Junk Bond Borrowers Squeezed in Europe After Year-Long Shutdown

By John Glover

July 1 (Bloomberg) -- The junk bond market is shut in Europe, forcing the neediest borrowers to rely on banks for credit and increasing the chance of defaults.

The only company to sell high-yield, high-risk bonds in euros in the past 11 months was Vienna-based builder Strabag SE, which raised 75 million euros ($118 million) in June. Borrowers sold $32 billion of the securities in the first half of 2007.

The first closure since European companies began selling bonds with below investment-grade ratings a decade ago may contribute to a fivefold increase in defaults within a year, according to Moody's Investors Service. The debt yields 705 basis points more than similar-maturity government notes on average, triple the so-called spread of 236 basis points a year ago, according to Merrill Lynch & Co.'s Euro High Yield Constrained index.

``Spreads are going wider, sentiment is weak and defaults are going to pick up,'' said Alex Moss, who oversees the equivalent of about $1.55 billion as head of high-yield bonds and leveraged loans at Insight Investment Management in London. ``Defaults are the soft underbelly of the high-yield market.''

Investors in junk bonds lost 4.35 percent on average in the first half, the worst start since 2002, Merrill's index data show. The debt is rated below Baa3 by Moody's and BBB- by Standard & Poor's.

Bondholders are avoiding riskier companies after the collapse of U.S. subprime mortgages sent European stocks to the worst declines in two decades and consumer confidence in France and Spain to the lowest on record. Companies are relying on loans at a time when banks are reducing their debt risk after $203 billion of credit losses and writedowns in Europe, more than the cost in America and Asia combined.

First Defaults

Royal Bank of Scotland Group Plc and Deutsche Bank AG led banks providing $54 billion in high-yield loans in Europe this year, down from $299 billion in the first half of last year, data compiled by Bloomberg show.

``The longer this goes on, the more companies are going to need to raise cash,'' said Chris Higham, who manages the equivalent of about $1.6 billion of junk bonds as a portfolio manager at Morley Fund Management in London, and is holding 10 percent of his assets in cash to reduce the risk of losses. ``Things aren't looking good for the second half.''

Kremikovtzi AD, the Sofia-based steelmaker owned by Pramod Mittal, became the first European company to default on junk bonds this year when it failed to pay interest in May on 325 million euros of 12 percent notes due 2013.

Too Expensive

Melrose Financial Resources Plc, the Scottish oil and natural-gas explorer in the U.S., North Africa and eastern Europe, canceled a plan for 250 million euros of bonds in November because yields were too high, said Chief Executive Officer David Thomas in an interview.

The Edinburgh-based company instead has $510 million of loans due 2014 at 3.2 percentage points above the London interbank offered rate from banks led by HBOS Plc's Bank of Scotland unit, Bloomberg data show. The bonds would have cost as much as 2 percentage points more in interest than the company was paying on its loans, Thomas said.

``It's hard to see the advantage of going with a bond in today's climate,'' said Thomas. ``The bond market was demanding more than we were prepared to pay.''

Europe's high-yield market is less than a tenth of the size in the U.S., drawing fewer investors and borrowers. U.S. companies owe at least $730 billion in junk bonds compared with $65 billion in Europe, based on Merrill indexes.

Central Role

While bonds make up 60 percent of debt for U.S. speculative-grade companies, the proportion in Europe is nearer 40 percent, with most corporate borrowing coming from bank loans, said James Ward, head of European high-yield debt at Axa Investment Managers and a professor of finance at the American University of Paris.

``High-yield is a more central part of a company's capital structure in the U.S. than in Europe, meaning companies are readier to issue,'' said Ward.

Sales of junk bonds in the U.S. are down 53 percent from the first half of 2007, Bloomberg data show. In Asia, first-half sales totaled $1.75 billion, compared with $4.9 billion last year.

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net
Last Updated: June 30, 2008 19:01 EDT