---

A year on from Events Radar’s previous leveraged finance webinar, Keith Mullin hosted a panel of experts including BNP Paribas’ Charlotte Conlan, M&G’s Fiona Hagdrup, Credit Agricole’s Jermaine Jarrett and Fitch Ratings’ Edward Eyerman, discussing the trends, opportunities and challenges facing the most exciting corner of Europe’s debt market.

Full circle

While January 2020 may feel like a lifetime ago, anyone charged with trying to make sense of Europe’s sub-investment grade debt market could be forgiven for posing the question: Are we back where we started? Credit spreads are near record lows, leverage remains sky-high, and primary markets are electric – buoyed by a healthy mix of M&A, buyouts and hurried refinancings at ever-lower coupons.

“We started 2020 as if it was the roaring 20s,” said Edward Eyerman, Head of European Leveraged Finance at Fitch Ratings. “We had an awful lot of credits that were discounting very good things for 2020 and 2021, leverage levels were high, cash flow forecasts were very aggressive and covenant erosion was accelerating.”

Eighteen months on, all three of these variables still apply, although ratings agencies, underwriters and investors align in the view that, given the lessons learned from the Covid market meltdown, evidence abounds that a lot has changed.

Edward Eyerman, Head of European Leveraged Finance, Fitch Ratings

“For sure it looks like we are in a new credit cycle,” Eyerman added. “We are upgrading our forecasts to go out to 2023. As companies are reopening and seeing that they have more volumes and pricing power, I think what gives legs to this recovery is that monetary support looks like it is going to remain well into 2022.”

Assessing the credit quality of Europe’s riskiest public borrowers was no easy task. Tried and tested methodologies were no longer valid as certain sectors saw their EBITDA margins wiped out overnight, leaving agencies scrambling to distinguish which issuers were suffering from a temporary lack of liquidity from those facing a permanent loss of solvency.

“In many ways we are back to the cycle of January and February 2020 - but with a bigger stimulus tailwind”

Lessons from East Asia, which went into lockdown months before Europe, provided some guidance as to how to assess the impact on the sectors most at risk from Covid, Eyerman said, with the key takeaway being that there would be some form of recovery – even for the likes of transport, leisure and retail. But the key fundamental from a European perspective was the immense scale of monetary and fiscal support, ranging from furlough schemes to unprecedented government bond buying. It is this backdrop that has given legs to the recovery, Eyerman said.

“In many ways I think we are back to the cycle of January and February 2020”, he said. “It is just that we have more of an economic and stimulus tailwind now that will make it last a little while longer.”

With the ECB is steadfast in its resolve to keep policy loose well in to next year, for Eyerman, the only question is: “Can fiscal policy stay there when crucial support schemes are eventually removed?”

Never waste a good crisis

Investors and underwriters, too, identify firm parallels between where we are today and where we were on the eve of Covid. But again, there are important takeaways that both sides have learned from the lessons of the pandemic.

“We went into 2020 thinking we were coming to the end of the credit cycle –we were certainly very much in late cycle,” said Jermaine Jarrett, Head of Credit Agricole’s High-Yield Syndicate. “The questions we were asking were where can spreads go from here? Do we think about more leveraged acquisitions to eke out some final gains? And it was about refinancing callable debt.”

What started, at the height of the March nadir, as a scramble to work out how banks could provide emergency liquidity to otherwise healthy companies that saw their businesses put on life support, quickly turned into a blistering market rally, with risk takers rewarded with double-digit gains in the months that followed.



Jermaine Jarrett, Head of High-Yield Syndicate, Crédit Agricole CIB

“You get the virtuous circle,” reflected Jarrett. “Those who were brave and stepped in were earning outsized returns, and that attracted yet more [investment]. This forced down spreads, which meant more companies could have market access. By the end of the year, it was almost back to normal, with issuers refinancing again and looking to see what opportunities we could find to take advantage of the phenomenal amount of liquidity in the system.”

Central banks were of course the architects of the blistering rebound. What started with a rally in European government bonds and investment-grade corporate credit quickly spread to junk bonds and leveraged loans. This was thanks to a deluge of HY fund inflows and an increasing number of non-traditional investors attracted to the asset class.

“We have learned collectively not to focus any longer on leverage”

In the immediate aftermath of the Covid-19 outbreak in Europe, the ECB pledged to buy EUR750bn in European government bonds up until December as part of its Pandemic Emergency Purchase Programme. The central bank also extended its Asset Purchase Programme, which includes eligible investment-grade corporate bonds, by EUR120bn. This would trigger a steady flow of cash into ever riskier assets as investors chased returns and the spread for higher quality products narrowed.

