The leveraged loan market is catching up with the bond market: fuelled by demand for collateralised loan obligations (CLOs), it has expanded to $1tn and is now within $100bn of the US high-yield market1. In this issue of Spectrum, we explain how leveraged loans can benefit a diversified portfolio of credit securities.
The global financial crisis dramatically changed the leveraged-loan landscape: it caused a shift from a bank-dominated to a syndicated market. In addition to funding companies via bonds, many institutional investors now provide direct loans to corporates with below-investment-grade credit ratings – so-called leveraged loans.
The practice has been spurred by the introduction of new regulations in the aftermath of the financial crisis, including the Basel III rules that have forced banks to de-lever their own capital structures. Data from S&P Global, for example, shows banks supplied about 84% of European leveraged loans as at the end of 2009, with institutional investors picking up the slack. According to the latest S&P figures, the situation has almost completely reversed with investors now accounting for about 82% of European large-cap leveraged loans.
Historically, investors have been the dominant players in the US leveraged lending market and banks have continued to reduce their exposure over the last 10 years or so: institutional investors now fund almost 90% of leveraged loans in the US compared to just 67% in 20032.
Today, the trend of disintermediation of corporate funding continues, and there is strong investor appetite for leveraged loans globally. What’s more, demand is expected to remain firm as the US Federal Reserve paves the way for further interest rate rises and other major central banks gradually normalise crisis-era monetary policies.
Swelling global loan market
Issuers have certainly been keen to meet the burgeoning demand for leveraged loans from global investors. For example, since 2010, the global leveraged loan market in Europe has grown from about €15.4bn issuance to €120.4bn in 2017. In comparison, the European high-yield debt market grew from €24.7bn to €93.6bn in the same period. Meanwhile, the US leveraged loan market has expanded from $500bn to become a $1tn asset class since 2010 – and is now within $100bn of the US high-yield bond market3.
Investors typically access leveraged loans through three vehicles: collateralised loan obligations (CLOs), loan funds and other high-yield credit vehicles.
In the US, CLOs are the largest investor in the asset class, accounting for 64% of the primary market compared to 6% for loan funds and 30% for others in 20174.
According to S&P data, in 2017 CLOs bought 50% of new European-issued leveraged loans with credit funds (40%) and other investors (10%) accounting for the remainder5.
Despite the conservative approach of CLO issuance, particularly given risk-retention practices (where issuers must keep at least 5% of risk on their own books), it seems that investors are still attracted to this kind of structure. In 2017, European CLO volume reached €21bn, an increase of 24% since 20166.
Figure 1: Institutional new-issue loan volume
Source: LCD, an offering of S&P Global Market Intelligence as at March 2018.
Flexible finance, attractive returns
We believe that security selection is equally as important as issuer selection in credit markets, given the varying risks and return potential of different securities within each issuer’s capital structure.
We therefore search the capital structures of issuers worldwide for bonds, loans and derivatives, enabling us to find opportunities to exploit differences in relative value among these instruments. This often directs us to leveraged loans, which can provide investors with an attractive risk-return trade-off and can complement a diversified portfolio of credit securities. This is due to the following reasons:
Bespoke structures: leveraged loans are contracts. They offer flexible terms for borrowers, allowing them to pre-pay loans as cash flows improve as well as the ability to waive other lending terms and conditions. Investors are protected by tight documentation, the use of various covenants, ‘negative pledge’ and change of control clauses, mandatory prepayments or voting rights regarding amendments and waivers.
Recovery first: most leveraged loan instruments sit at the top of an issuer’s capital structure – secured by a pledge on underlying assets. In effect, leveraged loan investors have the right to be repaid before others in case of default or debt restructuring. Thanks to ‘negative pledge’ clauses, the documentation also prevents future investors from sharing this asset-backed support. However, this may change as the loan trade becomes more crowded.
Historically, the recovery of first-lien leveraged loans post-default was close to 70% compared to 55% for senior-secured bonds7. Leveraged loan default rates have also been low over time, sitting at about 2.0% and 1.2% in the US and Europe respectively as at March this year8.
But the surge in demand for loans means that investors have become more willing to accept weaker covenants. In recent years, there has been an increase in cov-lite loans. According to Moody’s, cov-lite loans comprised about 80% of the US market last year, up from 75% in 20169.
Figure 2: Lagging 12-month loan default rate, based on principal amount
Source: LCD, an offering of S&P Global Market Intelligence as at March 2018
Floating coupons: Continued economic improvement around the world will increase investor appetite for low-duration products that helps manage portfolio duration.
Loans pay floating coupons, such as a 350bps spread above the EURIBOR index. This means that in an environment of rising interest rates, loans should outperform fixed-coupon instruments. (It is important to keep in mind, though, that the value of loans with a EURIBOR floor will be slower to respond to increasing short-term rates.)
A lending performance
The performance of the global leveraged loan market has mirrored textbooks as interest rates in many markets began to normalise. In the 12 months to February 2018, leveraged loans returned 4.22% and 2.92% in the US and Europe respectively10. In comparison, the US and European high-yield debt markets rose 2.33% and 1.54% respectively over the same period11.
