20 February 2019
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With US interest rates rising and the European Central bank on the cusp of ending quantitative easing, investors remain torn between seeking yield and preserving capital. In this challenging environment, European loans are an asset class to watch.
While government bond yields continue to trade close to multi-century lows, credit spreads on European loans represent attractive value. Despite unprecedented central bank quantitative easing, current loan spreads are at approximately 400 basis points (bps) over the Euro Interbank Offered Rate (EURIBOR) - substantially higher than they were before the start of the global financial crisis.
Figure 1. European loan spreads are higher than before the global financial crisis
Sources: Bloomberg and S&P Leveraged Commentary & Data as of 30 September 2018.
Loan investors are also continuing to benefit from lower European loan default rates. Although the ECB has never bought sub-investment-grade bonds or loans, it has allowed borrowers to refinance at advantageous interest rates, resulting in a drop from 4-5% per annum from 1999-2009 to 2-3% from 2010-2018.
There are five key reasons for which European loans look compelling:
1. Strong creditor protection
Since they are senior and secured, loan investors typically benefit from the following:
* Loans offer stronger protection than high yield bonds in the legal documentation. For example, the use of maintenance covenants, which are tested regularly throughout the life of the loan, as opposed to incurrence covenants, which are tested just once at inception of the transaction.
* A loan's credit rating is typically one to two notches higher than that of an unsecured or subordinated high yield bond.
* Recovery rates are superior for loans.
2. Diversification benefits and a good hedge against higher interest rates
A key characteristic of loans is their ability to act as an effective hedge against interest rate increases. European loans are almost unique amongst fixed income products in that they can deliver positive returns when short-term interest rates rise. Relative to other asset classes, European bonds offer both attractive yield and low duration.
Figure 2. Loans are floating-rate instruments
Sources: Bloomberg L.P., ICE Bank of America Merrill Lynch credit indices, S&P Leveraged Commentary & Data and WFAM Credit Europe as of 30 September 2018. All yields EUR-currency hedged.
3. Strong risk-adjusted returns
Loans can offer attractive risk-adjusted returns compared with a broad set of other credit asset classes, which reflects the asset class's strong fundamentals. Although leverage multiples have gradually increased, the debt stack remains supported by healthy equity cushions provided by private equity sponsors, which have resulted in loan-to-value percentages in line with the long-term average of 50%.
Figure 3. Loans offer good risk-adjusted returns
Sources: ICE Bank of America Merrill Lynch credit indices, S&P Leveraged Commentary & Data and Bloomberg L.P. as of 30 September 2018.
4. Favourable supply and demand dynamics
The European loans market is at an all-time high size of €178 billion1. Demand has been boosted by the current regulatory framework for CLO issuance, which stipulates that CLO sponsors must co-invest alongside CLO investors to ensure they have got skin in the game.
This is matched by strong supply - private equity sponsors prefer loans rather than high yield bonds as a funding instrument because of the less-restrictive call protection.
5. An attractive alternative to US loans or private debt
Since the start of the 2008 financial crisis, the European loan asset class has exhibited higher returns and lower volatility than US loans, thus producing stronger risk-adjusted returns. For European investors, this gulf is only widened by high cross-currency hedging costs for US-dollar-denominated assets.
This is unlikely to change - European loans should continue to benefit from the ECB's more accommodative monetary policy environment, which is motivated by its continued fight against low inflation and low real gross domestic product growth.
Two crucial points differentiate European loans from European private debt. First, private debt managers have not yet had to contend with a default and restructuring cycle. Second, the closed-end nature of private debt vehicles and absence of a secondary market in the notes issued by these vehicles means that a private debt allocation is much less liquid than an investment in European loans, which is typically accessed via open-ended fund structures.
The asset class has a record of compelling risk-adjusted returns, helped largely by strong fundamentals - and there is reason to believe that this will continue over the next 12 months. In the current low-yield environment, European loans offer an opportunity to diversify exposures, enhance yield, and potentially improve the capital position.
Jens Vanbrabant is head of High Yield at WFAM
