February 2019 European loan market – review and outlook · February 2019 European loan market –...

February 2019

European loan market – review and outlookFor Investment Professionals only

• European loans found relative favour with investors as 2018 marked a return to volatility for global markets. European loan returns were modestly positive, thanks to pricing stability and high running coupon income, unlike other risk assets

• Loan issuance was close to €100 billion in gross terms, leading to an expansion of the market, driven by an increase in LBO and acquisition financing with refinancing only accounting for a fifth of overall supply after a bumper 2017

• The widening in loans spreads, while less dramatic than for comparable public bonds, means they are near double their pre-crisis lows

• Ongoing diversification by geography of the institutional investor base should help to underpin demand for European loans in 2019

• Uncertainty could crimp overall M&A but could just as easily create opportunities for private equity, that has the dry powder even to take private some more listed companies, caught in the market crossfire

• While leverage levels may remain static, further attempts to dilute documentary protections need resisting – easier in volatile markets – and will make credit selection ever more vital for lenders

• Markets face 2019 with a number of global headwinds, though credit conditions remain benign and default levels low, meaning market volatility and the withdrawal of central bank support may conspire to reduce liquidity at times

• Loan markets have been the subject of a string of negative press and regulatory headlines over recent months, but fundamentals continue to support the asset class; that said, loan prices will likely be more sensitive to corporate announcements and earnings reports from here.

Past performance is not a guide to future performance.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested.

Overview

European loan market – review and outlook2

Contents

Summary 4

Review of 2018 6

Expectations for 2019 10

Risks 13

3

European loans delivered a year-on-year total return of 0.6% in euro terms (1.7% in sterling; 3.4% in US dollars) in 2018.1 It was a subdued year in absolute terms but, by producing a positive performance, 2018 was a standout year for European loans among a landscape of risk assets that were broadly and comprehensively negative.

European loan market was a rare positive performer in global markets in 2018

Source: Deutsche Bank Research, Credit Suisse, M&G, January 2019. Hedged to US dollar for comparison purposes

When comparing the performance of European loans to the most directly equivalent sub-investment-grade markets, in euros, the superior performance that resulted from relatively greater stability of issuer and investor base is apparent.

European loan performance surpassed comparable credit in 2018

Selected asset classes Hedged to EUR

European Loans 0.55%

US Loans -1.63%

European HY -3.44%

US HY -5.00%

European IG -1.11%

US IG -3.26%

Source: Credit Suisse, ICE BofAML, as at 31 December 2018

In complete contrast to 2017, when an eerie calm descended on markets, 2018 saw a return to volatility, meaning that the key defensive features of loans – that make them valuable in a portfolio context – were once again recognised by institutional fixed income investors.

Any adverse market price movement in the European loan market observed through the year, particularly in the final quarter, was largely in sympathy with other markets rather than being a sign of inherent, fundamental credit stress. This is true despite the global economic cycle being at a very late stage. Indeed, the market’s default rate reached a low of 0.11% by year end.2 The net impact of these price movements on loan performance – particularly evident in the wider market in the final quarter – was also suppressed by high running income which helped to prop up the loan asset class.

Despite a choppier backdrop, it was another active year for Mergers & Acquisitions (M&A) activity and thus for loan issuance, given the dependency on corporate deal-making. While the headline volume for the year was lower than 2017 (€96 billion versus €120 billion), net issuance, once refinancing activity was stripped out, was higher (€77 billion versus €67 billion).

2018 also saw far lower prepayments than 2017 given the super-normal refinancing activity that had taken place. Consequently, the loan market – as measured by its two main indices – grew by some 25% in the year.

Supply was met with strong demand – not least from the CLO community where €27 billion of new vehicles was raised in the year. There were signs of the financing costs of CLO liabilities increasing as the year progressed. This, coupled with sizeable issuance, saw an improvement in pricing terms for loans too, with new-issue margins rising by some 35 bps – back to the lower end of their traditional, post-crisis range of 350-450 bps, having fallen below the lower limit at the end of 2017 in response to the high refinancing activity.

