The case for European loans A senior secured loan primer

Transcription

1 The case for European loans A senior secured loan primer This document is intended only for Professional Clients and Financial Advisers in Continental Europe as defined in the important information, for Professional Clients in Dubai, Guernsey, Ireland, the Isle of Man, Jersey and the UK; in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors; in Switzerland for Qualified Investors; in Taiwan for Qualified Institutional Investors only; in Singapore for Institutional/Accredited Investors, in New Zealand for wholesale investors (as defined in the Financial Markets Conduct Act), and in Australia and the USA for Institutional Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument In Chile, Panama and Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public.

2 Introduction to European senior secured loans Objective In this paper we seek to provide a wealth of information on investing in European senior secured loans. Any references to senior secured loans should be considered with regard to investing in the European loan market. We will explore the following five topics in order to provide a framework for thinking about senior secured loans and a foundation for investing in the European market. 1. Investing in senior secured loans 2. Potential benefits of senior secured loans 3. Why consider investing now? 4. What are the biggest risks? 5. The Invesco difference Investing in senior secured loans Senior secured loans (SSLs) are privately arranged debt instruments that provide capital to a company usually with a below investment-grade rating and are issued by a bank or financial institution and syndicated by a group of banks and institutional investors. Senior secured loans may be issued in conjunction with leveraged buyouts, mergers or acquisitions. A company s payment of interest and repayment of principal on its loan is contractually senior to any other form of debt or equity. Within a company s capital structure, senior secured loans are: Senior to the claims of other creditors Secured by collateral, such as property, inventory, equipment and intangibles How senior secured loans work A senior secured loan is structured as a floating rate instrument that floats at a pre-determined spread over a reference rate, usually the European Interbank Offered Rate (EURIBOR). The reference rate, in general, resets every days on average. This is the key feature that makes senior secured loans different from other fixed income securities, as it reduces their interest rate sensitivity and relatively protects investors during a rising interest rate environment. Figure 1: Decomposition of current income Reference rate 3 month EURIBOR or 3 month LIBOR Rate resets periodically Additional interest margin Additional compensation for: - Credit risk - Liquidity risk Insulate against interest rate fluctuation + Dependent on credit risk profile of issuer = Total current income Subject to LIBOR/EURIBOR floors Provides cash flow stability Floating Credit spread Source: Invesco. For illustrative purposes only. 1

3 A different form of debt capital Senior secured loans are typically non-investment grade and differ from high yield bonds due to their floating rate nature, which makes them less susceptible to interest rate (duration) risk. Furthermore, senior secured loans benefit from being private debt, and because they are not deemed securities and thus are not traded on public exchanges. This means that investors, like Invesco, can elect to receive access to private information from the underlying companies which allows for a deeper credit analysis and underwriting process. Examples of private side information can be but is not limited to due diligence reports from independent consultants, forecasts and budgets, as well as access to the management teams such as the CEO, CFO and/or other senior management. Another key benefit of senior secured loans is that they sit at the top of the capital structure, which makes them less risky than other risk assets like high yield bonds and equities in the event of default. Similarly, the company s assets are typically pledged against the debt and the lender group benefits from covenants, which help protect them in the event of bankruptcy. As such, the average ultimate recovery of senior secured loans of approximately 80% is higher than high yield bonds and equities. Figure 2: Senior Secured Loans: A different form of debt capital Senior Secured Floating rate In the event of financial hardship, senior secured loans have first claim of repayment Company assets are typically pledged as collateral to senior secure loans As the reference rate resets, loans are less susceptible to interest rate (duration) risk. Priority of repayment in the event of default: High priority Senior secured loans Bonds Preferred stock Common stock Average ultimate recovery rates (%): Senior Secured Loans Subordinated Bonds 28.0 Prices Fixed- rate bonds Floating -rate loans Low priority Interest rates Source: Invesco, Moody s as at 31 December Price and interest rate chart is for illustrative purposes only and does not represent actual prices. Senior secured loans are typically non-investment grade, or high-yield, securities (junk bonds). High-yield securities have additional risks, including interest rate changes, decreased market liquidity and a larger amount of outstanding debt than investment grade securities. Investors of senior secured loans may not be able to enforce all rights and remedies under the loan including any associated collateral. If the loan is foreclosed, the investor may become part owner of any collateral and may bear the costs and liabilities of owning and disposing of the collateral. Senior Secured Loans Syndicated to a Large Number of Investors A senior secured loan is a privately arranged debt instrument that is used to provide capital to a company. They are issued by a bank or other financial institution (lead arranger) and syndicated through the primary loan market to a wide group of investors, including banks and institutional investors. After syndication, the senior secured loans are traded by various counterparties in the secondary loan market. Figure 3: The bank loans syndication and market trading process Syndicate Investor 1 Investor 2 Investor 3 Investor 4 Investor 5 Investor 6 Borrower Lead arranger Primary loan markets Secondary market Investor 1 Investor 2 Investor 3 Investor 4 Investor 5 Investor 6 Source: Invesco. For illustrative purposes only. The case for European loans 2

