Investors are turning attention to loans as they have become more attractive versus high-yield bonds

Key points

• The loans market has become a sellers’ market.
• One reason loans are attractive propositions for companies is that there is virtually no time limit on when they can be called.
• Most large institutions are investing in ‘leveraged loans’ – bilateral agreements made with a sub-investment-grade issuer.
• Investment-grade loans tend not to be syndicated and are retained by the original lending bank.

No market can exist without both supply and demand. The growth of the European loan market since the global financial crisis is testament to strong demand from investors being met by strong supply.

But there is rarely a perfect match between supply and demands; imbalances develop. This is happening in the loan market – it has become a sellers’ market. That has led to a weakening of covenants and the emergence of more risky loan structures.

Over the course of this year, companies have preferred to issue loans rather than high-yield bonds. David Riley, head of credit strategy at BlueBay Asset Management, says: “The terms offered in the loan market are more attractive and flexible than those on the bond market.”

Three years ago, it was possible for a company to issue a high-yield bond with a senior level of security but fairly loose covenant package. Riley says: “In contrast, a loan market issuer would have had to offer a stricter, maintenance covenant package.” But that is no longer the case. Riley says: “There is now little difference in terms of covenant protection between the two markets.”

Maintenance covenants exist because they are required by banks when lending to companies. Azhar Hussain, head of global high yield at Royal London Asset Management, says: “The lender would specify, and constantly assess, the ratio of debt to earnings it found acceptable.”

azhar hussain

If the company’s debt ratio went above this specified level, the bank would deem it to have breached the terms of its loan and would demand access to its secured assets, says Hussain.

This maintenance covenant has been replaced by a debt-incurrence covenant. Hussain says: “This agreement only comes into play when the company issues new debt.” As long the company maintains its capital structure, no covenant terms will be tripped if the firm’s earnings fluctuate.

While some might consider this erosion of this covenant protection as a negative development, others argue it is a natural part of the market’s evolution. David Milward, head of loans at Janus Henderson Investors, says: “Banks needed this protection because they were locked in for the full duration of the loan.”

But these protections are no longer needed as the market has become more liquid. Milward says: “If a company’s performance weakens, we have the option to exit the loan and buy something else.”

Anthony Robertson, chief investment officer at Cheyne Strategic Value Credit, agrees: “Covenant-light structures can, in some circumstances, protect investors.” In a covenant-light structure a temporary downturn in revenues will not trigger a default and will allow the company to right itself without having to restructure its finances, he adds.

Erosion of covenants is not the only reason that loans have become more attractive to issuers than bonds – their more flexible call terms add to their appeal. Riley says: “While a five-year high-yield bond cannot be redeemed by the issuer during the first two years, there is virtually no time limit on when a loan can be called.” That is an attractive proposition for a company as it allows it to re-finance at better terms if the business starts to outperform.

For some, the focus on the erosion of covenant protection is a red herring. Robertson says: “Of greater concern is the increase of all-in debt levels back to those last seen before the global financial crisis in combination with the emergence of uni-tranche financing.”

To understand the impact of uni-tranche financing, it is important to take a look at the structure of the loan market. Most of the loans large institutions are investing in are ‘levered loans’ − they are bilateral agreements made with a sub-investment-grade issuer. “Strong demand from both fund managers and collateral-loan obligation providers has encouraged banks to originate and syndicate more of these levered loans,” adds Riley

In contrast, investment-grade loans tend not to be syndicated and retained by the original lending bank.

Banks like to retain these loans on their balance sheet as the higher credit quality of these companies results in a lower capital charge. Riley says: “Even if banks were to distribute these loans, they would not be attractive to investors because the spreads are too narrow.”

david milward

While most of these loans are for sub-investment-grade companies, fund managers usually select those deals which are at the top of the capital structure. Riley says: “Typically we invest in first-lien loans – these have the first charge over the assets of the company.”

These are often referred to as secured loans as this loan is secured on the company’s asset, equity and the business’ cash flow.

Below the first-lien secured debt is the second lien and below that is the mezzanine, or high-yield debt, which is the subordinated debt.

Robertson says: “Recently companies have started to issue first-lien-only loans.” This is significant because it increases the proportion of first-lien debt within the capital structure.

Historically, first-lien loans were a small proportion of the company’s debt structure – it was the top of the pyramid with less senior debt making up the bulk of the debt structure.

This provided protection in the event of the default because only a small proportion of the loans had first claim on the assets.

Robertson says: “If the whole loan structure is first lien, then this becomes the entire pyramid; the second lien and unsecured debt are no longer there to incur the first loss if there is a default.”

This makes the loan provider more vulnerable to any potential change in the earnings of the business, as there is a higher chance of becoming capital-impaired.

Robertson says: “Not only does this make loans riskier for the investor but it also makes companies more vulnerable to default than might have been the case.”

Investors have been comfortable to provide loans to sub-investment-grade companies because default rates have been low and recovery rates relatively high, even when business cycles turn down.

But these trends were underpinned by a traditional debt structure. The popularity of uni-tranche loans has the potential to undermine this market stability.

Robertson says: “Their prevalence make it less likely that we will see low default rates and high recovery rates in the next downturn.”

Gabriella Kindert, head of alternative credit at NN Investment Partners, agrees: “We cannot extrapolate historical recovery rates because today’s loan structures are materially different.”

gabriella kindert

Not only is uni-tranching more prevalent but the growth of the covenant-light structure is also likely to play a part in re-shaping default and recovery rates.

Kindert says: “Around 70% of syndicated loans now have covenant-light structures. Before the financial crisis it was only 5-10% of the European loan market.”

Kindert is also concerned that the opaque terminology of the loan market has resulted in a lack of understanding. “Many investors in the loan market have misconceptions about senior secured loans,” she says.

Badly-defined terminology adds to the confusion. Kindert says: “In my experience, many investors do not realise they are investing in leveraged loans – they think they are buying senior secured bank debt.”

These investors assume the loans they are buying are underpinned by tangible assets such as inventory, property or plants and machinery.

Kindert says: “But the reality is the security to the loan is often only the enterprise value of the company based on value of the shares.”

Cash flow measures – such as earnings before tax, interest, depreciation and amortisation − can fluctuate, changing the actual value of the company. In stressed situations this can reduce significantly, she adds.

In addition, the guarantor of these facilities is also reduced. Kindert says: “Loans used to provide a 100% guarantee from all facilities but now it has been reduced to only 70%, with some being excluded.”

This means the level of security is much lower than it has been in other market cycles. Kindert says: “Until there is a downturn, it’s not possible to know what the recovery rates of loans with these structures will be.”

Robertson says: “The trend for more covenant-light structures along with the rise of uni-tranche deals are both a reflection of heightened levels of investor complacency.” This is a reflection of investors being price takers rather than setters who have no control over the terms of the loan.

This type of behaviour is typical of the late stage of the credit cycle. Robertson says: “And this always ends the same way – very badly.”