10%

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Euro

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Summary

1 Source: Credit Suisse2 Source: S&P Capital IQ LCDData source is S&P LCD unless otherwise stated


European primary loans: new issue margins and yields (in euro terms)

Source: S&P Capital IQ LCD, rolling three-month new-issue margin and yield (including floor, original issue discount) to 31 December 2018

Overall loan market returns were adversely affected by the sell-off in the final three months of the year, resulting in a negative quarter – a relatively rare occurrence for European loans.

European loan market returns over the last 12 months

Source: M&G, Credit Suisse Western European Leveraged Loan Index (hedged to euros), as at 31 December 2018

Past performance is not a guide to future performance

In our view, the loan market is not one to time nor to assess over a single calendar year but rather over a cycle. The superior risk-reward profile of European loans, for instance, can still be seen over a five-year period.

European leveraged loans: risk-reward profile over five years (in euro terms)

Source: Bloomberg, ICE BofAML, Credit Suisse, as at 31 December 2018

Loan spreads in the secondary market are near double their pre-crisis lows. The widening was particularly pronounced in the last quarter of 2018 but was less dramatic than that of high yield bonds that had been more exposed to European Central Bank (ECB) policy intervention.

Discount margins ended the year at 445 bps, some 60 bps higher than the start of the year.

European leveraged loan and European high yield bond swap spreads

Source: Bloomberg, ICE BofAML, Credit Suisse, as at 31 December 2018

Since the global financial crisis, our view has been that unlevered, European loan funds should generate returns of Libor+4% per annum over the medium term; ie three to five years. This may not have been achieved in the last two years, owing to adverse secondary price movement, but, with spreads where they are at the start of 2019, we think this looks like a reasonable prospect for the year ahead.

bps

700

600

500

400

300

200

100

0

%

7

6

5

4

3

2

1

0

Margin (LHS) Primary yield (RHS)

12.1801.15 07.15 01.16 07.16 01.17 07.17 01.18 07.18

%

1.0

-1.5

-1.0

0.0

-0.5

0.5

02.18 03.18 04.18 05.18 06.18 07.18 08.18 12.1801.18 09.18 10.18 11.18

Q1 0.90% Q2 0.00% Q3 1.45% Q4 -1.78%

Retu

rns (

hedg

ed to

eur

os) %

1 2 3 4

Volatility %

0 5 6 7

4.0European HY,3.68%

European loans,3.07%

US loans,1.93%

US HY,2.35%

3.5

1.5

2.5

2.0

3.0

Spre

ad p

rem

ium

(bps

)

08.05 08.07 08.09 08.11 08.13 08.15 08.17 31.18

1600

1000

1300

100

400

700

Merrill Lynch non-financial constrained high yield asset swap

Credit Suisse Europe leveraged loan 4-year discount margin

Sharpe ratio

European loans US loans European HY US HY

5 years 1.68 0.37 1.27 0.49

5

Loan supplyThis time last year, we estimated that gross issuance volume would reach €100 billion in 2018. Our assumption proved correct, with a total of €95.9 billion3 in new loans being raised during the year.

Annual European leveraged loan new issuance

Source: S&P Capital IQ LCD, as at 31 December 2018

Refinancing activity was far lower as a percentage of gross issuance in 2018 than the year before too, accounting for 20% of activity versus 44% in 2017, with prepayments even falling below their 25% long-term norm. Consequently, the loan market expanded in 2018.

S&P European Leveraged Loan Index (‘ELLI’) size and number of issuers


It was another bumper year for global M&A activity, both in value and volume terms, with the US making up the bulk of activity thanks to the wave of ‘megadeals’, particularly in the media and telecoms sectors.

