Whilst the growth of the market for senior secured bank loans has been strong over the course of the last two decades, their inclusion within portfolios is increasingly being considered as a core asset choice, particularly in the post-financial crisis era.
Advisors and their clients are looking to design strategies that allocate to either local (US or European) loan products or global funds, where the manager seeks to capture the best value inherent in both regions.
Looking at the European and US markets in isolation presents some very attractive investment propositions. The growth in global market allocations has accelerated especially where institutional investors can capture exposure to the market in a single strategy, with a manager who has a developed track record and experience across market cycles. With pricing remaining attractive, the asset class displays some compelling characteristics in today’s environment.
An asset class with embeded value
Senior secured loans are sub-investment-grade debt instruments that offer investors a unique blend of attractive yields and some protection against both credit and interest rate risk. These loans are commonly issued by companies for the financing of acquisitions, capital expenditures, and general operating purposes. Senior secured loans are underwritten by a lead bank and syndicated to other banks and institutional participants; they pay a floating rate coupon consisting of a base rate (LIBOR) plus an additional spread to compensate for credit risk. Transactions may also benefit from LIBOR floors, arrangement fees and original issue discounts (OIDs). Interest payments are usually paid quarterly, and in some cases more frequently.
Senior secured loans occupy a priority position in the issuer’s capital structure relative to other outstanding debt; loans are secured by some or all of the borrower’s assets, which means that loans typically have first-priority claim on the assets of a company in the event of default. In current loan market transactions, the structural subordination of more junior debt and significant equity cushion offers significant enhancements to the senior lender. The presence of covenants—contractual restrictions in the loan’s credit agreement that set minimum standards for a borrower’s financial conduct and performance – are additional structural protections. This protection ultimately comes in the form of higher recovery values in the event of a default. Whilst today the market default landscape is relatively benign, having downside protection in a high yielding asset class is proving to be an attractive feature for many asset allocators.
Loan portfolios are less sensitive to interest-rate risk
Due to the floating-rate nature of senior secured loan coupon payments, loans do not share the same interest rate risk (also known as duration risk) as fixed-rate debt instruments. When interest rates rise, the reference rate of the coupon also rises. Thus minimizing the negative price return associated with the impact of rising rates on fixed income debt. As we saw as recently as Q2 2013, the comments of the end of Fed-tapering sent concern throughout the markets, as investors whom were naturally long duration felt that the shift to a tightening of monetary policy could harm longer duration assets. While there are differing views on near term interest rate movements across global markets, investors who seek to mitigate some form of interest-rate risk have used the loan asset class to temper duration concerns.
Thinking globally – relative value
Investors who allocate to a global strategy should see value added through tactical allocation between markets. Their manager should look to take risk off the table if one region looks less attractive, and add risk when relative opportunities, risk metrics and market fundaments are favourable. At Babson Capital our approach is to couple our bottom-up credit assessment process with a macro view upon relative value. We look across geographies, industries, sectors, and issuers as well as across the capital structure, to find and exploit the best relative value investment cases.
Increasingly there has been a globalisation of loan issuance, as issuers will look to source financing where capital and liquidity are most readily available. Naturally, if capital flows are different between the US and European markets, associated pricing and return expectations will reflect these supply demand imbalances. It remains central to our thesis that investors should therefore not think of the loan market in just a European or US only context, but moreover an investment universe which provides many different attractive investment options.
Today, when we look at Europe, with primary issuance still significantly below peak (YTD issuance c.€30 billion v €152 billion in 2007, according to Credit Suisse,) we have increasingly focused on the significant value present in the European secondary market. As an active market participant we feel that the real upside for loans today is for those priced at a discount to par that offer upside from an early repayment of debt expected in the course of coming two to three years. With trade sales, refinancing in to the high-yield bond market and IPOs providing the momentum, these candidates that exit or can refinance tend to be those which are overall better performing. Companies with inherently lower leverage (debt-to-EBITDA ratios) and that are more cash flow generative, can frequently capture greater near-term returns through the pull to par effect, especially when compared to credits that are of a possible higher risk profile.
In comparison, the US dynamic is notably different. The primary market has been robust, buoyed by a far greater diversity of sources of capital. Year-to-date the US loan market has seen more than $426 billion of issuance (Source: JPMorgan), and has been supported by the resurgence of CLOs along with strong mutual fund demands, as well as new sources of institutional capital from US pension schemes allocating to higher yielding assets. Although market pricing today is closer to par, running yields are attractive at around five percent and with LIBOR floors present in all deals, structures remain robust.
Whilst the apparent opportunity for capital appreciation may be less obvious, outsized returns can be captured through active participation in primary issuance. Babson Capital believes where the credit risk is attractive, OIDs (Original issuer discounts) or the discount to par, can allow primary market investors to make sizeable commitments to the new issue pipeline. Our ability to be well-allocated across our relationship bank network can allow positions to be trimmed in the secondary market, often at price levels above issue price. This naturally unlocks an additional return premium for investors.
Through an active allocation process in US primary issuance, supported by capturing the pull to par on early repayment in Europe, global loan strategies can deliver the best of both markets for investors. Overlaying this with relative value decisions and opportunities to capture inefficiencies between currencies as well as regions can provide investors an attractive mix in a well-diversified portfolio. This makes the loan market a far more interesting asset class today.
As investors and advisors look for active management in sub-investment grade credit driven by the search for attractive yield opportunities, we believe it is important for clients to align themselves with an investment manager that is well-resourced in the local markets, who is familiar with regional market nuances and has a solid track record of experience through market cycles.
Whilst many managers can only focus on one geographical bias, investors should realise the full range of choices by working with their manager to determine an optimal strategy. By weighting allocations between global and local markets, investors can ensure that strategies give them optimal exposure to a senior secured credit asset class, with attractive floating rate coupons. This should continue to support a core allocation to the senior secured loan asset class against today’s alternatives.