4 Senior secured loans are a significant component of the corporate credit markets The European senior secured loan market has been an important source of financing to European companies for over two decades. At the end of 2016 the total European loan market size was 157 billion. The market is made up of approximately 280 well known, established companies that use senior secured loans as an integral part of their capital structure (financing needs), and which represent a diverse set of industries, as shown in the charts below. The European senior secured loan market is comprised of a diverse group of companies across all industries. Figure 4: European market size: 157 billion Euro loan market Euro loan issues Size of Euro loan market (bln) Number of European issues Source: Credit Suisse, as at 31 December European market presented by sector as represented by the Credit Suisse Western European Leveraged Loan Index. Figure 5: European borrowers represent a diverse set of industries CS WELLI Market Weight % Aerospace Cable/Wireless Video Chemicals Consumer Durables Consumer Non-Durables Diversified Media Energy Financial Food/Tobacco Forest Products Gaming/Leisure Healthcare Housing Information Technology Manufacturing Retail Service Telecommunications Transportation Utility Wireless Communications Source: Credit Suisse, as at 31 December European market presented by sector as represented by the Credit Suisse Western European Leveraged Loan Index. Potential benefits of senior secured loans Enhanced income and diversification benefits Today s investors are facing new and unique challenges as traditional fixed income investments are providing historically low income and are increasingly vulnerable to the threat of rising interest rates. European senior secured loans (EUR SSLs) offer attractive features such as enhanced income and lower duration relative to traditional bonds. European senior secured loans may also serve as a portfolio diversifier by offering the potential of low correlation to traditional bonds, as shown in the below table. 3

5 Figure 6: Five-year European SSL returns have been less than 50% correlated with popular fixed income assets Correlation of European SSLs with traditional fixed income indices Move in opposite direction Neutral Move in same direction Global Treasuries Global Bonds European Treasuries European Bonds Global Corporates European Corporates Source: Invesco, evestment, as at 31 December European SSLs represented by the Credit Suisse Western European Leveraged Loan Index; European Treasuries by the BBG BARC European Aggregate Treasury Index; European Corporates by the BBG BARC European Aggregate Corporate Index; European Bonds by the BBG BARC European Bond Index; Global Treasuries by the BBG BARC Global Treasury Index; Global Corporates by the BBG BARC Global Aggregate Corporate Index; Global Bonds by the BBG BARC Global Aggregate Index. Past performance is not an indicator of future results. An investment cannot be made directly in an index. Potential advantages over high yield bonds Investors in EUR SSLs have received consistent, low volatility returns for two decades. The Credit Suisse Western European Leveraged Loan Index (CS WELLI), a proxy for the European senior secured loan market, has averaged a 5.4% annual total return (EUR) since inception in 1998, with only three negative return years in that 19 year period. The CS WELLI total return for 2016 was 6.5%. In the past five years, the European loan market has exhibited less volatility 1 than alternative fixed income risk assets such as European high yield (HY) bonds; the five year average volatility of the CS WELLI was 2.15% versus 4.91% for the HY market. Accordingly, the senior secured loan market has had more attractive risk-adjusted returns compared to the HY market over the five year period Figure 7: EUR SSLs have achieved historically greater risk-adjusted returns versus HY bonds Total return (5 year) Sharpe ratio European SSLs European HY Bonds Sharpe ratio Total Return % Source: Credit Suisse, as at 31 December European SSLs represented by the Credit Suisse Western European Leveraged Loan Index; European HY Bonds represented by the Credit Suisse Western European High Yield Index. Past performance is not an indicator of future results. An investment cannot be made directly in an index. Longer-term investment horizons European Collateralized Loan Obligation (CLO) and institutional investors, who tend to invest over the long-term, dominate the EUR SSL investor base. This typically keeps volatility within the market relatively low and thus is a potential advantage over the fixed income markets, where retail (mutual funds, ETF, etc.) investors, whom typically have shorter investment horizons, are more prevalent. 1 Volatility as measured using standard deviation 2 Risk-adjusted returns as represented by the Sharpe ratio. During the five year period the CS WELLI had a Sharpe ratio of 2.77 versus the HY market s Sharpe ratio of European HY Bonds (HY) represented by the Credit Suisse Western European High Yield Index. The case for European loans 4