Leveraged loans acted as much-needed portfolio stabilisers in February, amid a sharp sell-off in global equity and bond markets. For instance, European high-yield bonds tracked by the Merrill Lynch European High-Yield Bond Index lost 0.7% in February, the lowest reading in 15 months, wiping out all of the gains from January's rally12. Meanwhile, loan returns were generally flat, reflecting the importance of a diversified credit exposure.
Figure 3: Leveraged loans generated positive returns amid recent volatility
|February 2018||YTD 2018||Q1 2017|
Source: S&P European Leverage Loan Index, S&P/LSTA Leverage Loan Index, S&P Global Leveraged Loan Index as at March 201813. Past performance is not a reliable indicator of future results and targets are not guaranteed.
Assessing the corporate capital structure
In addition to diversification benefits, we believe that the overall performance characteristics of leveraged loans mean that they should be carefully assessed against the merits of other fixed-income securities in a corporate capital structure. This enables a credit investor to identify instruments that provide superior relative value.
In our credit research, we compare loans against a diverse array of other instruments in the capital structures of issuers worldwide. As the two case studies below demonstrate, leveraged loans can take the edge off portfolio volatility while providing a good risk-adjusted return.
Verallia Packaging: a glass half-full
In 2015, private equity firm Apollo Global bought Verallia Packaging from French building materials company Saint Gobain for about €2.5bn. Last year, Verallia, a glass-packaging specialist, generated almost €2.5bn in revenue and an EBITDA of €504.1m. It has €1.9bn of outstanding debt, with both leveraged loans and bonds maturing in 2022 at the same level of seniority.
We find that Verallia’s term loan offers a steadier, higher return than its bonds. Investors with flexible mandates can therefore target superior instruments within the capital structure.
Figure 4: Verallia Packaging’s debt structure
|1st Lien||€375m term loan B4 1st lien paying EURIBOR+300bps|
|€500m bond paying a 5.125% coupon and maturing at 8 January 2022|
Source: Hermes Credit, Bloomberg as at March 2018
Figure 5: Verallia term loan v bond: option-adjusted spread
Source: Bloomberg as at 22 March 2018
IQVIA: healthy loan option
IQVIA provides information and technology services to the pharmaceutical and healthcare industries. The US-domiciled company offers services such as product and portfolio capabilities, commercial effectiveness solutions, managed care and consumer health in its domestic market.
In 2017, IQVIA delivered just over $8bn against an EBITDA of more than $2bn. The firm has almost $9.6bn of outstanding debt comprised of both syndicated loans and high-yield bonds. Again, the return from the IQVIA leveraged loan is stronger and less volatile, despite the headwinds experienced by the market in February 2018.
Figure 6: IQVIA’s debt structure
$844m term loan A 1st lien paying LIBOR+200bps
€377m term loan A3 1st lien paying EURIBOR+200bps
$1,188m term loan B 1st lien paying LIBOR+200bps
$748m term loan B2 1st lien paying LIBOR+200bps
$800m bond paying a 4.875% coupon and maturing at 15 May 2023
€625m bond paying a 3.5% coupon and maturing 15 October 2024
€1,425m bond paying 3.25% coupon and maturing at 15 March 2025
€420m bond paying 2.875% coupon and maturing at 15 September 2025
$1,050m bond paying 5.0% coupon and maturing at 15 October 2026
Source: Hermes Credit, Bloomberg as at March 2018
Figure 7: IQVIA term loan v bond: option-adjusted spread
Source: Bloomberg as at 22 March 2018
Leveraging the opportunity
Leveraged loans offer clear benefits to investors: an illiquidity premium, seniority in the capital structure, the ability to customise transactions, floating-rate coupons, lower volatility and diversification benefits. However, these advantages are not guaranteed and can only be captured through successful security selection.
We apply an unconstrained approach to credit investing, and seek the most attractive instruments within corporate capital structures. The Verallia and IQVIA case studies, shown above, demonstrate that leveraged loans can provide a stronger and steadier return than bonds issued by the same company.
By comparing credit instruments offered by the same issuer, investors can select those that offer the best risk-adjusted return prospects – be they loans, bonds or another security.
1 “At $1 trillion , leveraged loans are closing in on junk bonds,” published by Bloomberg on 3 May 2018
2 ‘LCD Global Review – US/Europe’ published by S&P Global Market Intelligence in March 2018
3 “The rise of leveraged loans as a $1tn asset class,” published by the Financial Times on 3 May 2018
4 Source: S&P European Leveraged Loans Index and S&P/LSTA Loan Index as at January 2018
5 Source: S&P European Leverage Loans Index and S&P/LSTA Loan Index as at January 2018
6 Source: LCD, an offering of S&P Global Market Intelligence as at March 2018
7 Data source: JP Morgan as at 31 December 2015
8 Source: LCD, an offering of S&P Global Market Intelligence as at March 2018
9 “Leveraged loan safety net may prove frayed for investors,” published on 11 May 2018
10 Source: Bloomberg, S&P LSTA and S&P ELLI as at March 2018
11 Source: Bloomberg ICE BofAML US Corporate index and ICE BofAML Euro Corporate as at March 2018
12 S&P European Leverage Loan Index, S&P/LSTA Leverage Loan Index, S&P Global Leveraged Loan Index as at March 2018
13 Note: European and global index returns exclude currency fluctuations