The European high yield bond (HYB) market has experienced record demand from investors. For the year to 14 June 2011, Europe saw a record $46.1 billion worth of high yield issuance, up 88 percent on the $24.5 billion recorded over the same period last year, according to information provider Dealogic. If this rate of issuance is maintained, the European high yield market will hit $100 billion for the first time for the full year.
This liquidity, combined with low government bond yields, has led to attractive all-in pricing for issuers (average yield of HYBs this year is just 6.9 percent, compared with the 10-year average of 10.4 percent, according to Credit Suisse). These trends have primarily been driven by (i) a willingness of higher quality corporates to embrace the public sub-investment grade market previously stigmatised as ‘junk’; (ii) the closer scrutiny of regulators on how banks internally credit rate loans, resulting in less sub-investment grade lending; and (iii) an increasing number of typically more conservative investors (pension funds, insurance companies etc) moving up the risk curve in search of yield.
The HYB market provides a source of senior and junior non-investment grade debt that is not readily available from banks. This is particularly important for forthcoming infrastructure re-financings as the market for senior bank debt has significantly contracted from when the original financings were put in place. HYBs can be used to cover at least part of the resultant funding gap, giving businesses a few years’ breathing space to de-lever their capital structures.
To date, however, only a few infrastructure companies have chosen to access this market to refinance their existing debt:
All of these assets, except Moto, have Regulatory Asset Base (RAB) pricing models which make it more straightforward for rating agencies and investors to judge the relative loan-to-asset base. The HYBs in these transactions, while being subordinated, sit above a senior debt structure which investors are confident will remain in the A/BBB+ ratings range. With natural de-gearing as the RAB increases with RPI (Retail Prices Index) and capital spend, these HYBs are positioned to provide investors with comfortable headroom relative to the RAB.
However, an RAB model is not necessary for infrastructure businesses to access the HYB market. Moto is a good case study of how other infrastructure and essential service assets can access the market.
What HYB investors want
Whilst HYB investors are similar to banks in looking at the risk of whether their capital will be returned, they differ significantly in three key respects: (i) they can typically ‘exit’ a credit by selling in the open market; (ii) they can hedge portfolios of credits using traded indices; and (iii) they like to capture yield for as long as possible and do not seek amortisation. Like banks, such investors’ credit focus includes a view on the ability to be refinanced or repaid. However, they differ in looking also at the liquidity in the debt and the relative value of the proposed transaction compared with companies with the same credit rating or indeed equity securities of similar businesses.
A credit rating is nearly always a requirement to access the high yield bond market and discussions with the rating agencies can be an influential factor, although price can compensate for ratings in a way that it cannot necessarily for bank lenders. While investors prefer to work within leverage and pricing ranges indicated by rating and comparable transaction analysis, other “soft” factors can often be instrumental in success. These include the quality of the management team and the management presentation; the strength of the covenant and security structure; and views on the defensiveness of a specific sector.
Infrastructure and related assets have a competitive advantage in rating agency views of recovery value and hence should be able to achieve higher leverage than standard leveraged buyout transactions. For example, leverage on Moto’s HYB was the “highest for a new high-yield bond issue since the credit crunch” according to S&P LCD. However, investors will always look at relative return once they are satisfied with credit quality. For Moto, the small issue size (implying less liquidity), refinancing risk implicit in the leverage, subordination and the resultant CCC credit rating for the bond, led to relatively high pricing. This was partially offset by perceptions of a stable, somewhat unique asset and a strong management team.
Why haven’t more infrastructure companies accessed the HYB market?
Timing – many existing infrastructure financings don’t mature until 2012 to 2015, are at low margins and the underlying interest rates have been hedged. Hence, there are few current incentives for shareholders to refinance and put more expensive debt in place.
(i) Accommodating banks – the large majority of infrastructure transactions have historically been financed by banks. Most of these banks have not been required to mark-to-market their infrastructure portfolios and have historically been willing to roll over debt positions for a short period at “off market” leverage and pricing levels rather than push companies to restructure or ultimately take security and sell the asset to get their capital back. The sense now is that banks are resisting such rollovers due to their own capital constraints under new regulation and in a backdrop of economies and markets that have not improved materially since the start of the financial crisis.
(ii) Difficult leverage comparables – the HYB market caters for a typical standardised product where rating, comparable transactions and structures are important. Investors make a decision to invest in a few days and the bonds are relatively liquid in the secondary market. The main comparable metric is debt to EBITDA. Due to the high EBITDA to cash flow conversion and the relative defensive nature of the businesses, infrastructure assets typically have higher debt to EBITDA ratios than leveraged buyouts. This makes comparisons harder as a high debt to EBITDA ratio does make rating agencies and investors more cautious.
(iii) Hedging – many infrastructure companies put in place long-term interest rate hedging (and many also put in place long-term inflation swaps) at the time of acquisition. As a result of the current interest rate and inflation environment these hedges are now materially out of the money. This adds complexity to the refinancing as the hedge needs to be paid out or restructured, affecting the credit metrics. A short term rollover of debt does not solve the mark-to-market issue, which will need to be dealt with again at the next refinancing date at additional cost to the business. A move to a longer-term capital structure at a senior level to match the remaining term of the swap, together with a junior bond, provides a longer-term solution while minimising any equity injection. The HYB market is moving to reduce the impact of this issue through the provision of floating rate notes which have re-emerged in reasonable size on some transactions (such as Priory Healthcare).
