The syndicated senior secured loan market, originally the dominant sub-investment grade asset class in Europe, is now, in our opinion, set for a resurgence.
This should be good news for institutional and professional investors, who could benefit from the mid-to-high single digit, floating rate returns on offer. With underlying interest rates typically reset every three to six months, this asset class provides protection from rising rates.
Should anticipated rate rises not materialise, protection from low rates is provided by the Euribor floors of at least zero, which almost all syndicated loans have featured in the post-crisis period.
Other key attractions are strong downside protection and liquidity. The institutional European syndicated loan market grew from the bank lending market and has many features designed to protect the lender. In the event of default, loans enjoy a first lien claim over substantially all of the assets of a borrower, helping to restrict losses. (On a global basis, first lien loans have been shown by Moody’s to recover 67% in the event of default).
In terms of liquidity, there is a well-established secondary market which, according to Markit, trades an estimated €7-9bn per quarter.
The asset class also offers a way for portfolio managers to reduce volatility in portfolios, which most macro strategists expect in financial markets at some stage in 2017. Syndicated loans tend to exhibit considerably less return volatility than other asset classes. In fact, for a similar return to that of syndicated loans over the last five years, Euro Stoxx 50 equity investors experienced approximately ten times more volatility, and the BAML EN40 European investment grade index approached double the volatility.
Diversification and composition
The European syndicated loan market is €175bn in size according to Credit Suisse, and comprises some 285 corporate issuers. The main source of new issuance is private equity backed leveraged buyout activity.
The market features a broad spread of industries, although exposures to financial services, energy and commodities are notably limited. Country exposures are weighted towards the core European jurisdictions, with a recent feature being an increase in issuers from North America, which have issued euro denominated tranches alongside dollar ones.
In Europe, Ucits rules limit the amount managers can invest in the syndicated loan market, making this a predominantly institutional asset class, whose investor base comprises banks, collateralised loan obligations (CLOs) and other institutions.
Unlike in the US, banks are still an important part of the European loan investor base. They are politically motivated to undertake local lending, with access to ECB initiatives (such as the LTRO) coming with the requirement to grow their loan books.
CLOs have again become an increasingly important part of the European investor base since the market reopened in 2013. Last year saw €16.8bn of CLO issuance according to S&P LCD, and predictions from investment banks for 2017 are for a modest increase. CLOs can drive demand for loans and tend to be long term holders of the loans they buy.
Usually buying via a specialist manager, other institutional investors such as pension funds, insurance companies and family offices take a long-term approach to investing in corporates via the loan market.
Fundamentals and outlook
Leverage levels are close to their long-term average (as assessed by S&P LCD) and interest coverage ratios have improved significantly post-crisis. Rising rates could be seen as a headwind for weaker borrowers, but should come with an improving macro picture, so Moody’s expects baseline default rates for the entire European speculative grade corporate universe to be in the 2% area for the next year.
The European syndicated loan market can expect to see significant future new issuance from refinancing and M&A. From 2010 onwards, M&A related issuance has made up between 40% and 60% of total new issuance, adding diversity to the market. This is likely to be driven by the approximately €325 billion which Prequin estimates private equity firms have at their disposal.
Complementing M&A will be refinancings from existing loan issuers, and issuers from the bond market. In the post 2009 period, many loan issuers moved to the bond market where they could take advantage of low rates to term out their liabilities. Recently however, the structural flexibility of loans has become a strong draw for issuers as they choose their market.
In a time of low yields, and with volatility expected to rise, we believe the European syndicated loan market can be a source of relatively stable floating rate income. With expanding European economies and abundant funds in the hands of private equity investors, we expect the market to grow and become an increasingly important diversifier in the portfolios of investors searching for duration neutral income.
Sam McGairl is a portfolio manager at Muzinich & Co