Leveraged Credit in Europe Isn't Overheating, HSBC Says: Q&A

(Bloomberg) -- Credit spreads and levels of corporate and investor leverage are among the indicators suggesting Europe’s leverage finance market isn’t in a bubble, according to Tim Morgan, head of high yield syndicate at HSBC Bank Plc in London.

Morgan, whose bank was one of the global coordinators and bookrunners on the debt financing for Carlyle Group LP’s buyout of AkzoNobel Specialty Chemicals, spoke with Ruth McGavin on Sept. 24. Comments have been edited and condensed.

Leveraged Credit in Europe Isn't Overheating, HSBC Says: Q&A

What does the AkzoNobel LBO say about demand?

All four pieces of the financing -- loans and bonds in the U.S. and Europe -- went very well as can be seen in the price action and retranching. I haven’t seen so much demand for euro-denominated bond and loans in some time, perhaps since before the credit crisis.

It shows that very sizable LBOs can be financed where the credit profile is strong and the deal is appropriately structured. Pricing was also tighter than deals done in recent months for both bonds and loans. This partly reflects the liquidity that these large capital structures offer.

Why has appetite strengthened in September?

Leading up to July there was a lot of new money supply, particularly in the loan market. High yield funds also experienced redemptions in the first half of the year, leading to a liquidity squeeze.

As such, investors were concerned in June and July about the pipeline of new deals coming to the market after the summer, including Refinitiv and the AkzoNobel buyout. The fear was that this wave of new issuance would take the market wider as investors sold assets in order to make way for new ones.

Over July and August, new money supply decreased significantly and investors rebuilt their cash positions, through both normal income and in some cases by selling assets. There was also a bit more confidence and optimism, so that when the big LBOs came, debt investors saw their orders materially scaled back.

Now we are left with continuing excess demand for new paper, which is magnified when new deals trade up. The market is more robust now than many people were expecting following a significant amount of new deals.

What do you see ahead for documentation?

There’s no "one size fits all" for documentation. I still expect to see an ongoing debate for European transactions around structure and covenants -- especially in loans -- as we have had all year. But there will be flexibility for better credits.

Covenant-lite documentation has increased this year, which means default rates will go down and it will take longer for significant financial stress to work through into the market.

Is the European market overheating?

Leverage levels in the loan market have started to creep up this year, but are less than half a turn above the average for the last five years and well below those seen before the credit crisis.

There’s a lot of demand from collateralized loan obligations and other buyers, but there aren’t many non long-term managers in the market and investor leverage hasn’t increased. If new issuance continues and the CLO machine were to cool, then the market could sell off, which would be a normal correction.

Bond yields are still attractive to issuers, but they have moved wider during the year, which suggests that the market isn’t in a bubble, it has moderated. And even though spreads are thin, they are much wider than they were before the credit crisis. Also, there isn’t a lot of leverage or short-term money in the market. In addition, trading desk and broker inventory levels are quite low.

Are there any broader external risks?

There are a lot of questions around the end of the European Central Bank’s corporate bond buying program, and whether a reduction in the number of investment grade accounts buying high yield bonds will affect the market. But we still see high-grade investors buying junk bonds, even down to single B rated credits.

Headwinds for leveraged finance include rising interest rates, developments in global trade and tariffs, as well as geopolitical risks in Europe. And there is some concern about economic growth in Europe.

So the market could potentially look less attractive for borrowers next year, but that doesn’t mean we are in a bubble now.

©2018 Bloomberg L.P.