“It is not surprising that non-traditional funds have been attracted to the high-yield market,” Jarrett said. “Frankly, that was likely the expectation of stimulus – that investors are being encouraged to spread the investments into riskier asset classes.”

While the presence of so-called investment-grade tourists in the European junk-rated debt markets is far from a pandemic-related nuance – indeed, the trend has been notable since the ECB began is corporate bond buying programme in 2016 – the experience of the last 15 months means IG holiday-makers are now a staple of European high-yield bond deals.

“The real message from this is the expansion of the investor base has taken us from a market where a small core of investors could almost dictate terms and determine whether a deal would get done or not, and now we are looking at one where the typical orderbook regularly has more than 200 investors,” Jarrett said.

“A big factor in the ability of the market to recover from a situation like 2020 is the fact it is large, it is stable and we do have very big investors, maybe not typical HY investors, participating in the market today,” Jarrett added.

Leverage? What leverage?

On the other side of the table, the experience has reinforced accepted truisms – namely, the importance of good and well-run companies with strong cash flows. But it has also forced investors to reassess that most principal of metrics: leverage.



Fiona Hagdrup, Portfolio Manager, M&G Investments

“We have learned collectively not to focus any longer on leverage,” said Fiona Hagdrup, Portfolio Manager at M&G Investments. “It was suddenly cast out as a relative irrelevance, as long as a company had the cash flow to wait out a return to normal.”

Investors who recognised this early in the crisis were richly rewarded, with early risk-takers pocketing huge gains, firstly in buying up beaten-up loans and bonds in the secondary market, and then in the primary markets once the floodgates for emergency liquidity financings began to open going into the summer.

“Nervousness, a drawing in of horns, conservativism and repositioning to defensive sectors – these were all the instincts of summer last year,” Hagdrup added. “But that was precisely the wrong strategy.”

“Embracing the triple Cs and the frontline and trusting the monetary and fiscal support: this was the way to deliver a stellar 2020 return, and even into 2021.”

Who is driving?

Just as there has been no doubt that central banks and investor confidence in their ability to deliver price stability were the key to unlocking markets from the Covid shutdown, it is just as clear what the force driving the stellar volumes in euro and sterling-denominated loans and bonds is private equity.

The presence of private equity in leverage finance is clearly nothing new, but the scope and scale of the deals and audacity of the takeovers is what separates us versus the outlook pre-pandemic.

“If we had done this panel three or four years ago, we would have said that what was holding Europe back was the lack of new deal flow,” said Charlotte Conlan, Head of Loan Syndicate and Deputy Head of Leveraged Finance Capital Markets at BNP Paribas.

“We were just circling the same deals, which were going from PE to PE. That still happens, and we are still recapping and refinancing but, in the industries that are being looked at, the industries themselves have changed,” she added.

Telecoms, a backbone of Europe’s high-yield bond market since its inception, continues to evolve as an industry and produces significant deal volumes. But whereas Europe has lagged hopelessly behind the US in terms of technology and software, now we are seeing huge deals in Europe.

“What was holding Europe back was the lack of new deal flow… now new sectors are coming through”

“New sectors have come through and are fuelling the deal flow,” Conlon added. “Investors, whether loan or bond [investors], want to see new businesses come through and the opportunity for PE to improve is always considered to be better.”

According to Loan Radar data, sponsor-backed loans for western European companies in the technology sector total nearly USD10bn year-to-date, already 70% of last year’s total in the sector.

In and out of fashion

Large swathes of London’s FTSE, dominated by comparatively out-of-fashion and underperforming stocks compared to the tech-heavy and expensive US indices, are said to be on the radar of private equity.

“The real strategic players are the private equity sponsors, and the outlook is dominated by public-to-private transactions, most obviously in the UK,” said Hagdrup of M&G.

For UK listed companies, there is a potent cocktail of pandemic-stricken companies being most vulnerable to takeover bids, coupled with the fact that UK assets are considered almost uniquely undervalued.

“It feels like a significant shift of ownership for swathes of the public stock exchange before our very eyes, whether it’s in tired old stocks through to pandemic beneficiaries like labs, testing and healthcare,” Hagdrup added. “In the UK alone, there is an outstanding amount that is in play or subject to a bid. For as long as that continues to play out, that will yield billions for loan and bond markets globally.”

Last year, Barclays led the largest high-yield funding exercise ever undertaken for a UK company, financing the takeover of big-four supermarket Asda using a mix of euro loans and sterling bonds. This deal was of course agreed way before the pandemic, but with at least three US PE behemoths having publicly declared their interest in fellow big-four super grocer WM Morrisons, similar takeovers – and the loans and bonds that finance them – look set to dominate the narrative.

