Flush Times for Europe's High-Yield Market

It's poised for a bright beginning in 2007, but rising risk consciousness may make the market lose some momentum by yearend

From Standard & Poor's RatingsDirect

The European high-yield debt market is poised to enter 2007 on strong footing. With record issuance volume, healthy returns, and low volatility, the European high-yield market has exceeded expectations in 2006. (High-yield debt carries below investment-grade credit ratings.)

Defaults have ticked up from record lows, even as there's concern that distress may be suppressed by less stringent debt covenants (i.e., financial requirements imposed on borrowers under terms of debt issues). Meanwhile, the economic backdrop—supported by vigorous business investment, elevated consumer spending, and strong export activity—is still robust, with growth in the eurozone forecast to reach a five-year high of 2.6% in the current year before decelerating to 1.8% in 2007.

The current buoyancy leaves less headroom for outsized gains in the coming year. Though there's little evidence yet suggesting an abrupt reversal of fortune, gains in European high yield remain contingent on ample supply of liquidity, low pressure on risk premiums (the difference in yield vs. low-risk debt issues), and a steady inflow of leveraged deals, which has been the main driver of deal volume in the last two years. Investors may continue to allocate substantial sums to European high yield as long as they have an abundance of investable cash and credit quality doesn't falter substantially.

New Complexities

In the European bond market, close to half of new speculative-grade bond issues in 2005 and 2006 were related to LBO and merger activity. The largest issuer to date is Netherlands-based high-tech company NXP Semiconductor with over $5.7 billion (€4.3 billion) in new issues in 2006, followed by British chemical company INEOS Group with $2.9 billion (€2.2 billion). The large and still growing demand of the European high-yield market investor base allows such companies to issue record-level debt even as overall covenants in these bond issues have become looser, raising concern that investors may not be sufficiently protected in the event of a default.

The significant impact of sponsor activity in the European high-yield bond markets introduces new complexities. The combination of more leveraged structures that underwent less stringent reviews and bond issues with loose covenants led to increased credit risk. Moreover, private equity sponsors sometimes use dividend recapitalization plans to boost returns and quickly recoup their initial investment in sponsored companies, while saddling the target companies with ever greater leverage.

This process may not demonstrate any adverse side effects as long as the company's cash flows are greater than the interest payments paid. However, once this balance is disrupted, because of a decline in earnings in a less favorable economic environment or on account of rising cost of debt service, it can puncture creditworthiness.

ECB Pedal Power

The current ledger of rating trends appears benign, but prospects for credit quality in the European high-yield segment are being tarnished by financial strategies that are ultimately unfavorable to bondholders: leveraged transactions, dividend payouts, and share repurchases.

In 2007, corporate earnings momentum, while expected to remain fairly healthy, isn't likely to match this year's pace. Simultaneously, the overall economic environment in Europe will be somewhat less buoyant than in the current year, although the principal engine of the economic recovery—business investment—is expected to remain strong going into the new year. In response, the European Central Bank (ECB) is expected to maintain its brake on the monetary pedal, raising rates another 25 bps from its current 3.25% by yearend and another 25 bps at the beginning of 2007.

The interplay of these factors will lay the groundwork for greater risk consciousness among investors, raising the likelihood that a higher premium will be demanded than currently in favor, even in the absence of a meaningful pickup in inflation. When exactly this risk will be reflected in bond prices is tough to pinpoint, though the current momentum signals that it will likely be close to yearend 2007.

Standard & Poor's credit analysts Diane Vazza, Devi Aurora, and Jacinto Torres contributed to this article