Several key words and phrases feature prominently in any conversation with investment bankers about the international debt capital markets.
There is the threat of illiquidity, caused by Y2K fears. Although a recent convertible research report from Goldman Sachs argues that 'the consequences of Y2K are likely to be short-lived rather than lasting, the truth of course is that no-one knows what the full impact will be, how long it will last, or what unexpected side effects there might be.
There is the spread of securitisation as sophisticated techniques are adopted in an increasing number of markets worldwide. Standard & Poor's, for instance, has highlighted Singapore as currently offering 'the most favourable conditions for the development of securitisation in the Asia-Pacific region, a key factor being the government's wish to develop a healthy secondary local debt market.
There is the growth of issuance by lesser-rated corporate borrowers and the new opportunities arising in high yield bonds, go almost hand in hand. High-yield spreads can range from a couple of hundred basis points (bps) or more over US Treasuries, to 700-800 bps, reflecting the issuer's credit rating and the purpose of the financing.
There is the central role that the euro has played in the changes seen in European capital markets over the past year, and will continue to play.
While arguments continue about the long-term prospects for the single European currency, it is already credited with transforming issuer and investor behaviour in a way no market participant can have fully envisaged. The traditional eurodollar market in Europe was largely limited to better known names with a single A rating or better. The rapid development of the new euro-denominated market has by contrast made it possible for less well known and less highly rated issuers to access a much broader investor base. Staples, the US-based cut-price office supplies chain, provided a first class example of this when it raised Eur150m to meet its euro-denominated funding needs in early November. Though relatively small, this transaction might have proved much more difficult to execute a year earlier, according to Peter Charles, responsible for corporate bonds at Salomon Smith Barney in London.
The prospects for a product which occupies the ground between traditional fixed income products and higher risk equity are positively stellar, with several major trends behind the evolution taking place. One is the growth in importance of credit products. Historically, the European bond market focused on currencies, with institutional investors investing in countries where the underlying currency was perceived as cheap. The arrival of the euro and a low interest rate environment have combined to change this approach to investment, and ushered in a period of rapid growth of credit spread products, in both investment grade and non-investment grade corporate bonds.
Two, the need to finance rapid technological advances has changed the dynamics and complexities of the capital raising business. A phenomenon which dates back almost two decades in the US is now spreading across Continental Europe as telecommunications and associated sub-sectors are privatised and deregulated. The example set by the UK is now being followed by the principal European Union countries. Salomon Smith Barney estimates that telecoms as a sector accounts for in excess of 60% of high-yield bond volume in Europe, and is likely to continue to do so for the foreseeable future.
Three is the emergence of a more active and aggressive mergers and acquisitions culture, in particular the growth of venture capital firms specialising in leveraged buy-outs. These come in two forms, the indigenous European firms such as Doughty Hanson and Apax Partners, and a more recent wave of US firms launch operations in London to capitalise upon their years of experience in their domestic arena. The arrival of such illustrious names as Hicks Muse, Clayton Dubilier and KKR (Kohlberg Kravis Roberts), to name only a few, indicates clearly that value in Europe is thought to be better than in North America. In other words, Europe is cheap.
"The market will continue to grow for many reasons," says Alan Ginsberg, New York-based Head of Global High Yield Research at Barclays Capital. "Europe is moving forward from a small base, and there's every possibility that it will equal or even exceed the US. It's a large economy, and high-yield bonds play an important tole in providing capital for growing companies."
Prospects for high-yield issuance in Europe are further brightened by Europe's need for a phase of significant industrial and corporate restructuring along the lines of that already witnessed in the US and the UK. "Many European corporates that were formerly state-owned are fatter and less productive today than their US equivalents were in the 1970s," argues Malcolm Stewart, Managing Director and Co-Head of European Leveraged Finance at Salomon Smith Barney in London. "The demand for money from companies that are not necessarily the most attractive credit risk builds a case for sustained growth in the high-yield bond market."
Observing the market outlook from the perspective of a European bank, Rick Deutsch, Head of European High Yield Research at Banque Nationale de Paris in London, agrees with the optimistic consensus. Arrived from Merrill Lynch earlier this year, he is in the throes of building up BNP's own capabilities in this burgeoning sector and is infectiously enthusiastic.
"Necessity is the mother of investment," he said in a credit research bulletin published by BNP earlier this year. "With few other available solutions to the search for yield, we expect that European money will find its way into European high-yield. With the pay-as-you-go state pension system under increasing pressure, more and more individuals will take the decision to invest in their own retirement. In a low interest rate environment, high-yield should be one of the pillars of a funded retirement plan."
Until now, argues Deutsch, the market has been driven by two things: leveraged buy-outs and early stage capital for project finance build-outs. "Due to the amount of money committed to LBO funds in Europe, estimated at about $20bn, we expect buy-outs to eclipse growth companies (including telecoms and media) as the major source of high-yield issuance in Europe over the next few years. If all of the money committed to buy-outs is leveraged five times, a round average level of leverage for an LBO, then it is easy to imagine a buy-out market of over $120bn equivalent, which implies a high-yield market of $80bn-$100bn equivalent."
"The heart of this market, the classic European 'Mittelstand' companies, is only just beginning to develop. The difficulty has been in weaning companies away from cheap bank loans, but times are changing. Whether arranged bilaterally or as syndicated loans, this method of cheap financing cannot continue. Banks are focussing more and more on their return on capital, and the Mittelstand companies will have to look elsewhere for their financing."
As in the US, so in Europe the telecoms industry has been one of the main drivers of this market in its intial stages. Moreover, not only has the high-yield market represented the transplantation of US technology to Europe, it has also been based on the wholesale transplantation of issuers and investors. While the arrival of companies such as Colt, NTL and Telewest in the UK kick started the market, events since, principally the creation of the euro, have seen a gradual move away from the dollar as the currency of issuance.
"A number of deals have already taken place which could not have been undertaken successfully in a domestic market," continues Deutsch. "You need a deep pool of liquidity to drive the market; the single currency has provided that. Sterling will eventually be overtaken by the euro as the number one high-yield market in Europe."
Where will the funds come from? Given the appetite of investors for OECD corporate paper, Malcolm Stewart predicts parallel growth in the indigenous European high-yield investor base and identifies three broad categories of investors. US high-yield bond funds are investing in Europe in growing numbers and volumes. Specialised high-yield bond funds are becoming established in Europe, as evidenced by the recent creation of the first CBO (collateralised bond obligation) fund by Intermediate Capital. This major source of new money and liquidity is expected to grow quickly in Europe. And as asset mixes change, traditional eurobond investors are beginning to allocate a small proportion of the funds under management to the high-yield product, as demographic and fiscal changes emphasise the need for income.
"Funds are forming at an increasing pace, and the supply and demand situation should benefit the market in Europe," concludes Stewart. "Europe is still relatively small relative to its potential."
A version of this article appeared in The Banker magazine, December 1999