The European loan market has started 2015 in good shape, with €8.15bn of issuance in the first month and a strong pipeline which is expected to continue to deliver a steady flow of new issue in the coming months. Returns have also been strong with the Standard & Poor’s European Leveraged Loan Index delivering 1.14% for January. After removing the effects of currency the return is 0.67%.
The strong new issue market has continued into 2015. The €78bn of issuance in 2014 was notable not simply for being the largest annual issuance number post the financial crisis but also for being evenly spread throughout the year. An ability to print steadily and without regard to volatility has been a traditional strength of loans as an asset class, both for borrowers and lenders. This current stability of flow has been caused by a return to M&A activity by the private equity community which drives 75% of the European sub-investment grade loan new issuance market. The circled area of the chart below shows the recent upswing in M&A activity as a percentage of deal count and the commensurate decline in the share taken up by refinancings.
The added diversity that the M&A upswing brings will be beneficial for loan investors who in recent years have seen the pool of loan market issuers shrink as borrowers have moved to the bond market. A particular beneficiary of the increased diversity will be the CLO market which registered €15bn of volume in 2014 and is expected to grow again with issuance in the €15-25bn range for 2015. The European CLO market made a slower post crisis start than in the US due to regulatory uncertainty which made issuance impossible until 2013. Now, with most of the regulatory questions answered, the stage is set for a resurgence in an investor base which made up 40% of the pre-crisis loan market.
So what features can we expect to see in 2015 in the loan market?
Firstly, we expect pricing and structuring trends to reflect the better balance between supply and demand described above. The loan market has added some flexibility to the structures on offer to borrowers, particularly as regards an increase in covenant-lite issuance. The continued presence of banks in the European loan market however, means that covenants will remain a key market feature. A senior secured lender can benefit from covenants on a revolving credit in the structure which is held by the borrower’s relationship banks. At 25%, the proportion of covenant lite in the European loan market is still less than the 60% in the US.
On the pricing front we are currently seeing primary yields in excess of 5% on most transactions, though there is some differentiation. In particular, the current trend is for the large transactions to be extensively chased by a varied investor base. This means that medium sized transactions, whilst still maintaining enough secondary market liquidity, can provide good opportunities for managers prepared to focus on them.
Secondly, we expect the impact of the drop in energy prices to be a positive fundamental driver rather than a negative one for the European loan market. The proportion of oil and gas related exposure in the European loan market is negligible compared to US exposure of 4.5%. For all those companies without direct exposure to energy exploitation, the drop in input prices and increase in customer activity should be a boon. There are also likely to be one or two interesting secondary market opportunities arising from the volatility in the oil and gas sector.
Thirdly, we expect the loan secondary market to become increasingly active as the year goes on. The traditional January rally was delayed by a week due to the wider market volatility but CLO issuance and the warehouses required to feed them, as well as a varied new issue pipeline, will drive strong activity. Although loan prices did not immediately leap higher on the announcement of QE, the search for yield is likely to drive more investors towards the loan market and have a tightening effect on CLO liabilities.
Our baseline projection for 2015 loan market returns is for indices to deliver in the 4-6% range. This takes into account current yields, pull to par, defaults and strong recoveries by virtue of the senior secured position in the capital structure.
An actively managed portfolio should be able to deliver more than this, though credit selection – as was so forcefully apparent in 2014 – will be key.