Global M&A annual volumes and number of transactions 2004-2018

Source: Bloomberg, as at 31 December 2018

The value of M&A deals reached $3.9 trillion by year end, eclipsing total values recorded in the preceding two years albeit not enough to top 2015’s post-crisis record. This filters through to private equity activity where it was also another active year for corporate deal-making. New buyouts and acquisition financing represented over 70% of total issuance in 2018. Recapitalisations – when sponsors take out debt-funded dividends from performing portfolio companies – remained low and moderated slightly versus 2017.

Use of proceeds


€ bi

llion

14 15 16 1706 07 08 1109 10 12 13

European leveraged loan new-issue volume

05 18

180

100

0

20

60

40

80

160

140

120

Review of 2018 €

billi

on

200

ELLI outstandings (LHS) Number of issuers (RHS)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

100

020

6040

80

160180

140120

300

200

100120

160140

180

260280

240220

3 & 4 Source: S&P Capital IQ LCD

50000

Value (USD billion, RHS)Deal count (LHS)

0

10000

20000

40000

30000

5000

0

1000

2000

4000

3000

14 15 16 1706 07 08 1109 10 12 1304 05 18

Recapitalisation Acquisition/LBO Refinancing

Perc

enta

ge o

f tot

al

08 1600 0402 06 12 141098 18

100

60

0

20

40

80


Loan demandAlthough there is currently no independent or verified measure of institutional flows into the European loan market, anecdotal and empirical evidence continues to support the theory that new demand from global pension funds and insurance companies for European loans – whether in fund or separately-managed-account form – was notable. It is estimated that the CLO share of the market is c. 40%, meaning that the remaining institutional share must be c. 35%, consisting of loan funds, separately managed accounts and some institutional multi-asset credit funds. This is a much more balanced composition than the US loan market, where CLOs continue to have a dominant role (c. 65% share), with daily-dealing retail funds making up most of the difference. The presence of retail investors has created a technical headwind for the US loans market too, with flows having been hit by changing interest rate expectations and unwelcome attention from regulators. Furthermore, with sizeable hedging costs from US dollar-denominated assets being a constant feature of 2018, a number of Asian investors reportedly diversified their loan allocation into Europe, and in size, further expanding the geographical spread of the investor base.

Having steadily reduced their share for years after the crisis, the amount of the market held by banks stabilised in 2018 and accounted for c. 25% of the year’s issuance:

Investor demand for primary loan issuance


CLO primary market volume in 2018 expanded, as we anticipated, but to a more significant degree, issuance being up some 30% on 2017 at €27 billion from 66 vehicles.4 The market continued to be underpinned by a small number of AAA-note buyers, but their pricing demands increased throughout the year – rising over 20 bps – creating upward pressure on loan margins to force the inherent arbitrage to work.

European AAA CLO pricing


European CLO issuance per annum


By year end, it was estimated that the average CLO needed a running margin of c. 400 bps to satisfy return demands of equity investors.

Total repayments halved in 2018 versus an extraordinary prior year. While significant volumes were seen in February, and again during the summer months, they tapered in the final quarter as market volatility led to some sponsor exits being put temporarily on hold or cancelled altogether.

European loan repayments per month


%

2014 2015 2016 201720112010 2012 2013 2018

100

60

0

20

40

80

Banks Institutional investors

Q416 Q217Q117 Q417Q317 Q218Q118 Q418Q318Q316

E+130

E+120

E+110

E+100

E+90

E+80

E+70

Basis

poi

nts o

ver E

urib

or€

billi

on

14 15 16 1706 07 08 1109 10 12 13

European CLO new-issue volume

05 18

40

25

0

5

15

10

20

35

30€

billi

on

5

2

0

1

4

3

02.18 03.18 04.18 05.18 06.18 07.18 08.18 09.18 10.18 11.1801.18 12.18

7

Loan pricingWe expected primary loan pricing to readjust lower in 2018, to a 300-400 bps range, given that it had fallen below 350 bps by year-end 2017, thanks to a high period of refinancing. However, with all the M&A-driven new issuance and the wider market volatility plus a rise in AAA financing costs, new-issue spreads rose – some 35 bps – to end the year at c. 380 bps, firmly back within the historical 350-450 bps pricing band.

