Banner Year for the European High Yield Bond Market

Diane Vazza, Managing Director Devi Aurora, Associate Director +1 212 438 2760 +1 212 438 1359 diane_vazza@standardandpoors.com devi_aurora@standardandpoors.com Banner Year for the European High Yield Bond Market NEW YORK (Standard & Poor s) Feb. 26, 2004 The year 2003 was a banner year for the European high yield bond market, with new issue volume hitting a record high of US$18.5 ( 16.3) billion, after having stalled visibly in the two previous years. 1 Looking ahead, expectations of a cyclical recovery, a continued accommodative monetary policy stance, declining default rates, and a slowdown in credit quality deterioration in the European high yield market will all continue to promote favorable issuance conditions, even though downgrades still tower above upgrades. Another key factor driving higher issuance volumes is the financing needs of fallen angels. Meanwhile, the rising share of issuance at the B- level or lower though not quite as high in Europe as in the U.S. spells caution for credit quality and defaults down the road. The near-term outlook for the European speculative-grade segment remains more benign, however, with the Outlook and CreditWatch distribution indicating an improvement in credit quality relative to a year ago. Only 25% of rated entities within this segment retained a negative bias, in contrast to 30% a year earlier. The healthcare and capital goods sectors appear best poised for potential upgrades, with 29% and 22% of issuers respectively listed either with a positive Outlook or a CreditWatch with positive implications. Sectors that still appear vulnerable to potential downgrades within the European high yield segment are oil and gas exploration and production, high technology, and forest products and building materials (where weakness is centered in building materials). In each case, more than 40% of rated entities within the sector were listed either with a Negative Outlook or a CreditWatch with negative implications. Chart 1. High Yield Bond Market New Issuance (US$ Billion) US Western Europe 140 120 100 80 60 40 20 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Includes all public, private (outside U.S.) and rule 144a issuance of straight debt, convertible debt, floating-rate notes, and medium-term notes by financial and non-financial entities. Excludes sovereign issuance. Data as of February 10, 2004. Source: Standard & Poor's Global Fixed Income Research, Thomson Financial 1 Europe is defined to include the industrialized countries of Western Europe. Banner Year for the European High Yield Bond Market Page 1

New issues in the European high yield bond market hit a record high of US$18.5 ( 16.3) billion in 2003, after having stalled visibly in the two previous years. The scale of the 2003 rebound in the European speculative grade market is all the more impressive in light of the fact that it came on the heels of a year that was characterized by record defaults. In 2002, the European speculative-grade default rate hit a record 13.87%, surpassing the global speculative-grade default rate of 9.49%. A total of 19 speculative-grade rated entities defaulted in Europe, on rated debt worth US$16.8 ( 18.7) billion. [For more detail on European defaults, refer to study titled EU 2003 Annual Default Study & Rating Transitions, published Feb. 12, 2004 on www.standardandpoors.com/gfir and RatingsDirect.] Still, new issue volume in 2003 surpassed the previous high of US$15.3 ( 14.3) billion recorded in 1999. In the current year to date, new issue volume has remained buoyant, with over US$1.8 ( 1.5) billion raised in the first 40 days of the year. The surge in the European high yield bond market mirrored the trend in its U.S. counterpart, which surged to US$130.7 billion compared with US$58.5 billion in the prior year. Even though growth in percentage terms was higher in Europe, the volume of issuance in Europe is still noticeably lower than in the U.S. (see chart 1). In 2003, financing needs by fallen angels issuers that have fallen to speculative grade ( BB+ and below) from investment grade ( BBB- and above) were a key factor driving higher issuance volumes in Europe. Indeed, of the US$18.5 ( 16.3) billion raised in the bond market in 2003, fallen angels accounted for US$7.3 ( 6.4) billion (40%). The 40% share of fallen angels total high yield issuance represented an increase compared with the 25% recorded in 2002. Indeed, average deal size rose from US$198 ( 221) million in 2001 (prior to the sizeable influx of fallen angels) to US$237 ( 251) million in 2002 and US$324 ( 286) million in 2003, expanding to accommodate the larger borrowings by fallen angels. Chart 2. Western European High Yield Issuance by Nonfinancial Subsector 2002 2003 (US$ Billion) 0 1 2 3 4 Telecommunications Media and Entertainment Capital Goods Chemicals, Packaging, and Environmental Services Consumer Products Healthcare Transportation Utility (Electric, Gas, & Water) Retail and Restaurants High Technology Metals, Mining, and Steel Forest Products and Building Materials Integrated Oil and Gas Aerospace and Defense Homebuilders and Real Estate Includes all public, private, and rule 144a issuance of straight debt, convertible debt, floating-rate notes, and mediumterm notes by non-financial entities. Excludes sovereign issuance. Source: Standard & Poor's Global Fixed Income Research, Thomson Financial Banner Year for the European High Yield Bond Market Page 2

