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Navigating rising distress levels in leveraged loans

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Insight
3 July 2023 |
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A direct lending strategy focused on the northern European senior secured segment offers one of the best protected high yielding opportunities at the present time, says Laura Vaughan, Head of Direct Lending.

Figure 1: ELLI distress ratio and EURIBOR lending rate both on rise

  • The S&P European Leveraged Loan Index (ELLI) distress ratio, which measures the percentage of loans in the index trading below 80, has been creeping up since early 20211, and despite a dip this year, suggests pressures are on the rise in the leveraged loan market.
  • These rising levels of distress should come as no surprise. At the height of the Covid-19 pandemic, central banks and governments flooded the market with liquidity. Since then, inflation has soared, and the business landscape has changed materially.
  • On top of this, aggressive hikes in interest rates have significantly increased the debt burden on borrowers. With the EURIBOR interbank lending rate going from 0% to 3.0% in the space of a year2, businesses that have borrowed aggressively – already feeling the pinch from cost inflation and lower customer demand – could face a difficult period ahead as cashflows come under strain. As a result, the number of restructurings and borrower requests for lender support is likely to increase in the short- to medium-term.
  • On top of a compelling return, the northern European lower mid-market senior secured segment can offer less downside risk and one of the best legal environments to negotiate any restructurings. By allocating to a strategy focused on northern Europe (as opposed to pan-European or the US) investors have the option of lending into the most creditor friendly jurisdictions. These are geographies where lenders have tried and tested the legal systems regarding insolvencies. The swift nature of the courts means that insolvency processes are faster, reducing value leakage from a borrower at a time when cash and asset preservation is paramount.
  • A broad range of direct lending fund options are available for investors to allocate towards – and they vary in yield, geography and risk levels. Looking at the medium-term economic outlook for Europe, the state of the banking sector and the various geopolitical issues currently at play, we believe it’s a backdrop that plays to the strengths of established direct lenders resourced with experienced teams and a robust origination strategy.

For further information on Federated Hermes’ European Direct Lending capabilities, please click here.

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