By Thierry de Vergnes
The European leveraged loan market has changed considerably since 2008. In the past few years issuers have strengthened their balance sheets, which has led to a vast improvement in default rates, and more conservative capital structures are being used with less leverage than pre-2007 deals and issuers increasing the equity contribution from approximately 30% to 50% of the capital structure.
Furthermore, the European leveraged loan space now offers huge opportunities for institutional investors. CLOs, which previously accounted for a large proportion of buyers up to 2007, are no longer as active as they once were, because most of them have reached the end of their re-investment period. Therefore, as loans reach maturity and need to be refinanced, institutional investors will have the opportunity to fill this gap on attractive terms. As a result institutional investors, most notably insurance companies and pension funds, are looking at this asset class with renewed interest.
Benefits Offered
As an asset class, senior debt offers an array of benefits. Firstly, leveraged loans are floating rate instruments, which means they typically provide a pretty stable performance. Secondly, senior secured debt sits in a high position on an issuer’s balance sheet and, therefore, offers good protection to investors should a default occur. It is also important to note, that the leveraged loan market is private, so investors can benefit from regular and detailed information that enables thorough due diligence and monitoring of an issuer’s performance. The leveraged loan market is also getting more attention from institutional investors on account of its attractive yield, crucial in today’s low yield environment, that are achieved with reduced levels of volatility.
Leveraged loans vs. high yield bonds
In fact, now that bond spreads are at approximately the same level as those of leveraged loans, we can even question whether investing in the high yield space is still an attractive option for institutional clients. As mentioned, one of the main benefits of leveraged loans is that they sit at the top of an issuer’s capital structure and have strict agreements designed to closely monitor an issuer’s performance, helping protect values as lenders can intervene in a timely fashion. In contrast, bond holders are in a much riskier situation, as the covenants are tested less frequently, meaning they may have to wait longer to protect themselves from any underperformance. Additionally, high yield bonds have typically had lower recovery rates than leveraged loans. The floating rate nature of senior secured loans could also prove beneficial in a rising interest rate environment. A rise in rates will reduce the value of fixed coupon high-yield bonds, while leveraged loans will benefit from any increase in yields with a pickup in their coupons, leaving the loan prices relatively unscathed.
Confirmation from the US
For final confirmation that the leveraged loan market offers great potential for institutional investors, we can look to the US where institutional investors have long been investing in this asset class. Even though market concerns surrounding the Fed’s tapering programme have accelerated US investors exiting from the high yield market, they have continue to invest in floating rate debt such as leveraged loans. Funds and ETFs with substantial exposure to floating rate debt such as senior loans have attracted inflows of $45.5 billion so far this year according to Bank of America. It is therefore clear to see why the European leveraged loan market is an appealing option for institutional investors, particularly given its ability to deliver solid returns that can help match growing liabilities.
Thierry de Vergnes is head of debt investments at Lyxor Asset Management UK
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