HYB investors have proven they are willing to invest in debt rated CCC and hence a combined loan and bond capital structure can maximise market leverage. For shareholders, paying banks to rollover debt when a roll doesn’t solve the underlying capital structure issues is likely to reduce equity value. Often, short-term solutions do not provide new capital for management to grow the business and a restructure or recapitalisation into a long-term, permanent structure will need to happen at some time in the future. The HYB market offers a longer-term solution with the flexibility to allow the businesses to grow.
Can the HYB market meet the needs of infrastructure equity investors?
Infrastructure equity is looking for good cash-on-cash dividend yields. While reducing leverage is likely to restrict distributions to equity, the HYB market does allow distributions to be built into the structure of the bond. Broadly speaking this is regulated in a standard HYB document through 50 percent of net income being available for distribution. It is also possible to have a number of carve-outs to increase the possible distribution (for example, listed companies with HYBs often have a basket for dividends based on a percent of market capitalisation). The HYB can provide shareholders yield once the company shows it can support such payments to equity. For Moto this meant distributions once a certain leverage level is achieved. Over time, with more infrastructure transactions accessing the HYB market, such restrictions should become more flexible.
Without an amortising profile, HYBs encourage reinvestment in the business. Additional debt for capital expenditure can also be incorporated into a HYB document. A planned capital expenditure schedule funded by a capital expenditure facility can be permitted. In addition, an incurrence test can be structured to allow for unplanned capital expenditure. The flexibility of the test depends on the starting leverage and the requirement to show deleveraging over the term of the bond. Moto has the flexibility in its documentation to debt fund a portion of its on-going development capital expenditure.
HYB investors can come into a capital structure on a structurally or contractually subordinated basis as well as on a senior basis. The Moto transaction showed strong appetite for a CCC subordinated transaction allowing the company to maximise leverage achievable in the market.
By undertaking a junior bond, Moto was able to optimise its senior loan and maximise total debt while still providing flexibility for ongoing business development.
The HYB market can provide debt with a term from five to 10 years. The term comes with pre-payment penalties, typically a “non-call” period of at least three years (i.e. net present value make-whole payment of spread over government bonds for three years) and then a straight line reduction in the percentage of coupon pre-payment penalty thereafter. The consequence is that it is expensive to refinance the HYB within the non-call period. Due to the high cash generation of Moto and the expected deleveraging profile, a shorter-term bond was chosen to give the company the opportunity to refinance the junior bond to an all-senior structure in the next four to five years without significant repayment costs.
Change of control
Typical change of control provisions in a HYB include bondholders having the option to put back the bonds at 101 percent of face value. To the extent the bonds are trading above 101 percent in the market, this option is unlikely to be taken by bondholders and the bonds can remain in place following a change of control.
Some perceived downsides
There are some characteristics of a HYB that may be viewed as unattractive by shareholders:
(i) Liquid market provides a daily price for the debt, although this does provide opportunities for the company to buy back its debt if it trades down;
(ii) On-going commentary on the company by the rating agencies;
(iii) More public disclosure on financial and operating results;
(iv) Complex inter-creditor arrangements, with some banks still nervous about interaction with HYB investors.
Moto’s strong performance over the last five years, together with its streamlined systems for reporting, made all of these perceived issues manageable.
A sustainable solution to financing infrastructure assets?
The HYB market has been a benign environment through much of 2011. However, as with any thriving asset class, commentators are already warning of market fatigue. Most notably, returns are starting to moderate. The European high yield market returned an average of just 0.2 percent over the past month, compared to 7.4 percent over the past six months, according to CreditSights. This is in stark contrast to the 15.3 percent and 56 percent returned in 2010 and 2009, respectively.
Furthermore, the high yield market is notoriously volatile and can move materially in a short space of time. For instance, the market has been knocked by sovereign debt concerns over recent months. Therefore, while shareholders may be enjoying attractively priced loan financing and “off market” leverage through structures put in place before the financial crisis, the risk they face is that the HYB market is not as liquid when they come to refinance. Hence, it is advisable that companies refinance well ahead of a looming maturity or risk being left with a less buoyant HYB market and hence worse terms for their refinancing.
The HYB market provides a market-based level of liquidity for infrastructure companies, especially for junior debt. The bonds can be structured to meet shareholder requirements once at a stable level of leverage. Moto has already set a benchmark for non-RAB based infrastructure and essential service companies looking to access the market to refinance debt. Furthermore, the market provides mark-to-market pricing and leverage, and hence a way of solving the equity injection required to achieve an appropriate debt refinancing. As more infrastructure and essential service companies access the high yield market, and as high yield investors increase their knowledge of the asset class and its defensive qualities, flexibility in terms should improve.
Spence Clunie is managing partner of fund manager Ancala Partners, having previously been head of Macquarie’s debt business in Europe. He originated and led the acquisition of Moto for over £580 million in June 2006 for a consortium of Australian pension funds
Anthony Forshaw is a Deutsche Bank veteran who has advised on many high profile infrastructure and leveraged finance deals. His team led the Moto HYB transaction and provided a portion of the senior bank debt