Relative value gap narrows between US and Europe

Yields in the European leveraged loan market fell below equivalent US figures, according to a Marlborough Partners report, citing S&P Capital IQ LCD data.

The relative value gap that fueled US investment in Europe’s leveraged loan market has narrowed, according to a first quarter mid-market report from private equity debt advisory firm Marlborough Partners released on Tuesday.

The report outlines a number of factors that could influence an eventual decline in US investor demand for European leveraged loans, pointing to declines in yield to maturity (YTM) for single B-rated term loans as a key factor.

“If a US investor invested in a European issue in Q1 2013, they would have received 51 percent basis points of incremental yield,” William Allen, partner at Marlborough told Private Debt Investor. That differential has been eliminated, according to Q1 data.

In Europe, average YTM on single B-rated term loans fell from 5.5 percent in Q1 2013 to 4.5 percent in Q1 2014, according to S&P Capital IQ LCD data. Currently, that does not compare favourably to returns that can be generated in the US, where YTM figures stood at 4.9 percent in Q1 2013 and 4.69 percent in Q1 2014.

The decline in single-B YTM has coincided with a continued increase in European leverage. Average leverage multiples (total debt/EBITDA) were 4.9x in the US and 5.1x in Europe for Q1 2014, according to S&P Capital IQ LCD data.

Marlborough also cites rising European mid-market debt-to-EBITDA multiples, transfer restrictions and longer settlement periods as cause for US investors’ declining interest. 

That decline may dampen prospects for Europe’s covenant-lite loan market, Allen said. Despite 25 percent of institutional new issuance being European cov-lite in Q1, most recent activity has been largely driven US investor demand, according to Marlborough.

“Most European covenant-lite issuance came from cross border companies based in Europe that issued to US investors, indicating that we don’t have a true cov-lite market here supported by European investors,” Allen said.

“Now that the margin differentials, which US investors were previously benefiting from, has gone and leverage is higher in Europe, it suggests that there will be less pressure on European investors to accept cov-lite,” he said, adding, “If you don’t have the threat of US investors providing the capital, the pressure on European investors should reduce.”

Although the market may see more European cov-lite, it will likely come from quality issuers in highly liquid deals, Allen said, adding: “We don’t believe it will become a product of choice.”

“We are questioning how much US investors will continue to chase [in Europe] and as a consequence of that, there should be less pressure on European investors to accept what US investors are prepared to do,” Allen said.

Allen also observed an increase in the number of trade buyers taking part in the market, which should help increase deal volume. While loan issuance remains suppressed, Allen observed that there has been some growth, as loans start to win out over bonds in certain situations.

“Loans have become more attractive as the margin and fee cost has come down and leverage has gone up,” he said. “The loan product is faring quite well relative to the bond product due to this and less restrictive prepayment penalties on loans.”