The telecommunications sector resumed its position as the top borrower by sector in 2003, after a hiatus of three years, with US$3.7 ( 3.3) billion raised in proceeds (see chart 2). Borrowing by issuers in this sector has been driven by the significant financing needs of fallen angels, e.g. Alcatel SA, Cable & Wireless PLC. Rising equity valuations in telecommunications have facilitated greater financial flexibility among issuers, many of whom have restructured their debt. Moreover, renewed investor demand for yield has also increased the attractiveness of the sector after three consecutive years of severe contraction. Next in line for issuance was the media & entertainment sector, which came to market with over US$3.0 ( 2.7) billion in new issues. Activity in this sector was fueled primarily by borrowing worth US$2.8 ( 2.5) billion attributable to French media and entertainment company Vivendi Universal S.A. a prominent fallen angel which borrowed funds primarily for refinancing debt and to a lesser extent, to finance the acquisition of British Telecom s 26% stake in French mobile operator Cegetel. Other non-financial sectors that recorded prominent increases in borrowing were capital goods, chemicals, packaging and environmental services, and consumer products. So far in 2004, European speculative-grade issuance has been dispersed relatively evenly amongst consumer products, finance companies, capital goods, and telecommunications. The proportion of convertible bond issuance fell to 16% of total bond issuance in 2003 from a record high of 30% in 2002, driven by companies looking for a cost-effective way to deleverage. The absolute volume raised in convertible bonds however actually increased to US$3.0 ( 2.7) billion vs. US$2.0 ( 2.1) billion a year earlier. Telecommunications issues were among the most prolific issuers of convertible bonds, raising US$1.6 ( 1.4) billion in 2003 to take advantage of benevolent equity market sentiment. High yield European issuers maintained a strong preference for longer-term bond issues in 2003, which is not surprising in light of the compelling low yields. Long-term government bond yields in the euro area have been held in check by continued monetary accommodation at the short end, notwithstanding rising expectations for an economic recovery. Furthermore, a declining proportion of rating downgrades and a slide in defaults contributed to spread tightening for corporate borrowers. In 2003, the proportion of new issues with maturities of seven years or greater leapt to 81% of total issuance from 57% in 2002. Meanwhile, the proportion of issues with maturities of 3-7 years fell to 19% from 43% in the same timeframe, and no issuance was recorded at maturities lower than three years in either year. Issuance volume increased at each rung of the speculative-grade ratings spectrum in 2003 compared with 2002, although the BB rating category comprising the BB+, BB and BB- rating designations saw the greatest activity. Nearly three-fifths of total high yield issuance raised in 2003 occurred in this rating category. Still, issuance at the lower rungs of the speculative-grade spectrum has been increasing in Europe, though the pace of growth is weaker than in the U.S. Moreover, volatility in Europe is more pronounced than in the U.S. in light of the lower volumes. The share of issuance rated B- or below in Europe rose to 25% in 2003, up from 13% in 2002, and 18% in 2001. The share of lower-grade issuance has yet to match its previous record of 46% in 1999, recorded at the height of the telecommunications boom. Interestingly, 2004 has yet to see a European speculativegrade deal above a B+ rating. The rising share of lower-grade issuance spells caution for prospective credit quality and defaults. When the share of lower-grade issuance (particularly at the B- level or lower) exceeds 30% for a sustained period of time, it generally serves as a reliable indicator of imminent default pressure two to three years ahead. Banner Year for the European High Yield Bond Market Page 3

