July 25, 2014 / 8:56 AM / 3 years ago

Small FRNs struggle as high-yield investors get tough

* Small companies struggle to jump on FRN craze

* Bond investors push back against short non-calls

* Investors warn on downside risks

By Robert Smith

LONDON, July 25 (IFR) - Large companies with pre-existing institutional loan investors have been able to obtain aggressive terms when issuing high-yield floating rate notes this year, but smaller borrowers are struggling to emulate their success as market sentiment sours.

High-yield FRNs were once a niche product but have become big business in Europe, tapping into the clamour for paper from both junk bond and leveraged loan investors. This year so far has seen 25 deals from sub-investment grade European companies, totalling more than 7bn-equivalent.

Yet many FRN deals have faced pushback this month. Italian fashion brand Twin-Set was forced to rewrite terms substantially and French jeweller THOM Europe had to scrap its deal altogether.

“If you do not have existing loan investors as anchors it makes life a lot more difficult,” said a syndicate banker.

“In contrast, on the recent £100m TES Global floater we had three anchor investors so the deal was more straightforward.”

Floaters have been popular with junk-rated borrowers as they offer access to the bond market with attractive call protection. FRNs usually have only one-year call protection with the first call at a price of 101.

Some large borrowers have been able to push terms even harder. Italian telecoms firm Wind and French cement maker Parex priced FRNs larger than 500m in June, and both had a first call at par.

However, these deals have left some bond buyers distinctly unimpressed.

“While I can appreciate the appeal of being short interest rate risk in an atmosphere of historically low yields, the poor call protection in FRNs means that you’re surrendering the upside from credit selection,” said Peter Aspbury, a high yield portfolio manager at JP Morgan Asset Management.

“Such a return profile is more appropriate for loan investors than for high yield bond funds.”


When loan investors do not show up, however, companies find things difficult. THOM Europe had no such anchor investors, according to a banker on the deal, so ditched its planned FRN tranche and increased the fixed-rate bond to compensate.

Pizza Express also dropped an FRN tranche on Thursday, but bankers on the trade stressed this was the issuer’s preference rather than a reflection of demand.

Mitch Reznick, co-head of credit at Hermes Fund Managers, argues that other than offering higher coupons, companies might need to issue bonds at a discount or up first call prices to get bond accounts interested.

Twin-Set Simona Barbiere had to do all three to get its deal over the line, while also extending its non-call period. The small 150m trade changed from non-call one to non-call 1.5, with a 102 first call. The deal also priced at an original issue discount of 99 with a chunky 587.5bp coupon.

The deal still flopped in the secondary market, however, and was bid at less than 98 the following morning.

This drop in the secondary market flies in the face of secured floaters’ reputation as a stable product, and some argue that these deals still present significant downside risks.

“Despite typically being senior secured, some recent FRNs have formed part of an over-leveraged all-senior debt capital structure,” said Aspbury.

“Being called at 101 after one or two years is therefore a questionable reward for taking on equity-like risk.”


This questioning of floaters’ risk-reward profile is part of a wider frustration from investors on shortening non-call periods in high-yield.

Most high-yield bonds have embedded call options at set prices, which limits price appreciation. Shorter non-call periods at low prices reduce the upside for investors, while the downside risks of lending to junk-rated companies remains. This problem is known as negative convexity.

While FRNs’ short call protection is well established, call protection periods have eroded for fixed-rate deals as well. Several five-year bonds priced this year had 1.5-year non-call periods.

Reznick says these call structures can be a deal-breaker, even when the company involved is strong.

“It’s tough to walk away from some deals based on fundamentals - good company, management, balance sheet - but if the short call structures preclude you from capturing the upside as the issuer performs, and you’re not compensated at launch, you stay out of the book.”

Investor resistance to short non-call periods is most clearly seen on Winoa Group’s recent pulled deal. The bond was launched as a six-year non-call two trade, but bankers had to withdraw the deal after investors pushed for three-year call protection and other covenant tweaks. (Reporting by Robert Smith, editing by Alex Chambers, Julian Baker)

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