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Junk and unrated bonds in Europe -- a growing risk [ClearOnMoney]
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Junk and unrated bonds in Europe -- a growing risk

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Commentary

Junk and unrated bonds in Europe -- a growing risk

6 Jun 2013 by Jim Fickett.

As in the US, so in Europe, the amount of junk corporate debt being issued is rising, and average ratings are falling. For now the European totals outstanding are significantly lower than in the US so, while this area should be closely watched, government debt and bank balance sheets remain the primary weaknesses of the European financial system.

I continue to think that the junk bond market in the US could be the flash point for the next financial crisis (Comparing subprime corporate and subprime mortgages). So I was interested to see recently that, also in Europe, junk bonds are being taken up with abandon by investors starved for yield. The Financial Times reports:

The debt levels of European “junk” rated companies has been deteriorating over the past three years, with the average leverage ratios for new issues rising from 4.5 times in 2010 to 5.4 times in the first quarter of 2013.

The average new credit rating has also been falling, with the share of single-B rated – or highly speculative grade – first-time issuers rising to 85 per cent this year, up from 73 per cent three years ago, according to Moody’s. [Note: single-B is just one step up from CCC.]

Private equity firms have also been using the buoyant markets for subinvestment grade debt in Europe to fund special payouts to themselves, extracting more money from their portfolio companies than at any time since the financial crisis.

“These issuers have less room to underperform on financial forecasts and will be more vulnerable to external shocks, including weaker economic growth or changes in the interest rate environment,” said Tobias Wagner, analyst at Moody’s. …

Since the European Central Bank’s measures to increase liquidity late last summer, strong demand has pushed yields on high-yield corporate bonds down from 9.2 per cent to 5.2 per cent, according to Barclays indices.

and

The first five months of the year have seen €66.7bn worth of sub investment grade – or “junk” – bond issuance, the largest year to date amount on record, according to data from Dealogic. Last month was the strongest ever month, with €19.1bn issued.

Much of this issuance has been from companies that would normally borrow from the loan market. About half of the 38 companies that issued “junk” bonds for the first time this year used to be purely loan financed, according to S&P LCD.

“The bond markets in Europe have been extremely receptive to borrowers across ratings categories and industries over the past several months with terms typically much less restrictive than in the bank market,” said Stefan Weiler at JPMorgan.

The shift from loans to bonds is being facilitated by stronger European credit markets as central bank intervention has pushed down sovereign bond yields and encouraged investors to pile into corporate bonds.

The FT might be missing a big part of the story. The Association for Financial Markets in Europe (AFME) publishes a quarterly High yield & leveraged loan report. This shows that the outstanding value of unrated bonds is much larger than the outstanding value of junk-rated bonds, and probably about half of the unrated debt should carry a junk rating.

It is unlikely that the European junk bond market is as as much of a danger as is the US one. In the US the very worst tier (CCC-rated) alone probably has nominal value of about $1.7 trillion. Guessing that half of the unrated market in Europe is really junk gives a total of perhaps €1.5 trillion for ALL junk, most of which is not nearly as bad as CCC.

So this part of the European market certainly bears watching but, for now, the interlocked axis of poorly capitalized banks and insolvent governments remains the foremost issue.