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Europe: The Bloom Is Off The Junk


For more than a year the European market for high-yield debt had been booming. So when Corus Group PLC (CGA), the troubled Anglo-Dutch steelmaker, decided on Apr. 30 to buttress its balance sheet with $600 million worth of junk bonds, it had every reason to believe the issue would be a success. But just two weeks later, Corus pulled the bonds off the market. What happened? No sooner had the company launched its offer, says Finance Director David M. Lloyd, than market conditions took an abrupt turn for the worse. Because yields on junk bonds had suddenly spiked, "it was no longer cost-effective to make an offering," Lloyd concluded.

Lloyd and Corus have lots of company across Europe. Worries about a rise in global interest rates, a sell-off in stocks and bonds in emerging markets like Brazil, and the impact of sky-high oil prices have sparked unease in the European high-yield market. As a result, bond prices are falling and yields rising, forcing a lengthening list of European companies to cancel plans for junk-bond issues. In addition to Corus, German chemical company Brenntag, Swedish shipping outfit Stena, and a number of others have changed their plans.

No one is ready to say the market is seizing up. But Europe's junk-bond market has hit a speed bump, just as the far bigger and more mature U.S. market recently did. Investment bankers calculate that more than $12 billion of high-yield bonds were brought to market in Europe during the first four months of this year, compared with $6.9 billion in the first six months of 2003. But issuance since mid-May has slowed noticeably.

Investors and bankers say the market's troubles have nothing to do with the creditworthiness of noninvestment-grade issues. According to rating agency Standard & Poor's, default rates in Europe fell to just 1.8% last month, the lowest level in three years. The main problem is that expectations of a Federal Reserve Board interest-rate hike as early as next month are encouraging insurance companies, asset managers, and hedge funds to seek higher returns. If the hedge funds shun European junk, that dramatic shift could drive up rates on these securities even further. The funds had rushed into European high yield in the last half-year.

The market is still open to those willing to compromise: British retailer Debenhams PLC raised $492 million on May 13. On the same day, Germany's ProSiebenSat.1 Media pulled in $180 million. But issuers are paying higher rates, and investors are less receptive to big deals. Companies are having to reduce the size of their issues and pay up to an additional 75 basis points. Take Debenhams: It trimmed the size of its planned issue by 15% and then increased the coupon on the $206 million euro-denominated part from 9.0% to 9.5%, and on the $286 million sterling part from 10.0% to 10.5%, before it found enough market interest. "With rates rising, investors needed more incentives before they would take on the risk," says Suki Mann, head of credit strategy at SG Investment Banking in London.

Some noninvestment-grade issuers are responding to the cooling market with innovative products, such as high-yield floating-rate notes, which protect investors against rising rates by paying a variable coupon. Spanish broadband services provider Grupo Corporativo ONO has successfully gone down that path. ONO Group Treasurer Jonathan Cumming says that adding a floating rate element to its recent bond issue -- which included a $216 million fixed-rate tranche and a $120 million floating rate tranche -- "made it easier to sell the bonds in difficult market conditions."

Some investment bankers say the market has stabilized. Phil Kelleher, managing director and head of European high-yield sales at Barclays Capital in London, argues that there has merely been a much-needed repricing of high-yield debt. What happened, he says, is that over the last six to nine months a significant amount of new money was allocated to junk by both existing investors and new entrants. Companies responded to this demand by bringing to market an unprecedented wave of new issues. The additional supply started to outstrip demand at the same time investors became more concerned about the destabilizing effect of rising interest rates and increased volatility in developing-world credit markets. This created a brief period of dislocation and resulted in a re-pricing of high-yield credit. Now, Kelleher says, spreads are widening to where they should be. "The market is now in a more stable, healthier state," he argues.

Analysts expect high-yield issuance to continue rising in Europe over the long term simply because the market is still in its infancy. Even though investment bankers earn a juicy 19.85% of their total bond underwriting fees from junk bonds -- though they only account for 4.27% of total bond issuance, according to researcher Dealogic -- most predict that only a handful of issues will come to market in coming months. Toward the end of the year things could get better, they say. But for now, with rates on the way up, it won't be easy to tempt companies like Corus back into the market.

By David Fairlamb in Frankfurt


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