Yield-induced amnesia hits Europe's junk market

Fri May 3, 2013 8:55am EDT

* High yield issuance surges as yields grind tighter

* Riskier instruments and looser terms abound

* Disparity with underlying economy fuels correction fears

By Natalie Harrison and Robert Smith

LONDON, May 3 (IFR) - Europe's dire economy prompted a rate cut this week, but did not derail an indiscriminate hunt for yield, enabling junk rated companies to push boundaries on leverage and sell risky subordinated Payment-In-Kind bonds with apparent ease.

High yield issuers have never had it so good, but there is growing unease from some camps that investors may be forgetting that markets can sell off, as well as rally.

This week's deals have been multiple times subscribed, allowing issuers to print bonds at coupon levels unimaginable just two weeks ago. Business is so great that some bankers say they are turning deals away.

Year-to-date issuance is running at EUR31.5bn, up 32% year-on-year, Barclays data show, and the diversity of deals is more akin to US high yield markets.

"There has been a good mix of deal structures and drivers for these transactions which have also come from a wide variety of countries, suggesting this is a sustainable increase in activity," said Mathew Cestar, head of leveraged finance in EMEA at Credit Suisse.

This week's deals include PIK toggles for R&R Ice Cream and Kloeckner Pentaplast, a dividend recapitalisation for bathroom equipment maker Sanitec, a raft of debut issuers in a broad range of sectors including tissue maker WEPA and UK retailer New Look, and jumbo refinancings for well-known issuers like Ineos.

NO BARGAIN BASEMENT

Some analysts predict the market will grow to EUR400bn by year end, having already quadrupled in size to EUR320bn since 2008, but it's not all rosy and there could be bumps along the way.

The most optimistic investors are confident that European high yield has finally reached a critical mass and will continue to grow, but deals are being priced so tightly that the risk of sharp losses from a sell-off is growing.

"The quality of deals is certainly lower than what we have seen earlier this year," said one high yield investor.

"In many cases leverage is being maxed out, and pricing is looking very tight. We're certainly not being offered any bargains."

New Look is one of the most highly leveraged deals of the week - around 5.8x Ebitda including its PIK debt, according to one banker on the deal, which is considered high for a business vulnerable to a pullback in consumer spending.

A clear sign that the market is getting frothy is also the resurgence of deeply subordinated PIK deals. PIK supply totalled EUR1.2bn in the first four months of the year, just below the EUR1.4bn seen in the whole of 2012, Barclays data show.

Analysts are growing increasingly concerned that investors are ignoring the fundamentals, warning that a correction could be brutal.

"With every incremental grind tighter we are cognisant of how 'toppy' the market may now look," said Simon Ballard, senior credit strategist at National Australia Bank.

"Further 'risk on' is simply extending the scope and extent of possible correction if and when it comes."

The Crossover index fell below 400bp for the first time in two years, and Barclays' cash index set another post-crisis record, reaching an average price of 106, in the same week that Spanish unemployment reached 27% and PMI data showed manufacturing remains in sharp decline.

The ECB rate cut also smacked of desperation.

BREEDING GROUND FOR DEFAULTS?

The paradox is worrying, suggesting central bank action, rather than improving fundamentals, has set the market ablaze.

"Investors need to be wary when market conditions prompt a flurry of new high yield issuance. Hot primary markets are often fertile grounds for future years' defaults," said Peter Aspbury, a high yield portfolio manager JP Morgan Asset Management.

A PIK toggle sold by German plastics and packaging firm Kloeckner Pentaplast was increased by 50% to EUR225m even though second lien lenders were swapped into equity in last year's restructuring. That's proof of how strong the yield hunt is.

Similarly, Irish telco Eircom, which only emerged from restructuring in June, is in the market with a EUR310m deal. The company still has EUR2.6bn of debt after the issuer's floating rate and PIK notes were wiped out.

Some observers suggested that issuers are tapping the same audience they burnt less than eighteen months ago, highlighting just how short some investors' memories are.

There's already some evidence of potential secondary volatility.

Investors may have been warned about a potential "bun fight" for good allocation on the Kloeckner PIK, but the bond quickly dipped back to par after an initial jump to 101 on the break as markets took a slight turn for the worse on Thursday.

"Next week could be interesting," said one senior leveraged finance banker.

"It's likely that some deals will not trade that well."

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