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Impact Investing

IPE special report May 2018

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Asset-Backed Lending: Take your pick

Europe offers good prospects for asset-backed lending with opportunities for investors to step into the shoes of banks in certain markets, reports Lynn Strongin Dodds 

At a glance

• The ECB has failed to revive European ABS markets due to skittish investor sentiment and withdrawal of well-established players as stricter regulation bites.
• Commercial real estate loans across are one bright spot but the UK’s impending EU referendum is casting a pall in the country.
• Senior secured loans are also a favourite for investors wanting relatively good returns and downside protection.

It is unsurprising that secured credit has gained a following in this prolonged depressed-interest-rate environment. There is a wide range of opportunities – from loans to asset-backed securities (ABS) and trade-receivable finance, while the returns are more promising than many other fixed-income instruments. However, fortunes do vary and certain sectors and geographical regions have fallen out of favour. 

Take ABS, which many people still blame for triggering the financial crisis. Overall, figures from Nomura show that by January 2016 the European ABS market had shrunk to an estimated €500bn, a fraction of the €2trn recorded in the halcyon days of 2007. Issuance was roughly €85bn in 2015 but it was more than offset by over €100bn of repayments, according to Standard & Poor’s (S&P). The largest redemption at par was the £7.5bn (€9.4bn) of Granite, the former Northern Rock prime RMBS master trust nationalised by the UK government.  

By contrast, the US market looks thriving, although it has not yet reached its pre-crisis peak. Issuance jumped 12% last year from 2014, according to trade groups, the Association for Financial Markets in Europe and the Securities Industry and Financial Markets Association.  

The European Central Bank tried to resuscitate the region’s moribund market with a programme to purchase these securities as part of its measures to inject around €1trn into the euro-zone’s financial system but interest failed to ignite. This is mainly because the established participants such as banks and insurance companies have been restrained by their respective more onerous regulations – Basel III and Solvency II – which imposes higher capital charges on ABS versus similarly rated covered, corporate or financial bonds. 

This is not the case with the commercial real estate loan market. The outlook is positive, with research from CBRE predicting that over €500bn of outstanding European commercial mortgage debt is due to mature and likely to be refinanced over the next three years. In the UK, about 72% is due for repayment during the four years from 2015 to 2018 inclusive.

“Banks are shadows of themselves and this creates opportunities for asset managers to replicate their activity in their own way,” says Shaheer Guirguis, head of secured finance for fixed income at Insight Investments, which targets residential loans across the entire risk-return profile. “We see opportunities at loans to value [LTVs] that range from 40% to 60% and spreads are anything from 250bps to 400bps, depending on the jurisdiction or mortgage type,” he adds. “The UK is very interesting because high street banks are restricted in what they can do. That allows specialist lenders to step in and take advantage of extremely wide spread levels for the risk that you take. In the Netherlands, this is much less of an issue as the banking system is meeting the demand for mortgage product by borrowers.”

M&G is also bullish on senior commercial mortgages – three to 10-year loans on commercial properties at loan-to-value (LTV) ratios of about 50-65%. “The main attractions are they sit at the top of the capital structure and offer investment-grade risk; quarterly interest payouts; the security of a first-ranking claim over a property; and a strong suite of financial covenants,” says Lynn Gilbert, head of senior commercial mortgages, M&G Investments. They can be fixed or floating rates, which gives a typical portfolio lower duration than an average corporate bond strategy. “

Around 70% of M&G’s investments are in the UK and they cover the full spectrum including offices, residential and hotels, while the rest are mainly in the Dutch residential sector and offices, hotels and retail in France, Spain, Ireland and Germany. 

As for returns, Gilbert notes that at the lower end – 50-55% LTV ratios will generate 175-200bps over LIBOR, with spreads of 200-250bps for those at the 60%-plus LTV level. 

