Keeping up with lenders

Author: | Published: 1 Mar 2014
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Edward Eyerman of Fitch Ratings discusses high yield’s changing structures and how the asset class matches up against bank lending as 2014’s financing tool of choice

High yield may remain a popular asset class, but fund-raising corporates are still tempted by the loan market. Based off Libor, loans are callable and easier to recapitalise quickly as a result. So bond structures are developing to adapt to the changing demand. Edward Eyerman, head of European high yield and leveraged finance within the European corporates department at Fitch Ratings in London explains the challenges facing the asset class.

What trends are you witnessing? Are covenants changing and in what way?

We're seeing covenant-lite (cov-lite) in very large leveraged deals, but they're fewer than the headlines suggest. We also see covenant loose and more documentation under US templates as arrangers offer access to US liquidity in addition to European liquidity. Although it's not a consistent feature of every deal, we see some European companies issuing dollar tranches in loans and bonds even though they don't have dollar revenues and costs – that has been happening since 2012 when absolute yields plus swap costs were lower in the dollar high yield market than in the European market. In 2013, the European new issue loan market returned to compete with US and European high yield. Large financings, such as DE Master Blenders, Springer and Ceramtech switched from bonds to all loans, and then from US cov-lite to more European cov-lite, highlighting that the European market was recovering.

Barring a systemic shock, we expect abundant liquidity from the US, the return of European CLO 2.0 and recovering bank appetite to compensate for the expiration of reinvestment periods on European CLO 1.0.

"As long as default rates are low and the funds flow keeps coming in, investors have to make a difficult choice"

Northern European banks in particular have recapitalised and the leverage finance teams in those banks, as well as traditional leveraged lenders like the Bank of Ireland, Commerzbank and Unicredit are again embracing leveraged lending as a risk-adjusted positive ROE line of business. The scarcity of assets in comparison to the liquidity chasing them translates into rising leverage, weaker structures and looser covenants. Borrowers tend to prefer the loan market because it's cheaper than high yield as it is based off Libor, which will likely be lower for longer in Europe given the inflation outlook and the fragility of the periphery. Loans are also callable and therefore easier to recapitalise quickly. So the bond market is missing out on the European champions like Ziggo and DE Master Blenders.

The issuance quality in the market is deteriorating as it struggles to keep pace with a rejuvenated loan market. We see the market having to take riskier instruments, sectors and geographies. There are growing numbers of peripheral industries: Italian gaming, Spanish leisure, car parks and auto suppliers that the loan market won't embrace at the moment. The high yield market will carry on growing but the issuance quality is getting weaker.

The last period of exuberance in the market was in the spring of 2011. Many of the bonds issued during that time, at notably much higher yields, have either defaulted or since had their credit qualities deteriorated so the bondholders effectively assumed the risk burden of the previous lenders.

Have you seen the effect of US tapering yet on emerging markets?

Yes. And emerging markets have been more affected by tapering and the reversal of global liquidity flows. European high yield has not been subject to that to date. The asset class appears to be participating within the narrative that Europe is safer and recovering. While we have this disinflationary environment, the expectation is that monetary policy interest rates will remain low. As a result, yield seeking is still making its way into the asset class and there are few other places to find it, especially for retail investors.

Fund flows continue to swell into high yield asset managers, perhaps as an alternative for the emerging markets outflows. The question then, is why high yield isn't considered a risky asset class as well? The answer at the moment points to excess liquidity within Europe and the US. You also have the narrative that Europe is now safe and corporate credit assets will participate in the broader developed market recovery. Compared to US and European investment grade and emerging markets, high yield benefits from demand for short duration as it is less sensitive to rises in benchmark rates. Loans of course, have no duration, and are set to perform well so long as default rates remain low.

European leveraged credit appears to be in a sweet spot at the moment. The only issue is that there aren't enough assets out there given demand, so the comparative risk-reward advantage may dissipate quickly.

Are you seeing investor protections being eroded?