European primary loans: new-issue margins


Furthermore, there was greater pushback from lenders than had been seen in recent times and a more balanced negotiation around terms between lenders, issuers and sponsors. This compared to a year earlier where issuers and sponsors were more able to dictate their own terms.

Incidence of a change to initial terms


The secondary market experienced a consequent widening. The four-year discount margin rose by c. 60bps – to 445 bps – over the course of the year. This is over 200 bps wider than the pre-crisis spread lows. Even with swap rates at their lows over a protracted period, this still results in a market that is projecting a yield to maturity, in euro terms, of c. 4.5%.

European loans yield and spread to swaps

Source: Bloomberg, Credit Suisse, as at 31 December 2018

In terms of relative value, the sell-off in high yield bonds at the end of the year brought that (largely unsecured) market into line with secured European loans.

European loan and high yield bond spreads

Source: Credit Suisse, Bloomberg (Merrill Lynch European HPIC high yield index asset swap spread), as at 31 December 2018

When viewed in terms of fundamental value, comparing the default-adjusted spreads of the two markets (which are based on stressing both asset classes for the average and worst defaults of the last decade), the superior risk-return case for loans remains compelling. This is down to higher recoveries as a result of the superior downside protection of loans:

Default-adjusted European loan and bond spreads

Source: Credit Suisse, Bloomberg (Merrill Lynch European HPIC high yield index asset swap spread), Moody’s Global Database, as at 31 December 2018

bps

525

350

275300325

375

450

400425

500475

Post-crisis pricing range

Q416 Q417Q414 Q415 Q418Q413

Num

ber o

f dea

ls

14 15 16 1706 07 08 1109 10 12 1304 05 18

150

125

0

25

75

50

100

Flexed up Flexed down

6 4 5

33

4 2 17 4 9

30 2519

30

48

14

48

109

131

0 07

14 13

3643

52

74

133

75

%

12.99 12.03 12.07 12.11 12.15 12.18

19

11

-11

53

7

17

1315


4-year Euribor swap

229 bps

445 bps

Spre

ad p

rem

ium

(bps

)

12.17 02.18 04.18 06.18 08.18 10.18 12.18

500

300

400

200

Merrill Lynch non-financial constrained high yield asset swap


European high yield bond

spread: 443 bps

European loans spread: 445 bps

%

5.0

-4.0-3.0

0.0

-2.0-1.0

1.02.0

4.03.0

Loans

4.45% 4.43%

3.28%

1.29%1.97%

-2.84%

High yield bondsCredit premium Adjusted for average defaults Adjusted for worst defaults


Structures: leverage and covenantsStructures suffered again in 2018, with ongoing dilution of investor documentary protection albeit not universally and not without some periods of pushback – particularly late in the year. In addition to the grinding up to 80% conversion from maintenance to incurrence covenants, other important protections were loosened. The ability to base financial tests on ‘adjusted proforma’ – rather than just ‘adjusted’ – EBITDA became commonplace in 2018, with issuers borrowing forward from future synergies and earnings-expansion measures (not yet taken) to boost their starting EBITDA. Such claims require lenders to feel fully confident that they are credible and achievable within a reasonable time frame.

However, one important tenet was largely preserved – the right to prepayment upon change of control. The concept of ‘portability’ of a loan, following a company’s transition from one sponsor to another did not make meaningful headway in the loan market, in contrast to the high yield bond market where this unwelcome feature is seen often.

The reduced role of the banks over recent years and the tolerance of incurrence covenant-only loans by institutional investors meant that the percentage of covenant-lite (cov-lite) loan issuance rose still further in 2018. Maintenance covenants remain typical only in ‘small’ loans (sub €250 million) but, even in this part of the market, they have been loosened to detrimental effect.

