Leveraged loans growth in Europe
Written by Sandra Haurant
Leveraged loans have played a key role in investing in the US, both for the retail investor and for institutions, for decades.
And they don’t seem to be losing momentum – according to Thomson Reuters, US leveraged lending reached a quarterly record in the first quarter of 2013, while leveraged institutional lending hit an all time high of $190 billion in the same quarter.
In Europe though, while interest in the asset class has picked up significantly in recent years, the concept has a long way to go before it reaches similar proportions. “If you go back to the origins, leveraged loans and high yield bonds started in the 1980s as vehicles to help private equity companies finance buyouts,” explains BlueBay Investment partner Peter Higgins. “At the time, it was more challenging to bring to Europe, partly because of the many different currencies.”
As an asset class in the States then, leveraged loans have had time to make their mark and prove their worth. “We’ve had a two-decade head start to better understand the market and get comfortable with the inherent risks in the asset class,” says Higgins. Loans have been part of the fabric of the American markets for long enough to have weathered more than one storm, says Eaton Vance portfolio manager and head of European loans John Redding. “It has been proven through three or four investment cycles. It has a long and transparent track record,” he says.
Redding explains that there are three main uses for these products in the US. The first is a market that is pretty much non-existent in Europe, due to legislative barriers: “Twenty-five years ago they were used in retail funds,” says Redding. “They were put into packaged portfolios that individuals could invest in. Then 12-15 years ago they were in structured products. And the third use is institutional.”
The retail market still makes up a substantial chunk of the US loans market, explains BlackRock bank loan team head Leland Hart. “About a quarter of the US market is made up of retail funds,” he says. In Europe, a real retail market doesn’t really exist, and this may, at least in part, explain a slower take up of loans within European investment sector, argues Hart. “There is a difference in market size and evolution,” he explains.
In Europe, loans are a relatively new area of investment for pensions, and they remain a fairly specialised area. “The take up and familiarisation is still fairly recent – we have come a long way already but there is further to go. It’s really a matter of what is familiar,” says Aon Hewitt head of global asset allocation Tapan Datta. “They have only been on the landscape seriously for about three to four years now.” he says.
Those funds that are already involved in this area tend to keep allocations low, with perhaps up to 5 per cent of a fixed income portfolio being invested in this way. “It tends to be an income play,” say Redding. “Generally yields are the mid to high single digit returns, with interest rates held artificially low at the moment.”
But one of the key elements of leveraged loans is their floating rate, and if interest rates rise, they will too. And with the possibility of interest rate increases looming worldwide, loans have been becoming increasingly attractive to the European pensions industry. Partly, says Redding, this new enthusiasm is born of a need to tackle the problems fixed income would face in a rising interest rate environment. “Pension funds are shifting a little more into loans. It’s an insurance hedge, just in case rates rise quicker than expected, which would cause significant damage in terms of the price of fixed income,” Redding explains.
But they are not just a useful hedge against those risks, says Hart. “A lot of clients are looking at these, not so much as a hedge, because most are matched. They are looking at them as outright investments.” Their appeal is multi-faceted. As well as the obvious interest rate attraction, loans can offer higher yields than many fixed income alternatives, and as they are more senior in the corporate structure they arguably offer greater protection. “Investors have warmed to the idea,” says Datta.
Of course, this is credit, and with credit comes particular kinds of risk. But it could be argued that perceived concerns about default may be overplaying things a little. “Defaults are not at the forefront of people’s minds, I don’t think they are a driver,” says Hart. “We are in a part of credit cycle where defaults are expected to stay low and stable.”
Higgins agrees, saying that defaults are “poised to remain low,” while Datta says: “The broad market view on corporate balance sheets is that they are in a reasonable place. Default issues are not to the fore.”
Indeed, default rates are low at around 2.5 per cent, compared with high yield bonds with a default rate of around 3.6 per cent, according to BlueBay. For Datta, the greater risk is that of liquidity. “Liquidity across the credit space is not at its strongest point,” he says. “If there is a shock, some sort of setback in peripherals, for example, there is a question over whether there are enough exit doors for the market.”
There has also been speculation that leveraged loans could be storing up problems for the future. In April, J.P. Morgan analyst Vivek Januja was quoted on US investment news site The Street, drawing a comparison between the US leveraged loans market and the growth in subprime leading up to the financial crisis. “The boom in these loans has been fed by a continued surge of inflows into leveraged loan funds. The genesis of this voracious interest is the search for yield, similar to the strong growth in subprime mortgages in 2006-2007,” Januja said, adding: “Credit quality remains good currently, but an interesting shift bears watching – the number of loan downgrades is up sharply and exceeded upgrades in 2013 for the first time since 2009 and downgrades in Q1 2014 are already at about double the pace of 2013.”
But for Redding, the comparison is not necessarily accurate, given that the leveraged loan is a very different animal. “Back in 2010, when we were much closer to the crisis, nobody [in Europe] wanted to talk about loans, even though we knew these were drastically different and were behaving differently. I think now, though, with each month or year that goes by, people are getting more perspective. People are simply more accepting that there are risks that investors need to be aware of.”
In spite of the risks, or perhaps thanks to an increased awareness and understanding of them, the appetite for loans has been on the increase throughout Europe. According to Credit Suisse, institutional leveraged loan issuance in Europe hit €70.8 billion last year, and European high yield bond issuance stood at €96.5 billion. The market is throwing its doors wide open, with borrowers and creditors keen to come in. Credit Suisse head of leveraged finance EMEA Mathew Cestar wrote in March: “When borrowers considered their financing options in the past, they looked at the European and US high yield bond markets and the US leveraged loan market but now, increasingly, they have a fourth option – the European loan market.”
“The European pension buyer base has grown pretty consistently,” confirms Hart. They may not reach levels as seen in the US, but perhaps Europe is ready to make them a serious part of strategies, both as an interest rate hedge and an investment in their own right, albeit in modest proportions. “I see loans as being a complement to fixed income portfolios,” says Hart. “They will never be a large proportion of a portfolio, but they will end up more mainstream. I see them becoming more of a rule than an exception.”
Sandra Haurant is a freelance journalist