The prominence of fallen angels in fueling new bond issuance explains the large gap between volumes in the high yield market and the mezzanine loan market, even though both markets experienced noteworthy growth and an increase in capacity in 2003. At the end of the year, speculative-grade bond issuance significantly outpaced the growth in mezzanine loan volumes (see chart 3). Mezzanine loan volume of US$3.8 ( 3.4) billion was recorded in Europe in 2003, much smaller than its high yield equivalent of US$18.5 ( 16.3) billion. Given their sizeable borrowing needs, fallen angels who have driven much of the activity in the high yield market are unlikely to tap the mezzanine loan market for funds, which is otherwise viewed as an attractive alternative to financing in the speculative-grade bond market, especially for leveraged buyout (LBO) transactions. Efforts to address the structural concerns of European high yield investors in some recent deals have been a factor that has abetted the recovery in high yield. In 2002, the European investor community had threatened a buyers strike amid rising defaults and much lower anticipated recovery rates compared to similar U.S. credits. European high yield bonds have traditionally been structured as senior unsecured obligations and issued at a holding company instead of at the operating company level. Generally, no guarantees are provided by operating companies upstream to the holding company. Consequently, high yield investors have found themselves materially disadvantaged by structural subordination a tiered setup where, in the event of default, their claims rank behind trade creditors, and often bank lenders, at the operating company. Chart 3. Comparing European High Yield and Mezzanine Loan Volumes (US$ billion) European Speculative Grade Issuance European Mezzanine Loan Volume 20 18 16 14 12 10 8 6 4 2 0 2000 2001 2002 2003 2004 Issuance includes all public, private (outside U.S.) and rule 144a issuance of straight debt, convertible debt, floating-rate notes, and medium-term notes by financial and non-financial entities. Excludes sovereign issuance. 2004 data as of February 10 for issuance and February 17th for loan volumes. Source: Standard & Poor's Global Fixed Income Research; Standard & Poor's LCD; Thomson Financial In contrast, mezzanine debt has historically shown greater flexibility in terms of amount and structure as well as the certainty of execution, and benefits from the presence of a broader range of lenders (e.g. banks and specialized funds). Mezzanine investors in Europe benefit from sharing collateral with senior secured debt holders, albeit on a contractually subordinated basis. Moreover, the ability to repay loans with limited and declining prepayment penalties in the early years makes mezzanine Banner Year for the European High Yield Bond Market Page 4

financing more attractive to issuers in comparison with the stiff penalties and relatively inflexible call provisions that are typically associated with high yield bonds. The European high yield market appears to be coming of age in terms of dealing with important structural barriers. For better quality BB-rated corporates, there is the potential to issue bonds that, subject to legal limitations on the provision of guarantees, rank pari passu with senior unsecured bank debt. Even for LBOs, where the capital structure requires senior bank debt to be secured, most future high yield deals will likely incorporate upstream guarantees to mitigate concerns over structural subordination and, in some cases, also provide security on a second lien basis. Nonetheless, the economic benefits of the enhanced support package provided depend crucially on the legal limitations that apply in many (common law) countries in Europe, and the ability to enforce security on a timely basis. In this regard, bonds issued by companies whose business and revenues are located in relatively creditor-friendly countries like the UK, Ireland, and the Netherlands would find more favor compared to issues emanating from countries like Italy or France. Chart 4: Western Europe High Yield Rating Actions 1988-2004 (no. of issuers) Upgrades Downgrades Downgrade Ratio 90 100% 80 70 60 50 40 30 20 10 90% 80% 70% 60% 50% 40% 30% 20% 10% 0 1988 1989 1990 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 0% Data as of February 11, 2004. Source: Standard & Poor's Global Fixed Income Research The surge in European high yield issuance in 2003 mirrored a slide in issuer defaults and a deceleration in downgrades. The speculative-grade default rate in Europe dropped to 3.03% at the end of January 2004 vs. 13.57% 12 months earlier. With 37 downgrades and 14 upgrades, the proportion of downgrades to total rating actions in the European speculative-grade segment dropped to 73% in 2003. This proportion though still high is lower than the 90% downgrade pace recorded in the two previous years (see chart 4). So far, two downgrades and one upgrade have been recorded in 2004. Banner Year for the European High Yield Bond Market Page 5