Covenanted loans and covenant-lite loans as a percentage of total new issuance


Loan markets were the subject of a string of negative press and regulatory headlines, particularly in the final few months of the year. Despite this commentary containing, at times, some misperceptions around the current leverage loan market, the fundamental picture remains supportive.

In terms of indebtedness, first lien leverage rose marginally to 4.7x (4.6x in 2017), narrowly above 2007 levels, though mitigated by far higher average equity contributions (52% versus 33% pre-crisis) from sponsors.

Total debt multiples remained static in 2018, at 5.1x. In this context, public commentary by the US Federal Reserve (Fed), the ECB and the Bank of England – that would indicate their careful attention to the state of leverage in the corporate loan world – is helpful.

Equity valuations of leveraged buyouts rose too, ending the year over 10x on average.

Average equity contributions to buyouts, purchase price multiples and new-issue leverage


100%

80%

60%

40%

20%

0%07 08 09 10 11 12 13 14 15 16 17 18

With covenants Covenant-lite

60%

50%

40%

30%

20%

10%

0%07 08 09 10 11 12 13 14 15 16 17 18

12x

10x

8x

6x

4x

2x

0x04 05 06

Equity (LHS)First lien leverage (RHS)

Total leverage (RHS)EV/EBITDA (RHS)

9

While credit conditions may remain benign, market volatility and the withdrawal of central bank support may conspire to reduce liquidity in global markets in 2019. This in turn may make risk asset prices precarious and hard to navigate. Nevertheless, high running coupons – and trading opportunities – bode well for a year of higher returns from the European loan market.

Secondary market opportunityThe return of wider market volatility, married with a population of loans that is largely cov-lite, should mean that secondary market prices will be more reactive than they have been historically while overall moves should remain more muted in comparison to whipsawing bonds. The diversity of the institutional investor base further supports the development of a true two-way market. Therefore, as we start the year with the vast majority of outstanding loans being priced below par, we suggest that there are ways to supplement returns from more assertive trading in the secondary market.

Percentage of loans trading above par


DemandCredit opportunity funds may well start to move away from loans in 2019 in search of opportunities in other parts of the bond markets, arising from the withdrawal of central bank support.

By contrast, we expect other institutional capital still to enter the asset class – not least from global pension funds looking to increase their allocations to European loans. Prohibitively high FX swap costs from USD to certain currencies also underpin a favourable assessment of euro-denominated assets.

After the highest year of CLO issuance seen since the global financial crisis, we do not expect the pace of new structured vehicles to continue in 2019. This is owing to the relatively concentrated buying-base behind the largest part of the capital stack, the AAA notes. There was also some front-loading of CLO issuance ahead of the new EU Securitisation Regulation that came into force in January 2019. Indeed, European CLO issuance may stall in the first part of the year as CLO managers get comfortable with the onerous demands of the new ‘Simple, Transparent and Standardised’ (STS) regime in Europe which confers a responsibility for evidencing detailed due diligence upon them and other reporting.

SupplyUncertainty, in its many guises, looks set to prevail in 2019. While this may create opportunities for M&A activity, favouring private equity sponsors with the dry powder to take private any beaten-up listed companies, it could conversely suppress corporate deal-making too. Growing fears about a fall in Chinese economic growth, an extended US-China trade war and a hardening stance against Russia plus the antagonistic state of political affairs in the US administration – to say nothing of European political unrest arising from Brexit, Gilets jaunes or Italian indebtedness – are some of the identifiable sources of risk as the year begins. Such storm clouds and potential for extreme volatility undermine business confidence and investment decisions. Corporate deal-underwriting also becomes a precarious business for banks.

Expectations for 2019

80%

70%

60%

50%

40%

30%

20%

10%

0%02.18 03.18 04.18 05.18 06.18 07.18 08.18 09.18 10.18 11.1801.18 12.18


1 Credit Suisse, ‘CS Credit Strategy Daily Comment’, 28 January 2019

The growing role of activist shareholders is worth highlighting too, whether forcing management to spin-off a division of a company or whether demanding other asset disposals. This can be a source of opportunity for private equity.

