Cov-lite comeback could thwart high yield FRN surge

Fri May 17, 2013 7:28am EDT

* Sponsors seeking leeway embrace high yield FRNs

* CLO backstop waning as reinvestment periods end

* Cov-lite loans could trump FRNs' flexibility

By Robert Smith

LONDON, May 17 (IFR) - High yield floating rate notes, once a niche product but now a more common feature in the market, may already have had their heyday, as corporates eye a renaissance in covenant-lite leveraged loans that could offer even more attractive funding.

A surge in FRN supply has been one of the key themes of the high yield market in recent weeks, driven by demand from collateralised loan obligations and a desire by leveraged borrowers to keep financing as flexible as possible.

Traditional loan borrowers value the shorter, usually one-year, call protection on FRNs, because it means the debt can be paid off after that period without incurring payment penalties.

Fixed rate bonds, in contrast, usually have more restrictive three- or four- year call periods.

Those factors have led to a doubling in FRN issuance, with 11 issuers pricing EUR2.3bn-equivalent of bonds compared to EUR1.3bn priced by five issuers at this point last year, according to data from Nomura.

Euro floaters have been dominant due to their natural backstop in the CLO market, but deals have not been restricted to that currency with sterling also seeing an influx, most notably from helicopter operator Bond Aviation and insurance broker Towergate more recently.

Towergate's GBP396m deal was the largest sterling floater to date and the largest European FRN all year, and unprecedented demand let the borrower drop a proposed fixed rate tranche, leaving it with a flexible capital structure that will make it easier to push ahead with plans for an initial public offering.

In the same week bathroom equipment maker Sanitec, which is also eyeing an IPO, and UK retailer New Look priced euro floaters.

"When two sterling FRNs and two euro FRNs price in one week, issuers, particularly sponsor-backed ones, are certainly going to take note," said Kevin Connell, managing director of high yield syndicate at RBS.

"However, there is a natural limit on how much will get done in FRN form. It's still an instrument, particularly in GBP, that you'd want to pre-market before launching in most cases."

COV-LITE CAPITULATION

FRNs have been particularly valuable to private equity sponsors if they are mid-investment cycle and are planning a potential exit from the business in the next year or so ahead. They first made a comeback in early 2011, with bathroom firm Grohe one of the first to issue such deals.

Market conditions have been so strong of late that Sanitec was even able to use some of the proceeds from its EUR250m FRN to pay sponsor EQT a EUR100m dividend.

Sponsors that fully recycle a loan capital structure in the bond market are also able to strip out maintenance covenants.

An outright capitulation on covenant-lite loans, however, could nip FRN growth in the bud because from an issuer's perspective, loans are cheaper and give borrowers complete freedom to prepay whenever you want.

In contrast to their American counterparts, European investors have been disciplined in their opposition to these loans, which offer less protection for investors against a deterioration in a company's performance.

But investors have relented when a euro tranche sits beside a dollar tranche, such as the recent Ineos refinancing. Ista's recent LBO financing also had all but two loan covenants stripped out, despite having no dollar component.

"There is still a certain contradiction in investors accepting FRNs but resisting cov-lite loans, and so FRN issuance is likely to be another driver of the European transition to pure cov-lite," said Peter Hurd, managing director, acquisition and leveraged finance, capital markets at Nomura.

STARING DOWN THE BARREL

The dynamics that have driven FRN supply are certainly changing. The dwindling reinvestment capacity of CLOs, the main buyers of the instruments, is regarded as the biggest threat to the instrument's longevity.

According to Nomura, EUR22bn of the EUR45bn existing CLO liquidity will expire by year end, with 76% expiring by July.

The CLO bid is staring down the barrel, fuelling the FRN surge as issuers rush to tap the market before it expires. Support from a broader investor base is therefore needed to maintain momentum in the market, bankers say.

New European CLOs have formed this year, but only at a slow pace, and the fact that some of those have larger bond buckets - 40% on Pramerica - frees managers to buy fixed rate notes over FRNs, which could further cap demand for floaters.

Loan investors raising further money through managed accounts have provided FRNs with more liquidity, but whether they continue to buy after the CLO bid wanes is an open question.

The most likely scenario, at least in the foreseeable future, is that FRNs will remain a tool for borrowers that cannot print cov-lite deals, if that market springs to life.

Ultimately though, bond investors will determine whether floaters become known as a fad or market staple in high yield. From an investor point of view, FRNs are more liquid than loans, and there is also the prospect of higher interest rates to consider.

"Although FRNs lack convexity, an investor does get greater interest rate protection. That could turn out to be quite attractive in the future," said Connell.