In the last 15 years, the leveraged loans market has first developed in the US and more recently in Europe thanks to the growing participation of institutional investors. Leveraged loans emerge now as a separate and strategic asset class that should be considered in the asset allocation process by any investor looking to get efficient exposure to the non-investment-grade markets. Indeed, leveraged loans enable investors to benefit from low volatility, attractive risk-adjusted returns and low correlation with other asset classes while getting access to sectors beyond public markets.
Leveraged loans are defined as senior secured loans structured as either a revolver or a term loan (including first and second lien) originated by banks for non-investment grade public or private corporations. The global leveraged loans market (approximately $1,300bn) is actually bigger than the high yield bonds market (approximately $950bn). Leveraged loans form the largest and the most senior piece of debt issued and they benefit from the best position in the corporate structure being closest to the operating company level. Seniority confers to lenders a priority claim on some or all of the borrower’s assets. Companies and private equity sponsors typically resort to leveraged loans to provide financing for LBOs, recapitalizations, acquisitions and internal growth.
As private instruments, loans are governed by detailed and tailored credit agreements that contain periodically tested maintenance covenants more restrictive than those contained in high yield offerings. Covenants, such as interest coverage (minimum ratio in terms of cash flow or EBITDA to interest payments) or leverage test (debt to cash flow or EBITDA), define what future operating and financial levels are required. As a result, lenders are able to monitor corporate activities. The key advantage of bank loans’ covenants is that they allow investors to negotiate with equity holders before financial difficulties arise, which improves recovery rates.
The European Market shows strong growth and improving liquidity
In Europe, leveraged loans volume has consistently grown over the last seven years from $17bn in 1998 to approximately $92bn in 2004. Europe accounted for 27% of all new global issuances in 2004 compared to 6.8% in 1998 (cf. Fig. 1).
In the US, leveraged loans have become mainstream investments for institutional and retail funds, which now capture about 70% of the market. Europe is following the same path as the market grows. According to the Loan Corporation Data, there are now at least 60 institutional investors regularly buying leveraged loans in Europe and the institutional share rose to a record 34.5% in the year ended June 30, 2005 compared to 25% in 2004.
The growing market share of institutional investors is actually crucial to the evolution of the European market that was historically dominated by the bank/client relationship. The presence of institutional investors induces more competitive and rational pricing and, since they have to mark-to-market, institutional investors require more liquidity.
The financial disintermediation process in which banks are being complemented by investors as an alternative source of funding supports this evolution. Facing this potential competition, banks have been more inclined to open up the loans market and to respond to institutional investors’ demand for more transparency and liquidity. Additionally, capital markets constitute for the banks an efficient way to price and hedge their credit exposures to corporate clients.
An asset class characterized by low volatility and attractive risk-adjusted returns
Loans typically pay interest at rates that equal a fixed spread of at least 125 bps over Euribor or Libor. As a result, pricing is insulated from interest rates movements and duration becomes irrelevant.
Loan spreads are characterized by low volatility. In the last five years, the average new issue BB/BB- spreads reached their lowest point in the first semester of 2000 (1H00) at 263 and were at their highest in 1H04 at 304, a 41 bp-difference. For B+/B credits, spreads move over the same period from 272 (1H00) to 304 (2H02), a 32 bp-difference. As a comparison, the Euro Merrill Lynch High Yield Index fluctuated by more than 1,200 bps during the same period (cf. Fig. 2).
The senior security package, high level of seniority and tight covenants enable loans to achieve a recovery rate well above expected recoveries for high yield bonds. Depending on the jurisdiction, loan investors would expect to recover 50 to 75% of capital investment in case of bankruptcy.
Volatility is also limited by the fact that borrowers have the ability to prepay the loan, thus limiting the upside potential. Therefore, it is not surprising that loans usually trade close to par, providing investors with attractive and predictable returns coupled with limited risk. Leveraged loans actually show exceptional risk-adjusted returns: between 1992 and 2004, their average returns amount to 6.79% with a 2% volatility.
The leveraged loans’ Sharpe ratio (cf. Table 1), which measures the unit of return per unit of risk, is among the highest of any asset class at 1.16 (cf. Fig.3).
Low correlation with other asset classes
A successful diversification strategy implies mixing uncorrelated investments. Leveraged loans are actually not correlated to traditional fixed income securities or equity and have attractive, independent risk-adjusted returns. Indeed, the loan’s floating rate interest and principal stability features explain the weak correlation of leveraged loans to other fixed income securities. Similarly, correlation to equity is limited since leveraged loans are usually used in the capital structure of privately held companies (cf. Table 2).
Loans being private instruments, asset management firms must rely on internal expertise to successfully invest in this asset class. Indeed, most European leveraged loans are not rated while banks’ credit analysts do not cover a large number of borrowers. Therefore, loans portfolio managers, credit and legal analysts must source information that is not easily available and use their know-how, developed for instance in the high yield activity, to appraise the loans. All those specific characteristics provide a natural barrier to entry to the loans market.
Leveraged loans fit well in a global portfolio, offering, along with high yield bonds, an alternative to traditional equities. Since leveraged loans benefit from one of the best risk/return and volatility profile, their introduction in a global portfolio increases diversification, reduces volatility and improves its Sharpe ratio. Increasing liquidity and growing participation of institutional players enhance the growth potential of this asset class.
Against this background, Dexia Asset Management has decided to create a new fund mainly focused on leveraged loans. With its considerable experience in the high yield field for the past six years, the Dexia Asset Management high yield team, strong of seven specialists in portfolio management, credit and legal analysis is in the best position to take advantage of the growing leveraged loans market.
Dexia Asset Management has been a major actor in alternative management for almost ten years. Dexia Asset Management currently covers most of existing alternative strategies. A team of more than fifty people, internal research and collaboration with the university world enable Dexia Asset Management to play a major role in product innovation. Its unique know-how shows in the numbers since Dexia Asset Management stands out as a prominent European leader in Alternative Management with more than e6.4bn under management.
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