The value of loans

Thierry de Vergnes explains why institutional investors are allocating to European senior secured loans for stable and attractive yields

The market for high yield debt has undergone a tremendous transformation since 2008. As the recovery wave rippled through debt instruments compressing spreads in its wake, investors have migrated along the credit curve in search of yield. First into high grade credit, then into high yield bonds, and eventually into senior loans. Those who once invested in senior loans via CLOs (leveraged securitisation vehicles) are back in the loan business – this time mainly via unlevered loan funds. Far from being a bold adventure, this is the logical result of the evolution of a market that has steadily been getting back on its feet over the last five years.

Sturdier foundations

With the profound reshuffling of the investor base for loans, the market now sits on sturdier foundations. Long gone are the technical features that contributed to the significant post –Lehman loan market sell-off (market value vehicle and ECP funded conduits holding loans and large unsold primary or secondary market positions on bank balance sheets). Also CLOs account for a shrinking portion of the investor base as the meager new issuance of CLOs pales in comparison with the significant loss of investment capacity from those coming to the end of their reinvestment period.

Attractive relative value

Were it not for new investors and increasing new loan issuance, the European loan market may have struggled longer to get back on its feet. But European loans have recovered, albeit at a more measured pace than their more liquid, better known listed bond cousins.

High-yield bonds posted 23 per cent returns in 2012 and their spreads have tightened so much that there remains little potential upside. Returns are likely to be more modest this year as investors are cautious about an asset class that offers little yield and is vulnerable to a rise in interest rates.

The 10 per cent return for senior secured loans is more modest than last year’s high yield returns, but on a risk adjusted basis, it is attractive for a low volatility asset class. Being floating rate instruments, loans feature a less volatile return potential and investors are wary of the effect of interest rate hikes on their fixed income portfolios.

Evolving investor base

Historically, the investor base for European loans was composed of banks, CLOs and until the onset of the credit crisis, other structured vehicles. The opportunities generated by the credit crisis generated interest from a broader set of investors – namely insurers and pension funds investing either directly or through funds. As such the steady recovery of the loan market is partly explained by an influx of these exacting institutionals.

In response to banks’ and investors’ calls for lower leverage, borrowers have had to tap the market with more conservative capital structures and offer higher spreads. In parallel, a new class of lenders – such as pension funds and insurers - are increasingly allocating capital to the loan asset class to capitalise on the better risk adjusted returns the disintermediation trend is fostering.

The new normal

Those entering the market now benefit from significantly higher margins than the pre-crisis level. While the bargains of the post crisis period may be over, margins have now settled around Euribor +450-500 basis points and yields between 5 and 6 per cent, a yield close to that offered by European high yield bonds.

Loan value

Now that bond spreads are nearing those of loans, some rightly question whether investing in bonds is still a good call. Once risk is taken into account, senior loans have much to offer thanks to their seniority and security, as well as their floating rate nature.

Loans rank at the top of the issuer’s capital structure and feature strict covenants. These are designed to closely monitor the issuer’s performance and enable investors to take control of the situation early should the issuer start to underperform. This helps loan investors protect value and is in sharp contrast to the situation bondholders face with less stringent covenants longer to wait to intervene.

In short, whereas senior secured loans are less liquid than high-yield bonds – senior debt funds typically offer fortnightly or monthly liquidity – investors may want to trade off longer investment periods in exchange for less volatility, lower default rates and higher recovery rates.

The floating rate nature of senior secured loans could also prove beneficial in a rising interest rate environment. As rates rise the value of fixed coupon high-yield bonds decreases and bond prices fall commensurately. Meanwhile, senior secured loans benefit from any increase in yields with a pickup in their floating rate coupons, leaving loan prices unscathed.

US and European loans

This more robust income profile has not been lost on US investors who have long invested in US loans. Over the summer, US investors – whose local market is larger and more mature than the European market – have accelerated their exit from high yield bond funds on the back of Fed tapering worries. Yet, they have continued to invest in floating rate debt such as senior loans.

The strong presence of mutual funds in the investor base for US loans engenders more volatility in the US market. In contrast, the European loan market is dominated by stable, buy-and-hold institutional and bank investors and insulated from the swing in flows by the current regulations which limit retail mutual funds from can buying loans.

The US bankruptcy regime may well be more predictable, and its market larger and more liquid, however, the increased depth and frequency of information provided by issuers to lenders in Europe, and lower volatility, are attractive features the European senior loan market offers for investors looking for stable high yields.

Portfolio construction

Demand is growing from new institutional investors and whilst the supply of loans is expected to lag the increasing demand for these assets, well-priced quality loan issuance should be healthy enough to build diversified portfolios offering a secure source of income to investors. We expect overall supply-demand balance for loans to remain stable and spreads to be relatively immune from the spread compression seen in other credit asset classes such as high yield.

Whilst there are still some short-term technical pressures in the run up to the closing of CLO re-investment periods, the majority of which should occur over 2013, this is unlikely to unsettle a scenario where spreads should remain at the ‘new normal’ levels of around Euribor +450 basis points. Such levels are enough to attract new institutional capital and make a robust investment case for income-seeking investors.

Thierry de Vergnes is head of debt fund management, Lyxor Asset Management UK

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