LONDON -- A group of money managers and investment banks is quietly developing improved protections for bondholders in the fledgling European high-yield bond market.
During the past two months, about 15 institutions have been trying to address investor concerns that they could be left high and dry in a bankruptcy situation. Currently, commercial banks effectively can shut out bondholders in a bankruptcy.
And, many investors might not be aware of the risk they are taking.
Because of a lack of adequate disclosure and a number of structural impediments, holders of European high-yield debt are considerably worse off than investors in U.S. high-yield bonds, according to a paper prepared for the group by Nigel Ward, a partner in the London law firm of Ashurst Morris Crisp.
"There should be a fair balance between the interests of the senior lenders and the high-yield investors. The high-yield investor should not necessarily be hung out to dry by the senior lenders if there is a financial problem," Mr. Ward explained in a written comment.
Tom Atwood, managing director of Intermediate Capital Group, a London-based mezzanine finance firm, said holders of European debt should receive comparable returns to what investors in equivalent U.S. issues receive in a bankruptcy. "We want it to be 40% to 50%, not nothing."
Because the market is in its infancy, this has not been a major problem to date, but there's a concern that investors could flee for years if there were a few well-publicized failures. Investment experts hope the $30 billion European high-yield market eventually will rival the nearly $500 billion U.S. corporate junk-bond market.
"I think it will follow the model of the United States because companies do want" access to capital, said David Hughes, director of global fixed income at INVESCO Europe Ltd., London.
Tim Grell, managing director of European leveraged finance at Merrill Lynch & Co., London, said three factors have been driving an expansion of European high-yield debt since 1997:
* Introduction of the euro eliminated currency arbitrage.
* Lower interest rates caused investors to enhance yield from other instruments.
* A focus on shareholder value generated huge corporate restructurings, outstripping the ability of banks and mezzanine finance to provide capital.
But Europe will not change overnight, and improving bondholders' rights will help ensure the long-term survival of the high-yield bond market, investors said. Pressure on European banks to provide better returns for their shareholders also might open up the market.
The problem is essentially twofold: There is a lack of adequate disclosure in some deals; and the structure of many deals subordinates the interests of bondholders to those of senior bank debt.
Subordination is not unusual, but European deals often structure high-yield debt to provide little recourse to bondholders. Many issue high-yield debt out of the holding company, while senior secured bank loans are tied to the operating company.
Various covenants also enable bankers to restrict the flow of cash to the holding company in times of a financial crunch, preventing bondholders from getting paid.
"It means the senior bank loan debt is sort of trebly senior," said Simon Pilcher, director of fixed income at PPM UK Ltd., London.
Bondholders' ability to influence restructuring -- through spinoffs, added leveraging or changes in ownership -- also is greatly limited.
"Bondholders can't participate in a restructuring," said David Hinman, senior vice president and high-yield product manager for Pacific Investment Management Co., Newport Beach, Calif. Mr. Hinman said he shuns the European market because it doesn't offer an adequate premium or a high enough nominal yield.
One issue is that bondholders would like a seat at the table when an issuer encounters financial trouble.
Case study
Investors are trying to determine to what extent they are subordinated in a default and how much they will get back on the pound, whether it's 10 pence, 50 pence or 90 pence, Mr. Pilcher said.
The collapse of Ionica PLC, Cambridge, England, last October was a case in point. The telecommunications company had raised some $570 million in high-yield debt, largely from U.S. investors, through a separate finance company. Cash flows went from the operating company up to the holding company. If the bondholders were going to get paid, money had to flow down from the holding company to the finance company.
Without any guarantees from the operating company or the holding company, the bondholders were "effectively subordinated not only to the bank debt but to equity holders at the holding company level," Mr. Pilcher said. PPM did not own any Ionica bonds.
Investors say a more even balance must be created between the banks and bondholders. "Put another way, we need to put a gun in the hands of the high-yield investor -- albeit with a time delay on pulling the trigger," Mr. Ward's paper said.
"Without the ability to enforce against/liquidate companies to whom the senior banks are lending themselves, the high-yield investor has no bargaining chips and is unlikely to have a place at the negotiating table."
Some options
Among the options Mr. Ward suggests: High-yield investors lend to the same legal entity as the senior secured lenders, with the caveat that bondholders must wait for, say, 120 days before taking action after a high-yield bond default.
Other options involve maintaining different entities to which banks and bondholders would lend capital, but giving bondholders better recovery rights.
It is much more difficult to provide bondholders with security from operating companies, because it could impede future financings and business development, he wrote. This problem could be addressed by inserting terms allowing the release of secured assets if certain financial tests are met.
Aside from the risk of poor recoveries, other issues also keep investors from the market. For one thing, the European high-yield market still is very small, and is heavily concentrated in telecommunications issues with a smattering of leveraged buyouts. Telecom companies comprise 70% of existing European high-yield bonds.
"I would call those categories the low-hanging fruit of Europe," Merrill Lynch's Mr. Grell said.
The parallel in the United States is to the early 1980s, when the high-yield market was dominated by oil companies and utilities stuck with uncompleted or exorbitant nuclear power plants, said Jennifer Leichter, managing director and senior portfolio manager, Putnam Investments, Boston.
Putnam now treats European high-yield bonds individually, and not as a separate market, she said.
Enough compensation?
The question is whether investors are being compensated for the added risk, even though European high-yield bonds typically pay a spread of about 100 to 150 basis points above that available in the United States.
The larger spread covers the added riskiness of bankruptcy and the lower liquidity in some European issues.
"You do pick up a higher spread but I don't know if it will compensate" for the added risk, given the lack of default history in European high-yield debt, said Jonathan Gregory, research analyst at Western Asset Management, London.
William Healy, director and head of Merrill Lynch Mercury Asset Management's European high-yield product, however, thinks many investors are focusing on the wrong issues. They instead should be looking at investment risks that are hard to analyze, document or enforce.
"No one has any idea what the default experience will be in the European high-yield market," he said, noting Ionica has been the only default in five years.
European governments and banks are less likely to let companies fail, and that won't change in the near term, Mr. Healy added. But any bankruptcies will be more spectacular, because there is no such thing as reorganizing company debts as there is in the United States.
"In Europe, once you get into bankruptcy, you're dead. There is no exit," Mr. Healy said.