Yes, but I'm more concerned about the rise in senior leverage which will result in lower recoveries for everybody, than I am about covenants or structural subordination. I am more worried about the return of high senior leverage because that simply means there's a greater claim on whatever residual value there is at default by the senior creditors. We saw what happened with the subordinated second lien and mezzanine market insofar as their recoveries were very poor from the 2006 and 2007 vintages, because senior leverages were so high. Better structures and covenants might have helped, but Europe remains senior creditor-friendly in terms of jurisdictional rights, especially with the UK scheme of arrangement as the forum of choice for distressed restructurings.

Portability became a mark of last year's high yield market. Do you think it's here to stay this year?

Yes, I think it's a debtors market right now. Again, there is too much liquidity chasing too few assets. And you don't see sponsors buying – instead they're selling via IPOs or strategic sales to global corporates. They don't want pre-payment penalties and change-of-control provisions to block their exits. Portability also allows secondary buyouts. However, valuations in the IPO market and among large strategics are pricing sponsors out of many deals at the moment. The only large secondary buyouts we have had are ISTA and Springer. With more leveraged buyout exits than new issues, net loan volumes are declining while global loan capital formation is expanding. Investors will have to tempt sponsors with higher leverage, looser covenants, tighter pricing and other debtor-friendly features like portability.

For their part, the sponsors have clearly indicated that in this valuation environment in core Europe it's better to be a seller than a buyer, so they're going to Spain and Italy where there is still a discount. They do not appear eager to overpay for businesses in the way they did in 2006 and 2007, especially given their return requirements and when there is very little growth on the horizon in Europe.

In 2012 there were complaints from the buyside about the absence of disclosure on high yield deals. Do you think that remains?

The standards have improved a lot from 2012, especially on issues like voting and enforcement rights, though reporting and disclosure discrepancies between loans and bonds of the same debtor remain. Nonetheless, as long as default rates are low and the funds flow keeps coming in, then investors have to make a difficult choice: it's hard for them to sit on cash when their mandate is to invest in high yield. So to make demands when there aren't enough assets already is difficult. A lot of these risk factors, although not ignored, are certainly not priorities.

What will it take to disrupt this cycle?

I don't know. Low coupons allow a lot of weak, even highly-levered businesses to carry on, and Europe is supposed to be fixed and recovering. Generally, it takes some sort of systemic event related to a market fail to de-rail the asset class. When that happens, there is a rush for the exit among holders of risky assets. In 2011, we had the Arab Spring, the Japanese earthquake and the Portuguese bailout – yet the new issue and secondary market carried on after brief blips. You could argue the emerging market situation and the Ukraine are similar now in 2014. It was only when Greece needed a second bailout in the summer of 2011, and the prospect of private sector involvement that sent everyone for the exits.

Of course, it's a lot easier to acquire risky assets than it is to exit them. Yields and spreads have come down steadily as confidence in leveraged credit assets improved, but a significant market fail that raises concern over the system and the correction will be swift and painful. It may not be as bad 2008 and early 2009 as there is much more depth and diversity in the market, though losses will indeed occur. Yet without knowing when that will happen, the structure of investment complex forces managers to remain invested as long as the music is still playing.

What are Fitch's priorities for 2014 within high yield?

We had a very good 2013 in terms of our penetration of the CLO 2.0 market and we hope to consolidate and grow our position in 2014, which will give us even more exposure to the European leveraged loan market and global investor platforms. We also want to consolidate our relationships with investors as a valued research resource, grow our market coverage of the indices and highlight companies that access the market with Fitch + plus one other agency.


Edward Eyerman
Managing director
Head of European leveraged finance
Fitch Ratings

London, United Kingdom
T: +44 (0)203 530 1359

Edward Eyerman is managing director and head of European high yield and leveraged finance within the European corporates department at Fitch Ratings in London. Ed began his career in 1994 as a sovereign and financial institutions credit analyst at Merrill Lynch in New York, where he provided fundamental credit research and relative value analysis on Yankee bonds. He moved to London in 1997, where he was an original member of Deutsche Bank's global markets' credit research department and subsequently its European high yield origination team.

From 1998 to 2002, Eyerman worked in the investment banking division at Credit Suisse First Boston, principally in the European acquisition and leveraged finance group. He holds a Bachelor of Arts in History from Holy Cross College in Worcester, Massachusetts, and a Masters in International Affairs from Columbia University's School of International and Public Affairs in New York.


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