Feeling the heat from high yield

As banks in Europe shift their focus to smaller corporates, some direct lenders are being forced to reassess their approach as they find themselves squeezed out of larger tickets.

Demand from everywhere: corporates need financing; investors need yield; fund managers need to deploy capital; and investment banks need revenue. In such a hectic environment, a number of European managers are seeing larger tickets as a way of distinguishing themselves from a crowded marketplace and have set about underwriting £200 million ($255 million, €227 million) loans and above.

But competition is now squeezing debt fund managers out of larger transactions. Fewer of the bigger corporates are tapping the capital markets for financing, which is pushing many banks to work with smaller corporates on structuring high-yield bond issuances around the £200 million mark – finding themselves pushing up against the larger debt funds. These new issuances are an important source of fees.

Issuance of European high-yield bonds reached €35.7 billion in the first quarter – more than double the previous three months and tripling the amount at the beginning of 2016, according to a report from the Association for Financial Markets in Europe.

Borrowers are taking advantage of the huge amount of liquidity available in the market and capitalising on the increasing use of cov-loose structures. Indeed, S&P Leveraged Commentary & Data figures show 60 percent of term loans above €500 million in the first quarter of this year were cov-lite transactions. Anecdotal reports suggest this loosening of covenants is feeding further down.

Fund managers have admitted to knocking off 25 or 50 basis points on individual coupons, but some remain confident they are withstanding the pressure. Anthony Fobel, head of direct lending at BlueBay, says “private debt is resisting pressures from the high yield and liquid loan market”. He accepts that “some pricing pressure is visible, but terms (including covenants) remain robust”.

Such confidence is not unfounded. Where private debt funds have found success in carving out a space is in sponsor-backed transactions. Many of the leading European private debt funds have marketed to the same group of institutional investors offering high single digits for their senior strategies and creating a floor for how low pricing can drop. It is also worth noting that 2016 was a watershed for the market, with record numbers of unitranche deals completed on both sides of the Atlantic.

But with banks working on smaller bond sizes, corporates now have more options. Public markets will invariably win on a cost of capital basis. Moreover, with M&A volumes muted at the beginning of the year, opportunities are narrowing. Maybe some of the larger debt funds will re-focus on their mid-market roots, where there is less liquidity available, or source deals not backed by sponsors. Perhaps it’s time to take a more innovative approach to origination.

No-one can stand still. With so much raised, capital needs to keep flowing. More aggressive pricing shows the pressure growing on lenders. But even though many complain about the deteriorating quality of assets, sitting out of the market – however heated it may be – is not a realistic option.