6 Why consider investing now? Eurozone GDP growth, albeit modest, as well as a healthy, supply and demand balance in the underlying loan market are positives for European SSLs. There are two macro themes that add to the attractiveness of European SSLs in First, over recent years, long-duration asset classes have benefited tremendously from European Central Bank s (ECB) stimulus policies. The question has been if not when the ECB will provide incremental stimulus. We are anticipating a softening in ECB policies, driven primarily by inflation data. The new question that will increasingly be asked will be when will the ECB start weaning the market off its accommodative monetary policy, which naturally leads to a rising interest-rate (Euribor) environment. This should lead to more demand for shorter-duration assets such as SSLs. As the majority of European loans are structured with a minimum (i.e. floor) of zero per cent for the Euribor component (as at Dec. 30, 2016, 3 month Euribor was -0.3%) they are therefore insulated from Euribor s current negative value and investor coupon income will increase when Euribor surpasses the zero per cent floor value. Therefore, in a steepening yield curve environment, the asset class has the potential to outperform longer-duration assets. Second, we see a repeat of the heightened sensitivity over political events. The lack of reliable predictive tools for election results has led to increased market volatility before and after these events. Against this backdrop, we believe European SSLs present a compelling allocation opportunity for investors given their defensive position in the capital structure and historically lower volatility than other fixed rate alternatives. What are the biggest risks? The primary elements of risk in senior secured loan investing are credit risk or risk of default and risk of principal loss given default. In line with these risks, Invesco's proprietary internal risk rating framework is designed to determine the probability of default and expected recovery. The percentage of risk attributable to each of these components depends upon where we believe the credit cycle to be. In the current European environment, default risk is in the less than 1% range 1 (in line with historical average) on a trailing twelve month basis, thus, the primary component of risk currently is expected recovery. Investor concern is often focused on the risk that a macro shock could lead to an increase in defaults. While loan volatility has been relatively low, the risk of contagion from other asset classes and macro events does exist. The European loan market has had limited systemic risk given it s the minimal exposure to the Oil and Gas sector. Nevertheless, there are likely to be some pockets of weakness. For example, some retailers and food manufacturers are exposed to softer demand (channel shift, macro-uncertainty and/change in consumer habits) and dollar-denominated sourcing costs (cotton and food commodities) are vulnerable. For 2017, we expect a default rate of approximately 2% by principal amount - which remains well below the 4.6% historical average between 2009 and The Invesco difference Depth and breadth of resources. Invesco Senior Secured Management (ISSM) has been managing senior secured loans since 1989, making us one of the original investors in this asset class. With 43 professionals dedicated to the Senior Loan team, including 29 investment professionals, we have one of the largest dedicated teams in the senior secured loan space. Given the dynamic nature of senior secured loans, the trading environment and the sheer number of issues and issuers, we believe that organizational size and depth of expertise is vital in this market. Market presence and scale. With global assets totalling over $40 billion under management, our clients benefit from Invesco's position as one of the largest senior secured loan managers in the world. This advantage occurs both in the new-issue market and in the secondary market. As a result of our leadership position in both active and passive management, we are one of the most significant trading counterparties in the European SSL market. 1 Source: Credit Suisse, as at 31 December European market environment represented by the Credit Suisse Western European Leveraged Loan Index. 2 Source: Credit Suisse, as at December 31, Expected default rate for the Credit Suisse Western European Leveraged Loan Index. 5