In this context, it is a fool’s errand to be too definitive about issuance for 2019. We expect the loan market to retain its popularity with sponsors at the expense of high yield bonds in the year ahead. Nevertheless, we cautiously anticipate a year of only modest expansion and gross supply coming in around €100 billion.

Primary loan pricingWith more uncertainty in the world and given the late-stage in the cycle, we think that the price of credit may well rise, as we started to see in late 2018. Thus, we expect new-issue pricing to hold steady in a +375-475 bps over Libor range in 2019 with scope to widen, should the market hit air pockets of macro and wider market unrest.

Secondary loan pricingThe widening of loan discount margins, resulting from the wider sell-off at the end of 2018 has not yet brought loan spreads into line with what would be consistent with the late cycle or indeed recessionary levels.

There is also the ballooning population of BBB corporates to consider. Over half of the world’s investment-grade corporates are now in the BBB category with a quarter of a trillion dollars’ worth of single A bonds having migrated to BBB in 2018 alone. When conflated with a paring back of quantitative easing programmes, it supports the theory that BBB spreads can only widen from here. Then, there is adverse rating migration to consider. The weakest of the BBB universe, the BBB- population, is nearly as big (70%) as the whole of the high yield corporate universe. With upgrade-to-downgrade ratios becoming more biased to the negative, this suggests that there is room for high yield also to widen, thanks to inherited supply. Could loans manage to remain unaffected in the face of such widening? Despite the dedicated locked-up capital that is CLO funds, it would seem unlikely.

Overall BBB (first graph) and BBB-(second graph) bonds as a percentage of high yield universe for US dollar and euro-denominated non-financial credit

Source: Deutsche Bank, Bloomberg, ICE BofAML, as at 31 December 2018

Structure: leverage and covenantsWhile leverage levels may be expected to remain capped by the leveraged lending guidelines set by the ECB and US Regulatory authorities, respectively, we anticipate that covenants will continue to be eroded in both the US and Europe in periods of under-supply albeit that lenders may be expected to push back when issuance is sizeable. In addition, our view is that other protections for lenders (such as limits on add-backs, restricted distributions et al) may see further dilution, making credit selection and due diligence on prospective issuers and sponsors ever more vital for lenders.

14 1600 02 04 1006 08 1296 98 18

USD EUR

%

350

300

0

150

100

50

200

250

14 1600 02 04 1006 08 1296 98 18

70

60

0

20

10

30

50

USD EUR

%

11

DefaultsDefault rates fell in 2018 and are far below the historical average default rate for the market. We expect defaults to be subdued in 2019 and remain far below their historical norm but for the rate to rise closer to 1%. Moody’s, the rating agency, expects default rates in the European loan market to continue to be low, while Credit Suisse expects default rates in Europe to remain below those of the US market, with a 2019 default forecast of 1.0% for European loans and 2.0% for US loans.5

European loan market default outlook


While acknowledging the inherent sectoral risk in the market that is Retail (see next section), the level of stress as a predictor of future defaults – as evidenced by the small, CCC-rated proportion of the index – remains at an all-time low.

European index stressed (CCC+ rated) percentage


Rating agency S&P observes a consistently high recovery rate for European first lien debt, which averages 73%, but are of the overall view that recovery rates could be somewhat lower in the next default cycle on average which makes discernment and bottom-up stock picking all important.

