European investors are having to face up to the harsh realities of the high yield market
Over the last couple of years, European investors have learnt about the opportunities and dangers of high yield bonds the hard way.
Two years ago, there was tremendous excitement about the prospects for investment grade and high yield bonds in Europe. Demand was expected to grow strongly as European governments encouraged individuals to provide for their own retirement.
At the same time, the introduction of the euro transformed Euroland into a gigantic single market for securities. Almost overnight, it became possible for a German investor, for example, to buy securities in any of the other 10 member countries with no currency risk. Looked at another way, any Euroland company issuing bonds could place them to a vastly larger group of investors than had been previously available.
In short, the corporate bond market in Europe was expected to develop rapidly because it suited companies and investors. Companies had access to a large and flexible new source of finance and investors had access to an asset class that offered the prospects of superior returns at a time of low inflation and low nominal yields on government bonds.
The predictions were partly right. As far as investment grade corporate bonds are concerned, the forecasts have been absolutely correct. Issuance of investment grade corporate bonds in Europe in the first half of this year amounted to e376bn, more than the total for all of 2000. And in mid-June, the size of the non-gilt market in the UK exceeded the size of the gilt market for the first time in recent history.
This illustrates that investment grade corporate bonds have gained acceptance as a mainstream asset class.
Although technology, media and telecommunications had already become widely recognised as exciting growth areas, forecasters failed to anticipate the extent to which the European high yield bond universe would become dominated by companies in the telecommunications industry. Just as the high yield market was starting to take off, central banks increased liquidity as a precaution against disruptions of financial systems by Y2K. High yield bonds were caught up in the resulting asset price bubble.
To understand why this matters for the market as a whole, it is necessary to remember what drives the performance of high yield bonds. In comparison with other asset classes, they are especially sensitive to investors' perceptions of liquidity and default risk. The risk of default is driven by a number of factors, including business cashflows, the overall level of borrowing, the level of interest rates and the ability to raise new finance from all sources, including the stock market.
If the bond issuers' cashflows are suffering because of price competition and/or because demand from customers is less than had been projected, the perceived likelihood of default will increase.
Since the beginning of the year, high yield bonds issued by companies in Europe's telecommunications industries have shown how these processes have worked in practice. Companies had built up large amounts of debt as they invested in their networks. But at the same time, cashflows were squeezed by fierce price competition and lower than expected demand.
In the meantime, the brutal sell-off of telecommunications and technology stocks meant that these companies could no longer raise money from the stock market.
Two sets of statistics illustrate the impact of these factors on the European high yield bond market. Merrill Lynch's Euro High Yield index rose by 0.6% in the first quarter of 2001 but fell by 20% through the first half of the year. At the beginning of the year, telecommunications-related companies accounted for around 70% of the European high yield bonds on issue, while industrial companies accounted for 30%.
Today, each of the two groups of companies accounts for around half of the European high yield bond market.
Yet the picture is not all gloom. Outside the telecommunications arena, high yield bonds in Europe have generally performed well. Although the June quarter saw the largest-ever high yield bond issue by a European industrial company (a e500m offering by Messer Griesheim), demand for industrial bonds is still vastly outstripped by supply.
In the US, high yield bonds from non-telecommunications groups have also generally delivered good returns. A key development has been the US Federal Reserve's dramatic cutting of interest rates: investors have perceived that this will bring forward the next cyclical upturn in the US economy.
The US high yield bond market differs from that of Europe in that it is much larger and broader: technology and telecommunications stocks are, relatively speaking, less important.
Crucially, mutual fund and other investors have continued to buy US high yield bonds over the last six months.
During the June quarter, issues of high yield bonds in the US amounted to $27bn. This compares with issues of $54bn in all of 2000. Around e2bn of high yield bonds were issued in Europe in each of the first and the second quarters of this year.
Looking forward, we expect that the European high yield bond market will have to contend with two key challenges. One is the ongoing troubles of the telecommunications sectors. Overcapacity in networks and hardware mean that many companies will continue to face stiff price competition.
This is bad news for corporate cashflows and perceptions of risk. It is probable that sentiment will suffer from high-profile defaults.
The second challenge is that industrial high yield bonds in Europe no longer represent attractive value.
In their desire to avoid the telecommunications industries, European investors have bid up prices of industrial high yield bonds to unreasonably high levels. And it is important to remember that not all the telecommunications companies that have issued high yield bonds are going to default.
In the medium term, there will be great opportunities to buy the bonds of fundamentally sound companies that have a strong business niche at bargain prices.
Investment grade corporate bonds have been accepted as a mainstream asset class.
European high yield market will have to deal with ongoing problems in telecoms sector.
Industrial high yield bonds in Europe no longer represent good value.
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