Why Now for European Senior Secured Loans? Market Features, Relative Value & Portfolio Inclusion Benefits The syndicated senior secured loan market, which until 2009 was the dominant sub-investment grade asset class in Europe, looks in our opinion, to be set for a resurgence. In this low yield environment, with potentiallys rising rates, we explain the features of the asset class, compare it with other similar asset classes and discuss how investors might benefit from an allocation to European syndicated loans in their portfolios. Features of the European Syndicated Loan Market Floating Rate Returns Loans are a floating rate asset class, typically offering mid to high single digit returns through the cycle, which reset their underlying interest rates on a frequent basis typically every three to six months at the discretion of the borrower. As such, syndicated loans provide investors with protection from rising rates and so tend to enjoy inflows in periods of rising rate expectations. Fund flow data is not available for Europe due to the absence of mutual fund structures. However, looking at flows into US loans in the chart below, it is clear that, in recent times, flows into syndicated loan mutual funds have been closely correlated to rising interest rate expectations. We can expect this relationship to play out in Europe as well when rates start to rise locally. US Loan Flows Vs. 2/10 yr Treasury Yield Differential Diversification and Composition The European syndicated loan market, as measured by the Credit Suisse Western European Leveraged Loan Index (CS WELLI), is 175 billion 11 in size and made up of well-diversified corporate exposures from approximately 285 issuers1. The main source of new issuance is private equity-backed leveraged buyout activity, with future supply likely to be driven by the approximate 325 billion of dry powder that private equity firms have available for deployment. Index issuer sizes range from 100 million up to 4.6 billion1. The European syndicated loan market features a broad spread of industries with, however, little exposure to financial services, energy, and commodity firms. Please see chart on next page. Fluctuations in commodity prices in recent years have therefore not had a significant impact on European syndicated loan credit quality. Country exposures are 1 Credit Suisse Western European Leveraged Loan Index, data as at February 28 th 2017 Page 1
weighted towards the core European jurisdictions 12, with a recent feature being an increase in the number of issuers from North America who have issued Euro denominated tranches alongside their USD denominated loans. Issuers from the USA now comprise 12% 1 of the CS WELLI, the fifth largest geography. Western European Leveraged Loan Index - Sector Breakdown by Market Value Source: Credit Suisse Western European Leverage Loan Index (CS WELLI). Data as at March 31 st, 2017. Investor Base In Europe, loans are predominantly an institutional asset class, as the current Undertakings for Collective Investment in Transferable Securities (UCITS) rules place some restrictions on investing in the European syndicated loan market. This situation is not expected to change in the near future, so the investor base is made up of three main groupings. The first of these is banks. Unlike the US loan market, and contrary to many of the predictions made post crisis, banks are still an important part of the loan market investor base. They are often politically motivated to undertake local lending in their own jurisdictions, and access to ECB initiatives such as the LTRO, come with the quid pro quo of growing their loan books. Secondly, Collaterised Loan Obligations (CLOs) have once again become an important part of the European investor base since the market reopened in 2013. Last year saw 16.8bn of CLO issuance according to S&P LCD, and the predictions from the investment banking community for 2017 are for a modest increase on this number. CLOs can drive demand for loans and tend to be long term, stable holders of the loan assets which they buy. The third grouping is other institutional investors. Usually buying via a specialist manager, investors such as pension funds, insurance companies and family offices take a long term approach to investing in corporates via the loan market. Liquidity European syndicated loans are a well-established asset class, and so benefit from a secondary market which trades an estimated 7-9 billion per quarter. Documentation and trading conventions are standardised by the Loan Market Association. Secondary market activity is seen as a necessary and complementary activity for banks involved in syndicated loan and CLO origination. Banks and brokers act as intermediaries to facilitate the market liquidity that investors require when investing in European syndicated loans. Page 2
Seniority and Security The European syndicated loan market for institutional investors grew out of the bank lending market in the 1980s and 1990s. As such, it has many features which were initially designed for bank lending. Most important among these is the position which loans occupy in the capital structure. As a senior secured first lien lender, loans are the first to get repaid by a borrower. In the event that the borrower defaults, loans enjoy a first lien claim over substantially all of the assets of that borrower. On a global basis, first lien loans have been shown by Moody s to recover 67% 11 in the event of default. Today, senior secured first lien loans make up 98% of the CS WELLI 22 Why Should Investors Consider European Syndicated Loans Now? Returns The European syndicated loan market has been a provider of steady mid-single digit returns through an economic cycle. In today s low yield environment, a return of 4-5%, in our view, looks particularly attractive. Returns are driven primarily by the interest margin which borrowers pay over the base rate. Protection from low rates is provided by the near ubiquitous Euribor floors, which almost all syndicated loans have featured in the post crisis period. The chart below shows how investors are compensated for the risk taken in new issuance. Given the supply demand dynamic as it stands, and the prices at which loans are currently trading in the secondary market, access to the primary market will be critical for returns in 2017 as a way to monetise the new issue premium. Average all-in TLB Spread of European B-rated Loans (bps) Sources: S&P Global Market Intelligence, European Quarterly Review. Data updated on a quarterly basis as at March 31 st, 2017. Volatility and Correlation Most macro strategists expect volatility in financial markets at some stage during 2017. With that in mind, it is worth looking at the performance of European syndicated loans in the context of their volatility and correlation with other credit asset classes. The table below shows that syndicated loans tend to exhibit considerably less return volatility than other asset classes. In fact, for a similar return over the last five years, investors would have had to expect close to double the return volatility. 1 Moody s Annual Default study, published March 31 st, 2017 2 Credit Suisse Western European Leveraged Loan Index, data as at February 28 th 2017 Page 3
