Junk Debt’s Escalating Risk Enticing Money Managers: Euro Credit

Europe’s high-yield bond market will get riskier next year, with some of the world’s biggest money managers predicting the lowest-rated and most-indebted companies will escalate sales to take advantage of cheap borrowing.

Investors earned an average 9.5 percent buying a record 71 billion euros ($98 billion) of junk bonds this year, according to data compiled by Bank of America Corp. and Bloomberg. The average yield investors demand to hold speculative-grade debt dropped 69 basis points in the period to 5 percent, approaching a record low, the data show.

“Credit quality is weakening,” said Michael Phelps, London-based head of European credit investments at BlackRock Inc., the world’s biggest money manager with $4.1 trillion in assets, including $31 billion in high-yield. “A lot of supply is coming from first-time issuers and that’s creating attractive opportunities.”

Money managers are taking on more risk because corporate default rates are approaching historic lows and the European Central Bank has pledged to suppress interest rates for an “extended period of time.” High-yield notes are also outstripping investment-grade securities, which handed investors 2.4 percent in Europe this year, seven percentage points less than average returns on speculative-grade bonds, Bank of America Merrill Lynch index data show.

Broadening Market

BlackRock expects more issuance from companies rated at CCC, eight levels below investment grade, while Pacific Investment Management Co. forecasts more bond sales from highly leveraged companies.

“The broadening of the high-yield market is key,” said Phelps. “It’s going to be increasingly difficult to experience the returns the high-yield market offered over the last three years unless you’re selective.”

Returns on the lowest-rated securities are exceeding gains on higher-ranked notes for a second year. Bonds rated CCC and lower paid 14 percent, compared with 9.4 percent for single B securities and 0.8 percent for AAA debt, Bank of America Merrill Lynch index data show. In 2012, the lowest-ranked notes returned 46 percent, compared with 30 percent for single B securities and 7.9 percent for top ranked bonds.

Issuers raised a record 5.7 billion euros of CCC rated bonds this year compared with 3 billion euros last year, Bloomberg data show. High-risk, high-yield debt is rated below BBB- by Standard & Poor’s and Baa3 at Moody’s Investors Service.

Edcon Bonds

Edcon Holdings (Pty) Ltd., South Africa’s largest clothing retailer, sold 425 million euros of CCC rated notes due June 2019 last month. The senior secured bonds, which were priced at par to yield 13.375 percent, have since jumped to 105.4 cents, Bloomberg data show.

“If the environment stays positive the market will be willing to finance higher-levered, riskier companies,” said Axel Potthof, who manages sub-investment-grade debt at Pimco, which oversees the world’s biggest bond fund.

Average indebtedness for first time bond issuers rose to 5.5 times earnings before interest, taxes, depreciation and amortization this year from 5.1 times in 2012 and 4.8 times in 2011, according to a Moody’s Nov. 5 report. New issuer leverage will continue to rise next year, “posing risks in a different future interest-rate environment,” according to the report.

Tank & Rast

Autobahn Tank & Rast Holding GmbH raised debt from loans and bonds last month that left the company’s adjusted debt at about 10.5 times earnings before interest, tax, depreciation and amortization, versus an average 4.7 times for buyouts financed in Europe this year, according to Standard & Poor’s Capital IQ LCD.

The central bank unexpectedly cut its main interest rate last month to a record low of 0.25 percent. Officials expect the key rate to remain at the same or lower levels for an extended period of time, ECB President Mario Draghi said at a press conference in Frankfurt on Dec. 5 after the bank kept the rate unchanged.

Sentiment toward high-yield credit has improved after almost five years of central bank stimulus measures helped reduce global corporate defaults. The trailing 12-month global speculative-grade default rate fell to 2.8 percent at the end of October from 3.2 percent a year earlier and below the long-term average since 1983 of 4.7 percent, according to a report from Moody’s last month.

“The confluence of events that made 2013 a record year are unlikely to change in 2014,” said Ray Doody, head of acquisition and leveraged finance in Europe at JPMorgan Chase & Co. in London. “There’s a reasonable pipeline building for early next year, particularly of inaugural issuers.”

Debut Issuance

Sales of bonds from debut issuers are driving market growth this year, accounting for 22 billion euros, or 31 percent of deals, according to data compiled by Bloomberg. First time issuers raised 9 billion euros, or 25 percent of total high-yield bond sales in 2012, the data show.

As the number of low-rated deals increases, investor safeguards are also getting weaker. DebtXplained, a London-based firm of legal analysts, calculates that 33 percent of the high-yield deals it assessed this year include so-called portability clauses, which water down bondholder protection when borrowers get taken over, up from 18 percent last year.

PIK Record

“Low interest rates on benchmark bonds have driven investors to search for yield by extending credit on progressively looser terms to firms in the riskier part of the spectrum,” according to the Bank for International Settlements quarterly review published this week. “This can facilitate refinancing and keep troubled borrowers afloat.”

As investors take on more risk, issuance of subordinated payment-in-kind notes, which allow companies to pay coupons with more debt rather than with cash, soared to an all-time high of 3 billion euros in the region, according to data compiled by Bloomberg. Globally, sales of PIK notes more than doubled this year to a record $16.5 billion, the data show.

About 30 percent of PIK issuers before the financial crisis have since defaulted, according to the report from the Basel-based BIS.

“As risk appetite rises, issuers seek to feed it,” said Aengus McMahon, a credit analyst at ING Groep NV in London. “Our expectation is for leverage on deals to creep up next year and for more aggressive structuring in PIKs and subordinated bonds.”

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