7 The diversity of our senior secured loan platform and the size of our dedicated team combine to facilitate exceptional market access, depth of understanding, and synergies across multiple investment offerings. Our scale helps enable us to: Garner favourable trade execution Provide underwriters with decisive, value-added views on the market, transaction structures, and pricing Receive preferential allocations on new issues potentially improving investor outcomes Credit process and proprietary tools. We developed one of the first institutional senior secured loan platforms and, ultimately, helped foster the maturation of the syndicated SSL market. Our analytical methods and tool suite establish the industry standard for predictive credit research in senior secured loans. By achieving a quantifiable and directly comparable methodology of the default risk and recovery potential, we believe our analytical framework establishes a distinct information advantage in the active management of SSL portfolios. Private side investor. Our team is solely focused and dedicated to the SSL asset class. As senior secured loans are not public securities, our team is organized to access private side information and maintains a separation from other teams at Invesco that trade in public securities. This organization allows us to access and use non-public information made available by SSL issuers (e.g., company financials and projections) without compromising other teams at Invesco. This access provides an information advantage over competitors that do not access such information. Access to private information means greater access to senior management and company projections. In addition, we can obtain financial information from issuers outside of the standard quarterly public reporting periods. By leveraging this information in the initial credit decision, as well as in ongoing monitoring of investments, we enjoy an information advantage over competing managers. While private information may not be as important in a benign (low) default environment, it plays a vital role in exposure positioning when companies are having difficulties or may default. Final thoughts The attractiveness of senior secured loans varies by market condition and investor objectives. However, we believe there currently is, and will continue to be opportunities for attractive riskadjusted returns and portfolio diversification in European senior secured loans. As a leading pure-play investment manager with an exclusive focus on senior secured loans, we are committed to helping our clients benefit from our long-term, consistent approach and our ability to deliver customized, opportunistic senior secured loan strategies. The case for European loans 6

8 Important information This document is intended only for Professional Clients and Financial Advisers in Continental Europe as defined in the important information, for Professional Clients in Dubai, Guernsey, Ireland, the Isle of Man, Jersey and the UK; in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors; in Switzerland for Qualified Investors; in Taiwan for Qualified Institutional Investors only; in Singapore for Institutional/Accredited Investors, in New Zealand for wholesale investors (as defined in the Financial Markets Conduct Act), and in Australia and the USA for Institutional Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument In Chile, Panama and Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public. For the distribution of this document, Continental Europe is defined as Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Spain and Sweden. All data provided by Invesco as at 31 December 2016, unless otherwise noted. Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid. Compared to investment grade bonds, junk bonds involve a greater risk of default or price changes due to changes in the issuer s credit quality. Diversification does not guarantee a profit or eliminate the risk of loss. This document is written, unless otherwise stated, by the Invesco Senior Secured Management Team. The opinions expressed herein are based upon current market conditions and are subject to change without notice. This document does not form part of any prospectus. This document contains general information only and does not take into account individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. Opinions and forecasts are subject to change without notice. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Neither Invesco Ltd. nor any of its member companies guarantee the return of capital, distribution of income or the performance of any fund or strategy. Past performance is not a guide to future returns. This document is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. As with all investments, there are associated inherent risks. This document is by way of information only. Asset management services are provided by Invesco in accordance with appropriate local legislation and regulations. 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Dutch Branch, UN Studio Building, Parnassusweg 819, 1082 LZ, Amsterdam, Netherlands. in Singapore by Invesco Asset Management Singapore Ltd, 9 Raffles Place, #18-01 Republic Plaza, Singapore in Spain by Invesco Asset Management SA, Sucursal en España, C/ GOYA, 6-3, Madrid, Spain. in Sweden by Invesco Asset Management SA, Swedish Filial, Stureplan 4c, 4th Floor Stockholm, Sweden. in Switzerland by Invesco Asset Management (Schweiz) AG, Talacker 34, 8001 Zürich, Switzerland. in Taiwan by Invesco Taiwan Limited, 22F, No.1, Songzhi Road, Taipei 11047, Taiwan ( ). Invesco Taiwan Limited is operated and managed independently. in the UK by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire, RG9 1HH, United Kingdom. Authorised and regulated by the Financial Conduct Authority. in the United States of America by Invesco Senior Secured Management, Inc., 1166 Avenue of the Americas, 26th Floor, New York, NY II-BLEUSSL-BRO-1-E 4/17 GL103