The bankers, borrowers and investors involved in the European high yield market have seen the bright outlook with which they started 2000 grow gloomier with each passing month. Market conditions and bond prices have become progressively worse during the year, and most participants agree that the market is facing its toughest times since the Russian crisis.

There are many factors behind the market's underperformance, some specific to European high yield and others related to the current dynamics of the international markets. Either way, investors have seen returns in the high-teens for 1999 transformed into a loss of 5.95 per cent for the year up to October. Companies, especially cash-hungry businesses in the fast-expanding telecommunications sector, that were relying on high yield debt to finance the rolling out of their business plans are now scouring the markets for alternative forms of funding to keep them afloat.

European high yield is still developing as an asset class and, compared to the more mature US junk bond market, there are structural flaws.

The lack of diversity among European high yield issuers - bonds from telecoms, media and cable companies make up 68.7 per cent of the market's value, according to research by Merrill Lynch - means that the recent drop in investor confidence towards companies from these sectors has hit high yield harder than the rest of the corporate bond market.

The low level of liquidity in the European secondary market has also had a negative affect on the level of bond prices. Even small amounts of selling can cause prices to plummet, and some prices can even fall without having been traded. Investors often complain that they cannot get banks to quote an up-to-date price on certain illiquid high yield names, and then it can be hard for them to actually get hold of paper at the same price.

Other problems in the European high yield market - which, thanks to strong inflows of new cash, is still blessed with good technical factors - have been caused by pressures in the rest of the corporate bond markets.

The best example is the souring of general investor sentiment towards the telecoms sector in the wake of the German UMTS auction and the rating downgrades of the leading European operators. In the subsequent repricing of the telecoms sector, high yield issuers were squeezed out of the market, reflecting investors' new aversion to risk. Start-up telecoms companies, once the darlings of the high yield debt, suddenly found that the bond market was closed to them.

European high-yield bonds bookrunners*
Managing bank or group	Number of issues	Total ($m)	Share (%)
DLJ	9	2,703,88	34.40
Merril Lynch	7	972.90	12.40
Salomon Smith Barney	7	903.98	11.50
Chase Manhattan	5	744.93	9.50
Goldman Sachs	3	550.70	7.00
Credit Suisse First Boston	2	380.55	4.80
Lehman Brothers	3	362.10	4.60
Dresdner Bank	1	240.58	3.10
CIBC	1	193.18	2.50
Morgan Stanley Dean Witter	1	143.60	1.80
Total	36	7,850.28	و
Source: Thomson Financial Securities Dataووووووووووووووووووووووووووووووووووووووووو* Jan 1 2000 to date

The plight of potential high yield issuers from the telecom and media sectors was illustrated in October by the postponement of a deal from IXEurope. The UK-based "internet hotelier" cancelled plans to launch a bond deal at the same time as its imminent IPO because of the difficult issuance conditions. The unrated company has an implied rating of around CCC, and in the current market only the higher quality non-telecoms issuers are able to get deals done.

The widespread investor unpopularity of the telecoms, media and technology sectors has lead to a split in the European high yield market, where new economy companies are unable to find funding while old economy industrial borrowers are favoured.

"There has been a dislocation in all asset classes from the TMT sector. The valuation crisis is not limited to high yield but also stretches across the equity market," says Mark Aitken, head of high yield capital markets at Dresdner Kleinwort Benson.

The recent bond and equity market volatility has shown that the European high yield market has been susceptible to panic when market conditions become tough. At the start of October most of the world markets were in chaos, but while none of its fundamentals had changed European high yield debt emerged as one of the most badly bruised asset classes.

Investor confidence was shaken by a poor performance on Nasdaq - which has more influence on high yield prices than any bond market - as well as rumours about investment banks' massive losses on junk bonds. Spreads widened by up to 20 basis points in just a few days across the high yield telecoms sector, and although there has been some bargain buying most bond prices have not yet recovered.

Bankers suggest that most of the price moves were caused by professional traders, their activities having more of an impact because of the illiquid secondary market, and that there was little selling by investors. However, it is clear that some buyers who had made their first forays into high yield during the salad days of 1999 have now decided to cut their losses and run.

"The high yield sector's average spread is going out, but this does not reflect the quality of some of the names in the market. The recent selling has been quite indiscriminate," says David Fancourt, a bond portfolio manager at M&G Investment Management.

The current low bond prices presents an opportunity for sophisticated investors to buy good quality names at bargain prices, but the process of sorting the winners from the losers will highlight the importance of thorough credit research. Some of the bonds trading at distressed levels will outperform next year, while others could be heading towards default.

As new money enters European high yield bond funds at the start of next year, the increased level of bargain hunting is expected to give prices a boost. However this recovery could be set back at any time by further drops on the Nasdaq and weakness in TMT stocks.

Better performance in the secondary market should lead to a brighter outlook for new issues, but the market's inability to absorb too many new issues could once again pose a problem.

"When the market stabilises there will be a window of opportunity for new issues," says Mr Aitken. "The widespread concern is that there will be too much deferred supply, which will overwhelm investor demand. As soon as the window opens it may shut again."

It seems that one key to the European high yield market's long-term health is diversification, to insulate it against future shocks in other markets and sectors.

"What will help the market is a cessation of some of the concentration on telecoms issuers. Consolidation among European high-yield telecom companies will certainly accelerate the recovery of the market," says John Wotowicz, head of European high yield at Morgan Stanley Dean Witter. "The winners of this process will emerge as stronger credits, and it may turn out that some of the market's concerns were overblown."

There is a healthy pipeline of between five and 10 industrial deals for possible launch before the end of the year, including issuers such as United Biscuits and Grohe. But the diversification process could take some time. The TMT sectors are still likely to dominate the market, and they are very well suited to high yield debt. After all, it is the telecoms, media and technology sectors - and their strong performances up to March this year - that allowed the high yield market to produce such high returns in 1999.