Regulatory and technical factors are likely to result in an evolution of the investor universe in European leveraged loans, providing significant opportunities for institutional buyers, says hedge fund CQS.
A loan holder benefits from maintenance covenants which can allow lenders to take action on companies if they breach pre-defined financial ratios, whereas bond holders have incurrence covenants and may only be able to take action in the event of a corporate action.
Loans are usually rated privately, as opposed to publicly for bonds, but Scordellis says loan holders receive extensive corporate information monthly – “so you stay on top of how the business is going” – whereas bond holders must wait for public dissemination.
Recovery rates on leveraged loans (70% to 75%) are far better than “high teens” levels for defaulted high yield bonds, but Scordellis says rates for secured loans will probably decline “due to a lot of defaulted deals having been restructured over the last default cycle anticipating a more v-shaped recovery”.
One disadvantage of leveraged loans is they have no protection from being called back by the borrower, whereas high yield bonds typically have non-call clauses valid for three to five years.
This means loans holders can “be repaid by the borrower at the borrower’s discretion, whereas to repay bond holders the make whole costs can be hugely expensive. Therefore leveraged loans trade at or around par, whereas high yield bonds will often trade to the call level. For the loan, you lose that upside.”
In addition, the loan market is less liquid, and instruments settle on T+10, while bonds settle on T+3.
Primary loan market spreads are currently 500-600bps and spreads range from 400 to 725bps on secondary markets now, compared to 200 to 325bps (primary) and 200 to 320bps (secondary) over the three and a half years to June 2007.
“Some deals can price inside [the current average spreads] if they are from good quality issuers, but from standard B-grade issuers in the market, those are the levels. Credit spreads have doubled reflecting the wider macro environment risks and the limited new money coming into the space.”
Scordellis believes current spreads provide investors with a good investment opportunity. However, you need to do your homework says Scordellis – the upgrade:downgrade ratio will remain “weighted towards downgrades” given the prevailing climate for high yield borrowers – making good security selection crucial in Europe.