The case for low default rates for the foreseeable future though is supported by liquidity. Interest coverage ratios remain comfortably high, compared to pre-crisis levels. There is also a lack of refinancing pressure, particularly after the huge wave of refinancing activity in 2017 and the volume of brand-new LBO issuance in 2018. This should stave-off default pressure in the near term:

European loan market maturity profile 2019-2027


12%11%10%

9%8%7%6%5%4%3%2%1%0%

09.09 09.10 09.11 09.12 09.13 09.11 09.15 09.16 09.17 09.1809.08

Average default rate 3.63%

S&P ELLI default rate

12%11%10%

9%8%7%6%5%4%3%2%1%0%

12.09 12.10 12.11 12.12 12.13 12.11 12.15 12.16 12.17 12.18

5 Credit Suisse, ‘CS Credit Strategy Daily Comment’, 28 January 2019

€ bi

llion

27

70

60

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23 24 25 262220 2119


Adverse credit migrationBuilding a loan portfolio is largely a ‘bottom-up’ activity, meaning that the investor is analysing each investment on an individual basis. The systemic problems in bricks-and-mortar retailers, however, may pressurise that part of the market in 2019 as was seen in the high yield bond market in 2018. Retail accounts for c. 6% of the market6 so European loans have relatively little exposure to its troubles but it remains a tricky sector for investment given historical sector default and recovery rates.

Furthermore, while default rates are low and while the CCC portion of the market is also extremely modest, we note that the net ratings (upgrade to downgrade) ratio deteriorated in 2018 – a trend that may have further room to run. European loans, however, have a much lower percentage of lower quality (credit rating of B3 or lower) deals than the US (7% versus 20% in the US).4

Net ratings ratio: upgrades to downgrades

Period UP DOWN Ratio Up percentDown

percent

2007 59 -102 1.73 11.2% -19.3%

2008 126 -137 1.09 22.9% -24.9%

2009 61 -272 4.46 10.4% -46.3%

2010 125 -100 0.80 20.4% -16.3%

2011 99 -100 1.00 16.7% -16.9%

2012 108 -113 1.00 21.8% -22.8%

2013 58 -73 1.30 12.2% -15.3%

2014 47 -44 0.94 11.1% -10.4%

2015 43 -37 1.16 15.4% -13.3%

2016 22 -43 0.51 8.5% -16.5%

2017 11 -22 0.50 3.9% -7.9%

2018 3 -28 0.11 1.1% -10.1%


GeopoliticsRising socio-economic tension, inflamed by the number of unpredictable and unconventional world leaders in situ, is likely to persist in 2019 and has the potential to create greater upheaval if the tides of easy liquidity are ebbing. Trade disruption between the US and a variety of countries, including China, could continue. ‘Value the bid’ is the investing mantra at such times and investors should ensure that their liquidity position is strong to withstand the changing nature of market liquidity, while being able opportunistically to be active in moments of dislocation and value.

The UK’s trade relations with the EU are likely to remain unclear for a considerable period, putting pressure on its economy. The uncertainty may crimp deal activity in the UK in 2019. Then again, it may also offer up some attractive acquisition opportunities in public-to-private terms for private equity sponsors. Sterling loans are likely to continue to attract a 50-100 bps premium compared to non-UK loans.

Supply – demand balanceSupply is dependent on a healthy M&A backdrop, which is itself vulnerable to geopolitical upheaval. Unlike two years ago, we do not foresee a year when supply could be constrained but demand remain resilient and unaffected, causing loan margins materially to contract. Now that wider market volatility has risen, demand and supply may be susceptible to the same market forces and uncertainty. That said, they may not move equally, creating moments of relative disadvantage or opportunity. Furthermore, we have specific cause for unease when the world’s buying-base for CLOs is heavily centred around the appetite of a small number of AAA investors who control the terms. This makes 30-40% of the European loans’ investor base vulnerable to unsystematic risk, in our view.

Risks

6 S&P European Leveraged Loan Index (ELLI)

13

Contrary to our base-line expectation, should 2019 prove to be a year less conducive to deal-making, we think that there will be a reduction in sponsor exits and thus prepayments too. Furthermore, in these conditions, the secondary market is likely to sell off, creating investment opportunities. Those loan managers with appropriately structured funds (closed-ended or open-ended with sufficient redemption protections) should be best-placed to benefit.

