The rise of leveraged loans

Lynn Strongin Dodds finds out why leveraged loans, traditionally popular in the US, are now seeing increased interest from the UK and European investors

The spectre of rising interest rates this year may have given a fillip to the leveraged loans market but the asset had already generated a buzz. Their relatively higher returns and ability to hedge duration risk had already caught fund managers’ attention, which perhaps explains why the needle barely moved in the wake of the US Federal Reserve’s surprise turnaround on the quantitative easing front.

Increasing population
Loans are extensions of credit made to non-investment grade corporations for a range of purposes such as financing acquisitions, refinancing existing debt and supporting business expansion. They sit between high yield and investment grade and as floating rate notes (FRN), have done a brisk trade since May in anticipation of the US central bank reversing its QE stance.

The news that the central bank decided to continue its monthly $85 billion shop of bonds did not inhibit enthusiasm from US institutional investors, who have been firm fixtures in the market since the 1990s and hold around 5 per cent in their portfolios. The same is true for their European and UK counterparts, who are comparative newcomers at 2 per cent holdings.

The numbers have yet to be crunched on the institutional side, but Lipper data shows that US retail money kept flooding into loan funds, marking 66 straight weeks of heavy inflows. They pulled in $1.3 billion in the week ended 18 September, during which the Fed made its announcement.

“Loans act as a natural hedge against rising interest rates because they are floating rate,” says ECM Asset Management portfolio manager Sam McGairl. “The Fed’s inaction means that rates will now not climb as quickly as anticipated but they will head upwards at some point, and when they do European loans will benefit immediately. For now, though, I think one of the main drivers for pension funds to invest in this asset class is the search for yield, which is there even without rate rises.”

Eaton Vance Management vice president and portfolio manager of its bank loan team, John Redding, adds: “In the past six to 12 months, investors obviously thought that we were heading towards increasing rates but loans remain attractive because they are senior, secured debt that rank at the top of the capital structure and net yields are in the 4 to 4.5 per cent range, which are only a bit less than high yield.”

They are also more appealing than the safe haven governments. For example, 10-year UK gilts are currently yielding around 2.92 per cent, while German Bunds are hovering around 1.9 per cent, according to figures from Bloomberg. Ten-year US Treasuries, on the other hand, are roughly 2.73 per cent.

“Spreads are high compared to other asset classes but they have been a fairly consistent performer throughout the years, except for 2008,” says BlackRock Fixed Income Portfolio Management Group managing director and member of the leveraged finance portfolio team, Leland Hart. “In general, we have seen pension fund clients look to move to assets that are yielding 4 to 6 per cent from 2 to 4 per cent not only for the higher returns but also to mitigate their duration risk.”

Since its inception in 1997, the S&P/LSTA Leveraged Loan Index has churned out steady average annual returns of around 6 per cent. As with many other asset classes, it nosedived in 2008 when Lehman collapsed and slipped into the red although the following year saw a strong rebound with a record 51 per cent hike. The index has since recovered its equilibrium and regained its status as a low correlation instrument to other investments.

As multi strategy asset management firm CQS senior portfolio manager for loans Craig Scordellis notes: “Leveraged loans are a good diversifier in the credit spectrum. They not only offer the best relative value but they also lessen the volatility relative to the wider credit markets. There are also wider opportunities for institutional investors due to incumbent players such as the banks and collaterised loan obligations (CLOs) withdrawing from loans because of regulatory and technical factors.”

Bank withdrawal
Banks traditionally held pieces of newly originated sub-investment grade loans on their balance sheets, in part because broader market demand was limited and high-yield assets did not incur regulatory penalties. They had represented about half the current universe of buyers but their role has been reduced due the stricter capital regime under Basel III.

A new report from Fitch underlines this shift, noting that banks have increasingly switched their focus away from holding loan positions to serving primarily as facilitators and distributors in the market. New rules under the Capital Requirements Directive IV dampened CLO demand, which comprised about a third of investment capital. Managers are now required to retain 5 per cent of total CLO liabilities on balance sheets and Standard & Poor’s figures predict that total European CLO appetite will diminish by 90 per cent to €5 billion by 2020.

Non-bank participants including pension funds and insurers have been more than happy to pick up the slack. A report from J.P. Morgan on 13 September showed that year-to-date inflows for leveraged loan funds have climbed to a record $50.2 billion while assets under management for the retail base have soared by 80 per cent.

European growth
The European leveraged loan market is also gaining steam with the second quarter of 2013 recording a hefty 47 per cent jump in volumes to €23.5 billion from the €16 billion raised in the first quarter, according to debt adviser Marlborough Partners. In the UK alone, loan volumes rose from €2.7 billion in the first three months to €4.7 billion in the second quarter while year-to-date loans, which totalled €7.4 billion in the six months to 30 June 2013, were also up by a similar proportion. The drivers have changed with refinancings out in front, accounting for 63 per cent of activity in the first half followed by merger and acquisition which at 32 per cent was at all-time low and recapitalisations on 5 per cent.

Although impressive, the UK and Europe do not hold a candle to the US, which is a much larger and deeper market. Figures from Thomson Reuters show that volumes in the second quarter came in at $323.3 billion, which was 11 per cent higher than the record first quarter of the year. It was also a 50 per cent hike on the second quarter 2007 pre-crisis peak.

As with any asset class, there are of course the negatives. “Historically default rates have been pretty similar for both loans and high yield bonds, but loans do evidence much higher recovery rates given their senior secured status,” says Neuberger Berman portfolio manager Martin Rotheram. “These are non-investment grade companies being lent to and investors need to ensure that their managers can conduct the in-depth credit analysis that is required to avoid the blow ups. We expect default rates in the US to be pretty steady for the next two years, below 2 per cent. But, from a European perspective, we expect they will be in the 4 to 6 per cent range.”

As a result, investors need to conduct more rigorous homework to assess a manager’s track record and pedigree. “It was interesting to see how many secured loan providers have come out of the woodwork as institutional interest has picked up,” says independent actuary firm Barnett Waddingham partner David Clare.” If you went back to the 1990s, when managers talked about bonds, they only meant gilts and corporates. Today it is a much wider universe. The difference with loans though is that you need to understand the risk/reward ratio and have a corporate finance background.”

McGairl adds: “There are two main ways to gain access - co-mingled funds, which have multiple investors, or segregated accounts that are tailored to a pension fund’s specific requirements. The market is not easy to invest in and you need good infrastructure because they are operationally intensive. This is not as simple to buy and hold as a bond.”

Despite these hurdles, leveraged loans will remain on the radar screen. A UK survey by Aon Hewitt consultants showed 36 per cent of respondents were considering increasing their allocation to this asset class as part of a long term strategic shift into alternative assets. Continental institutions, particularly the Dutch, have already made a move. Administrator PPGM has been targeting loans in the US and Western Europe since 2012 and they account for around 2 per cent of its €133 billion portfolio.

Written by Lynn Strongin Dodds, a freelance journalist

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