European loans seem to offer compelling value against the US market. But Joseph Mariathasan uncovers some telling structural disadvantages on this side of the Atlantic
In a world where there is little yield and no-one expects interest rates to go up, the loan asset class ticks a lot of boxes.
"It provides a solution for insurance companies and pension funds who have to find yield, but not in a risky way," says Jeff Boswell, a portfolio manager at Intermediate Capital Group (ICG). But he finds that, while US pension funds often have a set allocation to sub-investment grade debt, the same is not true in Europe. "That mentality has not existed for sub-investment grade, but it is a logical step to take for European and UK pension funds."
However, while the US institutional loan market is worth $700bn (€554bn) and primary issuance of collateralised loan obligations (CLOs) is motoring along with $30bn of new issuance in the past year, the European loan market is barely half that size - and even adding high yield only brings it up to around €500bn.
"There has been pretty flat growth since 2007, with a natural transition from loans to bonds," says Boswell. "The high-yield market increased from €100bn to €150bn but the European CLO market is only €120bn and new issuance has dried up."
Historically, the three biggest European loan markets are the UK, France and Germany. ICG finds that still remains the case, with each of the three countries accounting for about 25% of the market. The rest largely comes from Scandinavia, Benelux and Switzerland. As loan issuance is driven by private-equity deal flow, there is little coming out of peripheral euro-zone countries where few private-equity players dare to tread - although a few Spanish names with businesses focused away from the domestic consumer find some favour.
As well as sheer size, there are significant structural differences in both the supply and demand for loans between the US and Europe. Until 2007, Europe's market was funded almost entirely by banks and CLOs, both of which have essentially disappeared as banks shrink their balance sheets and CLO reinvestment periods expire.
Craig Scordellis, senior portfolio manager at CQS Investment Management, says that in the next 18 months, 90% of CLO capacity will start to amortise. He reckons that, between 2012 and 2017, CLO capacity will decrease by €50bn; Standard & Poor's estimates it will be just €9bn by 2014. CLO providers are required to maintain some exposure - ‘skin in the game' - and the simple fact is that very few are capitalised appropriately to do that anymore.
"This creates a potential issue as to who will be there in the primary market and to support the existence of the secondary market," Scordellis says. But it also creates opportunity, of course: "The decline in CLO capacity should result in higher yields and more attractively priced loans."
Indeed, yields are significantly higher on European than on US loans, despite reasonable corporate performance and relatively few borrowers from the euro-zone periphery. As of 11 May, the Credit Suisse US leveraged loan index (on a three-year discount margin) had a spread of 569bps versus 718bps on the comparable European index. Investors are demanding a premium for investing in Europe.
But as Jonathan Butler, head of European leveraged finance at Pramerica Investment Management argues, pure spread comparisons are not the whole story. Europe is a smaller market, but it also has a greater bias of single-B loans and also some large distressed and peripheral issuers skewing the indices.
"The European loan market has been dominated by private equity-sponsored issuance, while in the US there is a balance between corporate and private equity-owned businesses," he observes. "This has led to a distortion of credit quality in Europe to a majority of single-B rated new issues against a mix of BB and single-B in the US."
Matthew Craston, head of alternative investments at ECM, which has been managing open-ended loan funds since 2004, adds that the Chapter 11 process in the US can be a major factor in the yield difference between the US and Europe, as it means that when defaults occur they tend to be resolved more quickly and definitively. While some regimes in Europe - such as the UK - are extremely efficient, many are a lot slower.
"When a company defaults in certain European jurisdictions, that slower process can mean that the par value of the loan is retained for longer than it might be in the US," he explains. "The US and European indices perform extremely similarly, so it cannot mean that Europe has had worse credits. It's just that, in the US, if a loan trades down to 60 cents, for example, the debt might get restructured - so the 40 cents loss is absorbed and the new debt trades at 100 cents. In the European index, 100 cents goes down to 60 cents and sometimes stays there. That means more low-priced assets in the European index and, on average, higher yields in the secondary market."
Partly for these reasons, Craston generally favours European loans over US. "I think I prefer the value in Europe," he says. "If you are being brought new issues from similar companies at wider spreads, better covenants and lower leverage, then they are more attractive."
Butler takes the view that default rates in Europe will be higher than in the US. "The European loan market has done much less refinancing activity and been less proactive in financial restructurings to date," he argues. "This is interesting, since Europe has stronger covenant protection, in theory, but is actually driven by weak bankruptcy codes that are more favourable to companies than the US bankruptcy code through Chapter 11."
Scordellis concurs: "The lagging 12-month default rate in Europe is 4.9% versus 4% in the US, whilst the recovery rate in the US is 84% versus 76% in Europe. It is subtle but it makes a difference. "He also points out a number of other strengths of the US loan market over Europe's. The US market enjoys deep pools of capital from both retail and institutional investors - capital restricted in Europe thanks to loans being excluded from the UCITS structure - which improves liquidity and helps cap idiosyncratic credit risks. Ratings also have a more established role in the US. "In Europe, a lot of loans are ‘privately rated' by S&P [and the other agencies] - in essence, estimates given by the rating agencies, not to be discussed with other investors," says Scordellis. "The technicals of Europe makes it a more difficult market."
It is therefore not clear that European loan risk-adjusted spreads are broadly higher than those in the US. This is not to say that there are not some very good opportunities for the selective.
"Investors are being significantly better compensated than four or five years ago," says Boswell. One metric that ICG uses is the spread per turn of leverage: "Currently you can get paid 550 basis points over LIBOR for a new deal that is four-times leveraged, giving 100-140 basis points per turn. In 2007, the spread was 250 basis points for a six-times leveraged deal, giving closer to 40 basis points per turn. There is an enormous opportunity there."
But spread opportunity is all very well, as long as there is healthy supply. There isn't. Europe has accounted for just 13% of global issuance over the past 12 months, with a lack of higher-quality loans, as Boswell points out. Private equity firms have raised huge amounts of equity and with the banks and CLOs out of the picture the piece of the jigsaw missing is the senior debt, which Boswell identifies as a source of opportunity for loan funds such as his. But the broader M&A picture in Europe, and consequent demand for loans, is depressed, simply because bids and offers are struggling to meet.
"As a CEO, do you want to bid up for a European corporate, exposed to the sovereign crisis, and lever yourself before a probable recession?" asks Butler. "As a vendor, do you need to hit that low bid, or can you hold on until after the storm to achieve a more reasonable price?"
Moreover, Butler finds that record low yields on investment grade bond issuance means that corporates are currently able to outbid private equity firms for now. Together with the banks pushing corporates to diversify their funding bases away from loans-only funding, this has led to plenty of bond market activity, but much less in European loans.
"Capital gains from discounted loan purchases arising through M&A activity are possible, but many of the easiest opportunities have passed," says Butler. "Discounted loans now are usually stressed, and while there can be a full repayment, an ‘amend-to-extend' request could prolong the life of the loan and reduce the expected yield."
The education process for loans as an asset class for pension funds is still continuing, and while it does so there will continue to be a lack of pressure from investors to improve the structure of the market itself.
"Too many managers are too willing to accept sub-market returns and standards," says Butler. "There should be a greater push for public ratings, as opposed to credit estimates, improved economics in ‘amend-to-extend', the removal or material reduction of transfer fees, LIBOR floors, and a reduction in minimum transfer clauses and minimum hold clauses. This is the way to be able to attract many new or smaller institutional accounts to European loans."