Sentiment-driven price movementIncreased commentary on the loan market by regulators and other heavy-weight commentators may influence sentiment. With near 80% of the market being cov-lite, the price volatility of individual loans is now higher than it has been historically. Moreover, any gap between actual earnings and the heavily-adjusted proforma earnings upon which new issuance will have been modelled is expected to undermine investor confidence quickly. In short, loans will likely be more sensitive to corporate announcements and earnings reports from here.

While the diversification and heterogenous nature of many LBO credits is a defensive feature, it is telling that the portion of the market accounted for by technology companies has risen in European loans like everywhere else. Now accounting for over 10% of the S&P 500 Index, the sensitivity to headline risk in a sector that is likely to dictate the mood of equity and bond investors may inflame price movement even in the senior-secured loan world.

Secondary liquidityThe European loan market has been reasonably liquid since the investor base began to diversify fifteen years ago. It has always been an agency-based market though, never relying excessively on the market-making of the banks, so its liquidity was not unduly affected by the post-crisis regulatory changes that suppressed bond market-making. Thanks to the ongoing maturity of the investor base, now including plenty of non-CLO, long-term institutional capital, the liquidity situation has arguably improved. Volumes traded in 2018 exceeded those of a year earlier – a trend that we expect to persist – and, with a diverse investor base, comes a true two-way market.

Annual European secondary trading volume

Source: Refinitiv, as at 31 December 2018

That said, liquidity in any market can be capricious in difficult times and the long lead-time for settlement of European loans (c. T+30-40 days) needs to be factored in. For this reason, we think that European loans do not sit well in a daily-dealing fund without protections from large redemptions (eg notice periods, gating mechanisms, liquidity lines).

The bid-ask spread of loans remained within the range of its recent history during 2018 but the fourth quarter sell-off nudged the differential wider albeit within its normal range. This has the potential to reoccur in 2019 in moments of volatility.

European liquid loans: bid-ask spread


Sale

s (€

billi

on)

14 15 16 1713 18

175

150

125

100

75

50

25

0

08 09 10 1107 1205 0604

bps

2014 2015 2016 20172013 2018

140

120

100

80

60

40

20

0


ESGThere is now greater awareness of Environmental, Social and Governance (ESG) matters in credit markets, fanned by the preponderance of well-publicised company failures and scandals pertaining to accounting mis-statement or poor disclosure.

This topic is especially important in the European loan market, where companies are typically unlisted and may issue no listed debt securities either. Therefore, trends seen in the public markets to reduce investor disclosure and frequency of reporting should be resisted by lenders. While many investors are choosing to invest and trade loans from the public side to minimise the need for specialist resources, we think that the greater information flow that comes from being private-side is a significant advantage. It is also important in fulfilling one of the UN’s principles: active engagement.

RegulationUS CLOs may have been excluded from the remit of the Dodd-Frank Act, thanks to a successful lawsuit, in 2018, thereby removing the need for a 5% risk-retention stake in all vehicles to be held by managers. This check remains in force in Europe, however, and may prove to preserve greater credit standards. Furthermore, the European CLO market now falls under the aegis of the STS regulation of the EU.

End of LiborRegulators are working on the transition of loans from Libor as base fixing-rate to a new risk-free rate across sterling, dollars, euros, yen and swiss francs. While this is expected to create some uncertainty and require a huge administrative undertaking, it is unlikely to be a feature of 2019. That said, there may be a growing concern about the mismatch between the assets and liabilities within CLOs if the market for note issuance and loans diverge from a common fixing-rate, as is possible.

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Contact

Fixed Income

Andrew Swan +44 (0)20 7548 2375 [email protected]

John Atkin +44 (0)20 7548 3466 [email protected]

Henry Barstow +44 (0)20 7548 3469 [email protected]

Sunita Dey +44 (0)20 7548 3393 [email protected]

www.mandg.co.uk/institutions

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February 2019 European loan market – review and outlook · February 2019 European loan market –...

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