Attractive Low Volatility Returns (Annualised) Source: Credit Suisse data as at March 31 st, 2017. Credit Suisse Western European Leveraged Loans Index (CS WELLI), BofA Global indices, Euro High Yield (HE00), European Investment Grade (EN40), German Federal Government 3-5yr Index (G2D0), Euro Stoxx 50 Index (SX5E). Similarly, the correlation to other asset classes is limited. Whilst the table below shows a high correlation to High Yield over a five year period as there is a significant minority of issuers which issue in both markets, the volatility numbers show that despite the correlation, loans tend to fall less far and more slowly than High Yield in periods of volatility. The lower volatility of returns in the syndicated loan market is due to the make-up of the investor base as discussed above. The lack of mutual fund flows differentiate it both from High Yield globally, and US syndicated loans. Syndicated Loans Correlation to Other Asset Classes Source: BofA Merrill Lynch & Bloomberg. BofA BB-B Euro Currency Non-Financial HY Constrained (HP4N), BofA German Federal Government 3-5yr Index (G2D0), BofA European Corporate 3-5yr Index (ER02), Euro Stoxx 50 Index (SX5E). Data as at March 31 st, 2017. Comparison with Other Asset Classes So what are the pros and cons of syndicated loans versus comparable asset classes? We believe that the two closest asset classes are High Yield and Private Debt. High Yield A key difference between the two markets is that high yield bonds are usually fixed rate, while loans are floating rate. Whilst senior secured high yield issuance has become much more common in recent years, the syndicated loan market as a whole contains more first lien debt than the high yield market does, as evidenced by the 98% 11 senior secured makeup of the CS WELLI. High Yield is compensated for this risk, as the five year annualised return of 8.15% in the table above shows, but with higher volatility and lower recoveries through a default cycle as Moody s have shown 2. 2 Private Debt Investments in private debt typically enjoy the senior secured position in the capital structure, as syndicated loans do, and often with better documentary protection. The size of the transactions also means a better headline return and this is delivered on a floating rate basis, as with syndicated loans. What syndicated loans can offer which private debt can t, is liquidity. Private debt investments are typically closed end, while loan funds usually offer liquidity to investors. 1 Credit Suisse Western European Leveraged Loan Index, all denominations, March 31 st, 2017 2 Moody s Annual Default study, published February 15 th 2017 Page 4
Fundamentals The fundamental outlook for European syndicated loans is relatively benign. As mentioned previously, the composition of the market means that the volatility related to commodity-related borrowers, which have impacted other similar asset classes, has been largely avoided in the European syndicated loan space. Leverage levels are close to their long term average (as assessed by S&P LCD) and interest coverage ratios have improved significantly post crisis. Clearly rising rates could be seen as a headwind for the weaker borrowers, but rising rates in Europe should come with an improving macro picture, so Moody s- expects baseline default rates for the entire European speculative grade corporate universe to be in the 2% area for the next year as shown in the chart below. Defaults in loans will be mitigated by likely strong recovery rates. Sub Investment Grade Default Trends and Forecasts Source: Moody s Investors Service. Default and Recovery Rates of European Financial and Non- Financial Corporate Issuers. Europe Trailing 12-Month Issuer Weighted Spec-Grade Default Rate Forecast and Global Trailing 12-Month Issuer-Weighted Spec-Grade Default Rate Forecast. Data as at March 31 st, 2017. Supply / M&A Outlook We expect the European syndicated loan market to see significant new issuance in the coming months and years, both from refinancings and M&A. The chart below shows the reasons for which new issuance has taken place over the course of the last cycle. In the post crisis years, from 2010 onwards, M&A related issuance has made up between 40% and 60% of total new issuance, adding diversity to the market. This is likely to be driven going forwards by the (already mentioned) 325 billion of dry powder which private equity firms currently have at their disposal. New Issuance Deal Purpose (%) Source: S&P Global Market Intelligence. European Quarterly Review. Data as at March 31 st, 2017. Page 5
Complementing M&A will be refinancing activity generated both from existing loan issuers and issuers from the High Yield market. In the post crisis period, many loan issuers moved to the bond market where they could take advantage of low rates to term out their liabilities. As rates rise we can expect to see (and indeed are already seeing) some borrowers move the other way, drawn by the additional flexibility which the syndicated loan product offers. Conclusion In a time of low yields, and with investors expecting volatility to rise, we believe that the European syndicated loan market can be a source of relatively stable income, with floating rate returns expected to be in the mid to high single digits through the cycle. With growing European economies and abundant dry powder in the hands of private equity investors, we expect the European syndicated loan market to grow in the coming years and become an increasingly important diversifier in the portfolios of investors searching for duration neutral income. Page 6
FOR PROFESSIONAL CLIENTS USE ONLY NOT FOR RETAIL USE OR DISTRIBUTION. This document has been produced for information purposes only and as such the views contained herein are not to be taken as advice or recommendation to buy or sell any investment or interest thereto and the material should not be relied upon as containing sufficient information to support an investment decision. Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and are subject to change without notice. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only. The prices of fixed income instruments fluctuate in response to perceptions of the issuer s creditworthiness and also tend to vary inversely with market interest rates. The value of such instruments is likely to decline in times of rising interest rates. Conversely, when rates fall, the value of these investments is likely to rise. Typically, the longer the time to maturity the greater are such variations. A Fund investing in fixed income instruments will be subject to credit risk (i.e. the risk that an issuer of instruments will be unable or unwilling to pay principal and interest when due, or that the value of an instrument will suffer because investors believe the issuer is less able or willing to pay) The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future. Issued in Europe by Muzinich & Co. Ltd, which is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ. 2017-03-03-0848 Page 7
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