January 17, 2014 10:15 am

Risky high-yield debt makes return in Europe

Investors fretting the corporate credit market is becoming overheated have pointed to the return of boom-era “payment-in-kind” debt.

Indeed, one of the “frothy signs”, identified by RBS analysts, is the issuance of nearly $7bn of PIK bonds in Europe last year, the highest level since the financial crisis.

These high-yield bonds, which are mainly issued by private equity sponsors of leveraged buyouts, give borrowers the option to pay lenders with more debt, rather than cash.

A survey of global institutional investors in private equity by Coller Capital, a London-based private equity group, found that three-quarters of those polled say the level of PIK debt is evidence of “over-exuberance”.

Investors have good reason to be wary. An American study by Moody’s, the rating agency, of 62 companies that issued debt with PIK features – mostly during the credit bubble – showed a default rate of 30 per cent in 2009, almost double the 17 per cent default rate of comparably rated companies.

Unsurprisingly, issuance of PIK debt collapsed during and after the global financial crisis. According to Dealogic, the number of global PIK deals plunged from 37 in 2007, worth a total of $17.8bn, to just two in 2010, worth a total of $366m – both in the US.

But last year saw a strong recovery in the global PIK market, with 39 deals worth a total of $15.3bn – more than three times the 2012 total. European PIK issuance also shot up from $503m in 2012 to $6.8bn last year, accounting for a much greater share of the global market than in previous years.

The recovery in the initial public offering market offers private equity groups that sponsored leveraged buyouts opportunities to sell their investments. But sponsors that are unable or unwilling to sell will continue to find PIK bonds a useful way of extracting value from their LBO investments in the form of a dividend.

Moody’s warns that companies issuing PIK debt could be downgraded, in spite of an improving operating environment. Because PIK bonds issued for shareholder distributions increase group indebtedness and indicate an aggressive sponsor financial policy, this can result in a downgrade of the bond’s rating.

The rating agency also says that less creditworthy LBO vehicles could issue PIKs in 2014. The current wave of PIK issuance has been mainly from companies which have stable operating performance, with investors not taking up weaker companies’ PIK notes.

“This resistance will be tested in 2014, as investors seek yield in an environment where weaker new companies are also successfully issuing bonds,” says Tobias Wagner, an analyst with Moody’s.

Kevin Corrigan, of Lombard Odier investment managers, says recent PIK issuance in Europe has come from relatively stable companies. “You start to get worried when weaker companies come to the market – that hasn’t happened yet,” he says.

Mitch Reznick, of Hermes Fund Managers, says he is not “holier-than-thou” about PIKs, but stresses it is always important to focus on and assess individual bonds. “For investors, PIKs can be a way of earning an attractive return in a market where enterprise value is rising and you believe there is scope for a successful IPO.”

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