Issuance on the rise
Paul Hatfield, Alcentra
I still take a very positive view on the loan asset class in both Europe and the US, although there is certainly capacity for more issuance, especially in the European market. However, I think the amount of dry powder private-equity has to its name, combined with the recent uptick in M&A activity, means 2014 will be a better year for new issuance. Economic recovery in both markets, though still in its early stages, will also help in this respect.
We’ve seen declining default rates and I expect 2014 will remain a year with few defaults. Outside of the loans we already know are headed that way, there should be no surprises in that area.
Inflation does not seem to be exactly racing ahead and with recent events in Washington pointing to continued low interest rates the backdrop for borrowers remains favourable. I think interest rates will stay lower for longer in Europe until the problems with peripheral countries are sorted.
Loan demand set to continue
Through 2013, there was $620.6bn of issuance in the US market, compared to €75.8bn in Europe (a large jump from €23bn in 2012)1. This disparity is reflected in the number of issues in each market: 1,478 in the US versus 508 in Europe2. It is worth bearing in mind the US loan market is much larger than its European counterpart with a total notional value outstanding of US $751bn, versus €144bn in Europe1.
We (Alcentra) expect continued demand for loan assets in Europe. However, a number of factors, including a fledgling return of the European CLO market, limited scope for retail investors and the smaller size of the LBO market, is likely to contain any moves toward parity with the US in terms of size.
Liquidity is undoubtedly greater in the US than in Europe. In the US, on average more than US$400bn of principal value in loans has been traded each year since 20073, clearly outstripping the market size of European loans in total. In Europe the private nature of many financings – often numbering a handful of lenders in a ‘club’ deal – tends to limit the volumes traded, with many participants buying to hold until maturity. Though liquidity is lower in Europe, for institutional investors this may be seen as presenting less pressure on prices (both upward and downward), potentially meaning greater price discipline can be maintained and volatility minimised.
Covenants are common in the European market but increasingly rare in the US. In 2013 the US loan issuance was on average 52% ‘covenant-lite’ versus 26% ‘cov-lite’ in Europe, with the majority of the latter being in ‘crossborder’ deals4.
We believe covenants will remain an important part of the European market this year, with the greater discipline we see in evidence from the mainly institutional investor base important in maintaining lender-friendly terms and deal structures.
Falling default rates
Default rates in the US and European loan markets have started to converge, after a long period of higher European numbers inflated by directories’ businesses and Spanish issuers. In the US, the lagging 12-month default rate by volume decreased to 2.11% at the end of 2013 from 2.41% at the end of September 2013. In Europe this rate has fallen from 3.14% to 2.88% over the same period (starting at more than 6% at the beginning of 2013).5
We believe European default rates will be benign throughout 2014, with rates falling further than their current level. However, we expect by the end of 2014, rates will have normalised below the mean of 2.5%–3.0%. As a senior secured asset class, we continue to believe that high rates of recovery, and therefore low default loss rates, will continue throughout this year in both the US and Europe.
Average annual total returns for US loans have been 5.60% versus 5.50% in Europe from 2003 to 20136. In 2013, US loans returned 6.15% while European loans returned 8.7%. As such we would expect a total return for a diversified portfolio of US loans to achieve approximately 5%-6% in 2014, relatively unchanged on 2013. For European loans we expect returns of 6.5%-7.5%, slightly lower than last year.
PAUL HATFIELD’S OUTLOOK VIEW
- Economic recovery in US and European markets will help to keep default rates low
- Interest rates will stay lower for longer in Europe until the problems with peripheral countries are sorted out
- Inflation doesn’t seem to be exactly racing ahead and with events in Washington pointing to continued low interest rates, the backdrop for borrowers still seems very favourable
1. Credit Suisse, Leveraged Finance Strategy Monthly, April 2014
2. Credit Suisse, Leveraged Loan Index and Western European Leveraged Loan Index, Monthly Excel Data, April 2014
3. S&P/ LSTA, 2013
4. Credit Suisse, 2014 Leveraged Finance Outlook and 2013 Annual Review, February 2014
5. S&P ELLI Default Rate, Excel Data, April 2014
6. S&P Capital IQ, April 2014