-based fund-management subsidiary of Zurich Insurance Group.
The biggest deal to date was a $1.5 billion issue by Amsterdam-based cable-TV company United Pan-European Communications. But even conservative German companies are being tempted into the water. Deutsche Nickel, a specialty metals company, and Sirona, a dental technology spin-off of electronics giant Siemens, have both made issues recently. So why are companies with access to cheaper finance from their house banks lining up to pay stiffer rates on junk bonds? It's simple: to gain flexibility. No matter how close a company's relationship is with its regular bank, it can't normally get loans for longer periods than five years. And the bank will usually insist that 20% of the loan be repaid each year. By contrast, bonds usually run 10 years, and investors hate early payment. "We have the money for much longer," says Han Wagter, chief financial officer of Amsterdam-based Kappa Packaging Group.
Kappa's story is typical. A $1.7 billion buyout from its Dutch parent KNP last year, it was funded initially with an old-fashioned bank loan. But when the time came to refinance part of its loan in July, Kappa issued a $650 million, 10-year junk bond with a top yield of 12.5%. Better yet, says Wagter, the company built up direct relationships within Europe's investment community--very useful if, like Kappa, you plan an equity issue sometime down the road.
Investment banks, which stand to gain additional fees for equity issues, are keen to promote that idea. "Issuing high-yield can be a way of preparing for the future," says Robin Doumar, co-head of European leverage finance at Goldman, Sachs & Co. in London. "You can see it as a sort of halfway house between bank lending and equity." It can even benefit companies that already are listed. The price of shares in British telecom company Orange, for example, rose 30% to 40% in March when it was promoting a $740 million junk bond on a road show. "Orange's experience shows that if you've got a good story, you can tell it via high-yield," adds Doumar.
So far, American houses have grabbed the lion's share of the burgeoning market. Donaldson, Lufkin & Jenrette Inc., the leading U.S. junk underwriter, and Goldman Sachs lead the league. Morgan Stanley Dean Witter, Chase Manhattan Bank, and Salomon Smith Barney are also in the top five. Among the Europeans, Barclays Capital, Warburg Dillon Read, and Deutsche Bank are the main players. Following its acquisition of Bankers Trust, which has a track record in U.S. high-yield, Deutsche is poised to snatch a bigger slice of the pie. "The competition," complains one banker, "is ferocious."
Still, if the market grows as fast as analysts expect, there will be plenty of business to go around. For starters, European investors have developed a good appetite for junk. Once reluctant to buy anything more exotic than government bonds or blue-chip equities, investors are being seduced by the 10% to 13% that high-yield bonds typically pay.
Over 10 years, junk-bond portfolios earn an annual 2% to 4% rate premium over government bonds. "Investors need yield and diversification," says David Hughes, a high-yield fund manager at asset-management giant Invesco in London. "Now that the single currency is a reality, they can't get either [of them] by exploiting currency and interest rate movements. But they can get part of what they need by investing in high-yield bonds."
As a result, many institutions have started to acquire the junk habit. Among them are the fund-management subsidiaries of France's Groupe AXA, Germany's Deutsche Gesellschaftsfond fur Fondsverwaltung, Italy's Assicurazioni Generali, and MeritaNordbanken, the Nordic banking giant. More than a dozen high-yield mutual funds were launched in Britain this year. New Flag Asset Management, a boutique that buys European high-yield bonds on behalf of institutional investors, set up shop in London this year. And Munich-headquartered insurer Allianz plans to set up a high-yield fund for institutional and private investors soon. With all that activity, it's small wonder that CCF's Rollin figures that one of the market's biggest problem is lack of bonds: "The demand is outstripping the supply."
Yet the market is bound to hit some bumps. Kirch Group, the German media outfit, discovered that on Sept. 24 when it was forced to postpone until next year a planned $1.1 billion junk bond because investors wanted higher yields than the 12.75% to 15% the company was ready to pay. Potential buyers were leery of Kirch's creditworthiness, especially in the absence of a detailed explanation of the group's strategy. "There's some junk that investors just won't buy," says one investment banker. Insurance and pension-fund trustees could cap the amounts such institutional investors plonk in junk. And some of Europe's state-run banks could be tempted to offer incredibly low interest rates on loans to keep their customers from issuing junk.
There's always the risk, of course, that the market could be temporarily derailed next time there's a financial crisis that sparks a flight to quality, as with Russia last year. Even so, European markets are at last getting what they have long lacked: choice and flexibility--and some real competition.