The next stage of growth may be driven by the refinancing needs of non-investment grade (non-IG) corporates and financial sponsors, such as private equity houses, still heavily exposed to bank funding. It is also anticipated that any pick up in mergers and acquisitions (M&A) could result in an increased demand for non-bank funding. The exceptional growth to date has been down to a virtuous combination of strong fundamentals and unique technical factors such as low rates, abundant liquidity and increased risk appetite from investors. While these technical factors may not always be as supportive, the fundamental underpinning of the market should continue to be a force unabated for the foreseeable future.
At EUR300 billion, the European high-yield market has reached the size where it can offer liquidity and efficient pricing across sectors. It is now a deeper, more diversified and more mature asset class that is becoming highly attractive to both issuers and investors.
For example, according to the Mercer 2013 survey of pension funds, about 10 per cent are investing in high-yield now up from only 5.5 per cent of pension funds in 2011. Over that same period, the average allocation level changed from 4.3 per cent to about 5 per cent.
The financial crisis showed corporates the importance of a diversified capital structure. Across the board, companies are now thinking strategically about how to enhance flexibility, diversify exposure, and extend duration. High-yield bonds do all of that.
However, the fact remains, that European corporates are still largely bank financed, especially when compared with those in the US.
Balance sheets across the European banking sector must continue to shrink for another five to seven years, according to Deloitte. Arguably this deleveraging will impose a structural shift in how corporates are funded. Reduced bank lending means non-IG borrowers may scramble for alternative sources of liquidity for their funding needs.
And the need for significant refinancing is there. About EUR45 billion of non-IG bank debt is set to mature annually over the next four years. If one third of the maturing bank debt is refinanced in the high-yield market, in line with the trend seen since 2009, that alone could provide a further EUR60 billion of incremental growth for high-yield bonds up to 2017.
M&A-related issuance is also showing signs of recovery. From about EUR3 billion a year between 2009 and 2011, it rose to EUR5 billion in 2012 and had already reached EUR6 billion by July this year**. Looking to the future, issuance of up to EUR10 billion a year seems reasonable, especially in light of historical evidence. This would further add to the high-yield growth story.
On this basis, we could see further growth of around EUR100 billion – 120 billion in the European high-yield market by 2018 through corporate bank to bond refinancing and increased M&A alone.
Add to that the continued financial sponsor activity, including refinancing of Leveraged Buy Out loans in the capital markets, and a market size of up to EUR450 billion within the next five years is eminently plausible.
All this needs setting in the current context of a European high-yield market that at EUR300 billion is still only 30 per cent of its US counterpart, which is worth a whopping EUR1 trillion equivalent***.
Europe may never achieve the same depth or size. Its underlying economies are more fragmented, diverse and governed by different regulations. But the gap is very large given the relative size of the two economies. Europe’s GDP was about USD17 trillion last year compared with USD16 trillion for the US. What that suggests is a European high-yield market with considerable upside.
Clearly there are still risks to this growth outlook, such as a sudden rise in base rates, renewed eurozone worries or a surge in upgrades for fallen angels (companies downgraded to non-IG during the crisis).
However, we firmly believe a critical inflection point has been passed. It is not a matter anymore of whether the high-yield market is here to stay as the main non-IG alternative bank funding. It is only a matter of time.
* FactSet
** S&P LCD
*** FactSet
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