“We expect default rates in Europe to remain low and European credit to continue to benefit from ECB action”
David Milward

Omni Partners is also mining the prospects in this segment but is solely focused on short-term loans sized at £3.2bn annually – secured against UK residential and commercial markets. Its latest fund – the Secured Lending Fund II (OSL II) – recently gathered additional commitments of $34m (€30m), taking the total to $240m. Since inception in April 2015, the fund has delivered a net return of 11.1% on loans that ranged from six to 18 months in duration with LTV ratios capped at 70%.  

While London and the south-east of the UK still account for 50% of the firm’s lending, Steve Clarke, founder and head of risk at Omni also sees opportunities in the big six regions – Manchester, Birmingham, Leeds, Bristol, Edinburgh and Glasgow due to economic and employment growth. Particular areas of interest are student housing, as well as hospitals and conversions of office buildings to residential following new re-zoning laws that enable these types of development. 

The main glitch on the horizon for this asset class in the UK is the impending EU referendum which could result in the country leaving the EU. “Just as we saw in the run-to the Scottish referendum last year, activity has slowed,” says Clarke. “However, we believe it will be a bump in the road either way. There is a lot of pent-up demand and people are waiting for Northern Rock to unload its next tranche of loans. However, if we do Brexit, there will be short-term negative sentiment but for long-term investors the UK market will continue to be attractive.”

Although it is difficult to predict the result, there is no doubt that these commercial real estate transactions are and will continue to be labour intensive. Gilbert believes it is important to have a one-stop shop that has the ability to write significant amounts, originate loans directly, handle greater complexity and negotiate bespoke terms: “We may do one deal out of the 30 that we look at but it requires the resources and proper infrastructure to do the due diligence, go through the documentation, rating procedures and reporting process.” 

Clarke has similar views and notes that Omni has Amicus Finance Plc, which serves as the fund’s origination platform and is responsible for the entire front-to-back loan process. Credit analysis is also key, according to Guirguis. “You need to understand the quality of the people you are lending to as well as the valuation and collateral of the property you are lending against. Once you determine that quality you can move onto the structure in terms of the pricing, maturity and performance testing.”

Looking beyond real estate, Guirguis points to value in trade and auto finance but, as in real estate, credit analysis on the underlying pool is crucial. Fitch has fired a warning shot over a rise in delinquencies in the US car finance market but remains positive in Europe because of low projected delinquency rates and rising new car registrations across all five major EU economies as interest rates remain low.  

Non-performing loans are another area of interest, particularly in Ireland, Spain and Italy, where the bank pressure is the greatest but the opportunity for enhanced returns is the highest, according to Guirguis. Overall, a detailed analysis of 105 banks across 21 countries in the EU conducted by the European Banking Authority (EBA) late last year, revealed that about €1trn of non-performing loans – nearly 6% of the total loans and advances of Europe’s banks or 10% when lending to other financial institutions –  is excluded. The equivalent figure for the US banking industry is around 3%.

There are also disparities in the collaterised loan obligation arena. “A single A-rated CLO will generate around 200bps of additional spread versus an equivalently rated corporate bond,” says David Milward, head of Henderson Global Investors’ loan portfolio. “In the secured loan and high-yield markets there are headwinds coming from the US and whilst spreads look a little wider than Europe today, this reflects fears over rising default rates. However, we expect default rates in Europe to remain low and European credit to continue to benefit from ECB action.”

Milward believes there is greater interest in the relatively safety of senior secured loans as they are higher up the capital structure and offer more downside protection. Northern Europe seems to be the favourite hunting ground, as the courts are more investor friendly than those in the southern part of the region.  “You will get to the same end result in southern Europe but the process of restructuring companies takes longer and there is more court involvement,” he adds.

Martin Rotheram, senior portfolio manager for European floating-rate loans at Neuberger Berman is also a proponent. “European loans returned around 4.6% last year. With below-average default rates expected to continue, the protection that being senior secured affords, as well as the potential ability to benefit from any future interest rate rises, floating rate loans certainly deserve consideration for most diversified portfolios.

The fund manager prefers the larger names in the index, typically with more than €500m in debt and €100m of EBITDA, as they tend to be more stable businesses with longer track records but also have deeper syndicates, which gives greater liquidity in each name.

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