“There is an outstanding amount that is subject to a bid. That will yield billions for loan and bond markets globally.”

Where there is PE…

There is covenant erosion. This is nothing new, and it’s not clear what effect the pandemic has had. True, the bonds and loans financing the buyout of ThyssenKrupp’s elevator division saw a certain amount of push back from investors, prompting cosmetic changes to documentation. But for the most part, deals sponsored by private equity continue to test the limits of lender flexibility.

Covenants work after all

“These are the most pro-borrower conditions I have ever seen,” said Edward Eyerman of Fitch. “The idea that cov-lite is here to stay is validated by the experience of the pandemic.”



Charlotte Conlan, Head of Loan Syndicate and Deputy Head of Leveraged Finance Capital Markets, BNP Paribas

Put simply, covenants work. When an array of otherwise healthy companies saw their cash flows wiped out and the likes of airlines and restaurants saw their business models made temporarily illegal, borrower-friendly documentation assisted many in avoiding default.

“The pandemic highlighted how important cov-lite was to allow these businesses to trade through their initial difficulties,” Eyerman added. “Even though spring covenants were being tripped, they were all waived – and all for the right reasons. There was a good cohesion in interests in protecting the market, rather than opportunism we might have anticipated.”

The only real sticking point has been how vulnerable lenders are to structural subordination, Eyerman said.

In a famous example, cruise giant Carnival raised some USD4bn in senior secured bonds at the height of the pandemic difficulties in April 2020 – obligations that rank ahead of its sizable stack of unsecured debt that the issuer had sold when it was a stable A-rated company, should the cruise line end up in what at the time seemed the very likely position of being unable to pay back its debt.

“I think that the risk assumed by lenders, particularly their vulnerability to subordination, has also been validated by the pandemic,” Eyerman added.

“These are the most pro-borrower conditions I have ever seen”

For most lenders though, this experience is a footnote to the pandemic lessons, and there has not been a clamour for increased protections.

Think of the credit

Rather than digging their heels in, investors are instead taking stock of the fundamentals, avoiding complacency and, above all, narrowing their focus on strong, big and stable credits.

“There has been quite the advertisement for private equity in the past [fifteen months],” Hagdrup said, noting how the ownership structure helped support businesses through the initial round of Covid lockdowns in early 2020.

Ultimately, presented with a choice between a strong credit with weaker documentation and a weaker one with lender-friendly covenants, the former wins out every time.

“It is right that the mitigant to diluted documentation is [choosing] better and bigger businesses,” Fiona Hagdrup at M&G said. “A company with a market presence, heft and influence should ultimately be a durable one, particularly for a first lien lender.”

“It is hard not to feel positive at the moment,” she added. “One runs the risk of leaving sizable return on the table. Calibrated for even a prudent, pessimistic outlook, it’s hard to see us getting to long term historic average default rates given the community of borrowers we have.”

Blooming ESG

Aside from the tsunami of primary market activity, the most obvious data, especially in high-yield bonds, is the exponential growth in ESG-labelled issuance. So far this year, European sub-investment grade corporates have raised nearly USD22bn of debt labelled green, sustainable, or social, up 270% compared to last year.



Keith Mullin, KM Capital Markets

“The pull from investors on this topic has been taken seriously by issuers of all ratings classes,” said Jermaine Jarrett of Credit Agricole. “That has really driven the increase in leveraged issuance of both green bonds and sustainability-linked loans and bonds. That has been the real development in the market this year.”

The catalyst for the expansion in high-yield borrowers has been the development of sustainability-linked bonds (SLBs) this year and last. While the product has been a feature of the loan market for some time, the rapid expansion of SLBs in the investment-grade bond space last year has this year trickled down to the high-yield market, to the extent that high-yield bonds with coupon step-ups are now a market staple.

Standard green bonds, which have a dedicated use of proceeds, were slower to catch on in high-yield, where borrowers are typically smaller, with smaller treasury teams and by and large lacking the infrastructure or energy projects which lend themselves to standard use-of-proceeds bonds.

SLBs, by contrast, whilst requiring a borrower to have a dedicated sustainable finance framework, preferably endorsed by a third party, offer the chance for borrowers to reap the benefits of robust ESG policies with potentially cheaper borrowing costs.

“What the sustainability-linked product really helped with was the introduction of potential financial benefits for getting it right,” said Jarrett. “[SLBs] help drive ESG to be a much more central part of what issuers do as a matter of course.”

“[Green and sustainable issuance] has been a fantastic development because, firstly it’s good in and of itself, and secondly the investor base has certainly been demanding for some time,” Jarrett added. “A big proportion of our forward calendar is ESG-linked in some way.”