European leveraged loans:
An allowance that’s here to stay
We believe that the European leveraged loan market is one of the most interesting but underestimated asset classes in the global credit sphere. Over the past two decades, the asset class has evolved into a distinct set of opportunities, while building a track record that stands apart from competing asset classes. For example, European leveraged loans have generated a higher rolling five-year average Sharpe ratio over the past ten years compared to US loans, US and European high yield bonds, emerging market companies as well as than to US and European equities.1. Additionally, the asset class has produced 10 consecutive calendar years of positive total returns, delivering 4.6% on an annualized basis.2. We believe this leading risk-adjusted performance is positioned to continue given the current market environment. The asset class consistently offers one of the highest yields in public credit markets, while an exclusively institutional investor base should support a stable return profile given their longer investment horizon term as well as the pricing power of CLO investors.
The credit performance of European leveraged loans was a notable driver of the attractive risk-adjusted return profile. The asset class has experienced lower average defaults and higher recovery rates compared to other segments of leveraged credit markets3. In addition, the rate of improvement for these measures was also higher3. This could be attributed to the underlying borrower base which increasingly consists of larger and more mature companies in addition to permanent private equity sponsors. The structural and compositional characteristics of the asset class also helped credit performance. For example, the asset class is almost entirely categorized as first lien, while the opportunity set is well-diversified across countries and sectors, with notably large allocations to industries that are generally less cyclical in nature. Notably, European loans generally provide diversification across a broader portfolio as there is limited overlap with companies appearing in European equity and high yield bond markets.
The asset class’ rate structure is another key factor when considering risk-adjusted performance. Negative underlying base rates have an impact on the overall yield of fixed rate bonds; however, this dynamic is negated in the loan market by the Euribor floors. In addition, fixed rate bonds are negatively impacted by upward movements in interest rates, while loans are sheltered from this impact given their floating rate characteristics.
The significant increase in “cov-lite“ lending was a notable shift in the asset class and is arguably a detrimental development from a lender’s perspective. However, this dynamic provides an issuer with more flexibility to focus on navigating tough times, potentially improving an investor’s default experience. Additionally, we believe that the increasing integration of ESG factors by borrowers and lenders could be an important driver of change within the asset class, but ultimately will make lending an attractive place for investors. that focus on sustainable investments.
This paper demonstrates an attractive investment opportunity we see in the European leveraged loan market, demonstrating that the asset class should be viewed as a core holding in a well-diversified portfolio.
- Source: ICE BofA, Credit Suisse, Bloomberg. Data covers ten years to December 2021. See endnotes for more information.
- Source: Credit Suisse. Data as of December 2021. European lending as represented by the Credit Suisse Western European Leveraged Loan Index.
- Source: Credit Suisse. Data as of December 2021. European loan metrics are higher than European high yield, US high yield and US high yield.
European leveraged loans: an allocation that is here to stay
The evolution and compelling performance of European leveraged loans
- A large and increasingly liquid set of opportunities
- First risk-adjusted returns
- Future returns are supported by attractive yields
- Institutional ownership promotes stability
The attractive risk-adjusted return profile is driven by:
(1) solid and improving credit performance
- Low defect rates and high recovery rates
- Maturation of the borrower base
- Seniority in the capital structure
- A diverse set of opportunities
- Composition of the defensive sector
(2) the asset class fee structure
- Protection against negative rates
- Well positionedfor the rate hike
Changing market dynamics that investors should be aware of
- The prevalence of covenant lite loans
- Growing focus on environment, social and governance (“ESG“) considerations
European leveraged loans: the basics
European leveraged loans are a form of debt issued by companies that typically hold a publicly available credit rating below investment grade. These are floating rate instruments that pay an Euribor base rate, which resets periodically (usually every three months), plus a spread that provides investors with a satisfactory level of compensation for the additional credit risk that they assume, in relation to a “without risk“ investment.
Leveraged loans are generally classified as senior secured instruments, which means that a loan investor has the first claim on the company’s assets and cash flows in the event of default by the company debt.
The evolution and compelling performance of European leveraged loans
A vast and increasingly liquid set of opportunities:
With over €With 350 billion in assets and around 500 individual issues, the European leveraged loan market has become a distinct segment of the financial markets. The asset class has grown tremendously, more than doubling in size over the past five years (Chart 1).
The combination of significant growth and more issuers to invest in has led to increased liquidity within the asset class. This dynamic is highlighted in Figure 2, which shows a 206% increase in quarterly trading volumes at 15 major sell-side banks since the fourth quarter of 2014. As a result, large-scale investment managers can potentially trade hundreds of millions of loans. euros in a few days.
Figure 1 and 2: A set of deep and tradable opportunities
Size of the European leveraged loan market
European leveraged loan trading volumes at 15 banks
Nominal amount exchanged (€billion)
Top chart source: Credit Suisse. European leveraged loan market represented by the Credit Suisse Western European Leveraged Loan Index. Data from December 2021.
Bottom chart source: Loan Market Association. Data as of December 31, 2021. Nominal traded volume data is from 15 participating banks that are members of the Loan Market Association.
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Ares Commercial Real Estate Corporation published this content on June 10, 2022 and is solely responsible for the information contained therein. Distributed by Public, unedited and unmodified, on Jun 10, 2022 8:12:12 PM UTC.
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