Asian investors spot anomalies in leveraged lending

Buyers are demanding higher-rated tranches in response to what they see as a lack of liquidity in the leveraged loan markets.

Leveraged loan investors are demanding higher-rated tranches due to what they see as a lack of liquidity in substandard loan markets.

Japan’s Norinchuchin Bank has bought the top tranches of every European CLO raised in the first six weeks of 2019, the Financial Times has reported, adding that the bank has increased its holding of collateralised loan obligation securities which are triple A-rated. Although PDI’s requests for comment to the bank were not returned, a source confirmed that the bank has been looking at the US private debt market since last year.

Lesley Lo, a director of MetLife Investments’ institutional client group, notes that there was a correction in the US market during Q4 2018 which saw tranches with higher ratings sold by mutual funds and exchange-traded funds because lower quality loans did not have enough liquidity.

“The double-B tranches underperformed compared with single-B (lower credit ratings), which is an anomaly,” she notes, adding that “it also creates buying opportunities for long-term investors [like us].” MetLife Investment Management has $588 billion in assets, of which balance sheet assets constituted $420 billion as of September 2018. Lo says that Asian insurance firms and their institutional clients have asked her team about this deviation.

Although it is not clear if certain types of securities, including cash flow-based CLOs, market value-based CLOs, and ABS CDOs, have seen this anomaly, the implication of the deviation is critical to some institutions in Asia as they tend to ‘buy and hold’ these structured products.

A CIO at an Asian institution says his peers tend to not trade CLOs, but hold them till they mature, though there are occasional pre-redemptions and refinancing cases. His organisation invested in CLOs issued in Europe a few years back, to achieve a minimum four percent return, typically with a five-year holding period. For Asian institutions, leveraged lending exposure comes from the US and Europe.

In the US, the Board of Governors of the Federal Reserve System has followed the leveraged lending market via its Shared National Credit Program. Board members recognise that non-bank entities have increased their commitments in the leveraged lending market through purchases of loans, direct underwriting, and syndication. The latest report concludes: “More leveraged lending risk is being transferred to these non-bank entities.”

CLO market participants are banks, asset managers, insurance firms, and hedge funds. Banks purchased triple-A tranches, accounting for 59 percent of the total investor base of the top tranches, while mezzanine and equity tranches were preferred by asset managers, insurers, and hedge funds, according to Deutsche Bank Research on the US CLO investor base as of November 2018.

In Europe, leveraged loan issuance decreased on a yearly basis, to €22 billion in Q4 2018 from €65.9 billion in Q4 2017, a 66.7 percent decrease, according to Association for Financial Markets in Europe. The issuance includes first lien, second lien, and mezzanine financing.

Notably, most of the European leveraged loans issued in Q4 2018 were first lien loans, accounting for 98.4 percent of total issuance by volume. However, some managers have shifted their focus to first lien secured loans this year.

Fiona Hagdrup, a London-based fund manager of leveraged finance at M&G Investments tells PDI that given the late credit cycle, her team is lending only at 4x EBITDA, on average, with security, to companies whose enterprise valuation should remain in excess of that multiple.

Her team used to manage collateralised loan products with a CLO 1.0 structure but today all managed assets are in unleveraged, open-ended fund form, investing in companies with an enterprise value of €500 million-plus, or separately managed accounts.

Eurozone companies have benefited from low-interest rates and therefore amassed cheap loans from banks. The European Central Bank’s latest report shows that the low general level of interest rates has supported net loan demand in major European countries.

However, Anthony Flintoff, a Sydney-based analyst at S&P Global Ratings, asks if investors will have enough liquidity in difficult market conditions. “This was observed in the previous downturn, and there is no evidence in Europe that the situation will be any different in the next downturn,” he adds.

In addition, about 40 percent of the European leveraged loan investor base is rooted in CLO securities, notes Hagdrup, adding that it underpins a smaller percentage than the US leveraged loan market where about the two-thirds are CLOs.