Chart 5: Western Europe High Yield Downgrades by Subsector 2002 2003 (no. of issuers) 0 5 10 15 20 25 30 Chemicals, Packaging & Environmental Services Metals, Mining & Steel Telecommunications Consumer Products High Technology Utility Health Care Homebuilders/Real Estate Co. Oil & Gas Exploration & Production Retail/Restaurants Transportation Aerospace & Defense Capital Goods Forest Products & Building Materials Media & Entertainment Insurance Bank Source: Standard & Poor's Global Fixed Income Research Chart 6: Western Europe High Yield OL and CW Distribution Aerospace & Defense Automotive Bank Capital Goods Chemicals, Packaging & Environmental Services Consumer Products Finance Co. Financial Institutions Forest Products & Building Materials Health Care High Technology Homebuilders/Real Estate Co. Insurance Media & Entertainment Metals, Mining & Steel Oil & Gas Exploration & Production Retail/Restaurants Telecommunications Transportation Utility POS (CW) POSITIVE (O) STABLE (O) NEGATIVE (O) NEG (CW) (no. of issuers) CW--CreditWatch; O--Outlook. Data as of February 17, 2004. Source: Standard & Poor's Global Fixed Income Research 0 2 4 6 8 10 12 14 16 Banner Year for the European High Yield Bond Market Page 6

In 2003, chemicals, packaging & environmental services suffered the most downgrades by sector with six actions (see chart 5). The six actions reflected multiple downgrades on three issuers: Avecia PLC, Rhodia SA, and Vantico Group S.A. (the last mentioned defaulted on its senior unsecured debt on Feb. 1, 2003, and is no longer rated). Profitability in the chemicals sector has continued to be burdened by weak demand and the strength of the euro. Other sectors affected by downgrades were metals, mining and steel and telecommunications, each recording four downgrades. Although still one of the leaders in the downgrade category, downgrade volume in the battered telecommunications sector has eased substantially in the last couple of years. In 2002, European telecommunications issuers with a speculative-grade rating suffered 25 downgrades, accounting for over one-third of all high yield downgrades experienced that year. Looking ahead, credit quality appears poised to improve within the European speculative-grade segment relative to a year ago. As of Feb. 17, the distribution of Outlook and CreditWatch listings suggests that, of the 106 entities rated in Europe at the parent level, 25% were listed with a negative bias, 68% were stable, and 7% were listed with a positive bias. In contrast, 30% were listed with a negative bias, 63% were stable, and only 7% were listed with a positive bias 12 months earlier. Sectors most likely to benefit from potential upgrades are healthcare and capital goods, with 29% and 22% of issuers respectively listed either with a positive Outlook or a CreditWatch with positive implications. Sectors that still appear vulnerable to potential downgrades within the European high yield segment are oil and gas exploration and production, high technology, and forest products and building materials (where weakness is centered in the building materials subcategory). In each case, more than 40% of rated entities within the sector were listed either with a Negative Outlook or a CreditWatch with negative implications (see Chart 6). Weakness in the oil services sector reflects some specific issuer-related risks, but also provides evidence of competitive conditions in the merchant refining and seismic services subsectors even as integrated oil and gas companies are enjoying a bonanza from high oil prices. The negative bias in high technology reflects continued sluggish conditions for the semiconductor equipment market, as well as lower-than-expected demand for third-generation (3G) mobile network infrastructure, pricing pressures, and decreasing headroom to cut costs in the face of falling revenues in wireless infrastructure market. Scott Holtzman contributed to this report. Copyright 2004 by Standard & Poor's, a division of The McGraw-Hill Companies. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources or others, Standard & Poor s does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtained from the use of such information. Banner Year for the European High Yield Bond Market Page 7