By Scott Page
The European floating-rate loan market is trading at a meaningful discount to the US market and appears to be a tempting investment. As of 30 April 2013, the S&P European Leveraged Loan Index traded in the secondary market at an average price of 93 – a sharp discount to the average price of 98 for the US market, as represented by the US S&P/LSTA Leveraged Loan Index. While on the surface this may seem to be an attractive valuation and a buying opportunity, we recommend some caution when approaching this market.
While we believe some opportunities in the European loan market can prove attractive on a risk/reward basis, we conclude that the potential return premium, overall, isn’t sufficient to make Europe more attractive than the US floating-rate loan market. We find the European market weaker in several respects:
Fundamentals: the fundamental condition of underlying European issuers is weaker, on average, than their US counterparts. The trading discount is warranted due to higher risk and does not necessarily represent a better return opportunity. In many instances, the issuers are more-challenged credits, with generally higher leverage and a more difficult economic environment ahead.
Demand: weaker demand is likely to continue to weigh on the European floating rate loan market for two reasons: reduced demand from collateralised loan obligations (CLOs) and retrenchment by previously active European banks. In Europe, banks and CLOs comprise more than three-quarters of the demand for floating rate loans but their appetite for new issues has greatly diminished. Banks are under pressure to raise capital and are seeking to delever, not buy more loans. In contrast, the US benefits from a broader demand base of institutions, including hedge funds, prime-rate mutual funds and high-yield bond funds; banks play a much smaller role. The most common mutual fund vehicles in the European community, known as UCITS, are prohibited by regulations from buying floating rate loans. Other vehicles such as managed accounts are being used in Europe, and some managers are exploring alternatives known as “listed funds” to circumvent the prohibitions faced by UCITS.
Structural characteristics: Structural issues like dealer support, liquidity, size and volume still favour the US market. Dealer support is important because it translates into tighter spreads and greater liquidity. About four or five trading desks make active markets in Europe, compared with eight or nine in the US S&P reported 231 investor groups in the primary US market, compared with 88 in Europe as of May 2013. In 2013 we have also seen the share of the leveraged finance market in Europe continue to shrink in favour of high-yield bonds.
Creditor protection: Creditor protection in the US benefits from a uniform, well-established bankruptcy code, compared with an array of statutes in Europe.
We believe that US floating rate loans should continue to comprise the bulk of a portfolio’s allocation to the asset class – about 90%-95%. Select European floating rate loans can add value to the US core, through an investment process built on experience, expertise and in-depth credit research.
Scott Page is head of the floating rate loan investment group at Eaton Vance
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