Across the spectrum
Against a low interest rate backdrop, Paul Hatfield, chief investment officer and head of the Americas at the Alcentra Group, takes an upbeat stance on credit and loan market prospects despite some market concerns about the potential for overheated valuations and deteriorating credit values. Here, he explores the latest developments and prospects in the sector.
In a volatile global investment market, sub-investment grade corporate credit markets enjoyed mixed fortunes in 2014. But viewing the sector as a whole we remain very positive on the market and believe there is still capacity for significant new issuance in both the US and Europe.
There are several reasons for this. From a loans perspective, the current interest rate environment remains benign, providing a supportive backdrop to companies. We believe action by the European Central Bank (EBC), lowering interest rates and injecting new stimulus to fixed-income markets will also help. Overall fundamentals in the US high yield market remain in good shape with corporate performance strong despite some mixed performance data1.
New regulator and capital requirements on banks are also driving them to pull back from lending. In Europe, there is a growing dearth of capital supply for small and medium-sized companies and this creates significant investment opportunities.
The credit market did see some significant retail outflows from high yield bond funds earlier this year, following warnings from US Federal Reserve (Fed) chair Janet Yellen that high yield bond valuations appeared “stretched.”2 But this situation has since stabilised and we do not see the shift in flows as a reflection of fundamental concern about credit quality.
In recent months some market commentators3 have expressed fears valuations are becoming overheated, credit quality is deteriorating and that a new credit bubble may be building. However, while it is true that the market saw rising leverage in 2014, this did not cause us any major concern given the current low interest rate environment, although we continue to keep a close watch on leverage levels.
From an investor protection perspective the increase in covenant lite issuance has been a major feature of the market over the past 18 months or so - about 70% of the US market is already ‘cov-lite’. A few cov-lite loans have also come to market recently in Europe, though it is still too early to tell if these will start a wider trend in continental Europe. Despite the increasing popularity of these loans, we continue to take covenants very seriously.
While we have seen some weaker sectors coming to the market and the launch of some aggressive structures, we believe lenders should remain focused on managing downside risk. We believe businesses that generate strong cash flows rather than those that might offer massive upside potential with weak fundamentals look more attractive in this environment.
From a default perspective, the current market looks very robust. Major markets and ratings agencies are not expecting widespread defaults any time too soon. Credit quality is also strong. In the US particularly we are watching for any signs of excessive leverage, lack of covenance or excessive dividend recapitalisations. But collateralised loan obligations (CLOs) now account for more than half of the market in terms of holding leveraged loans and they tend to be more disciplined than retail funds.
The rise of loan funds and the realisation there are alternative sources of capital available in size to either complement or supplant the banks have both helped to create new market opportunities.
Diversification across asset classes is a useful strategy - particularly if investors can gain exposure to both loans and bonds. Increasingly we see institutional investors demand global funds with a strong degree of investor flexibility.
Beyond specific asset allocation it is also important for investors to choose which geographical exposures they want access to.
The US market for both loans and bonds is deeper and more diverse than the European market and trades more frequently, offering greater liquidity. However, unlike Europe, the weight of money entering the US market, particularly from retail ‘hot money’ flows, has driven new issue spreads tighter and put pressure on covenants resulting in weaker deal structures which promise lower recoveries in the event of default.
Relative value between US bonds and loans and European bonds and loans is constantly changing, resulting in the need for a flexible mandate that can respond by adjusting allocation to maintain the best risk adjusted returns across these four sectors.
Looking ahead a number of factors are likely to influence credit markets over the next 12-18 months. The end of the US quantitative easing (QE) programme will have repercussions across various asset classes, though we believe this is largely priced into the market and will have more of an impact on the global equity market than it does for the global fixed income sector. Geopolitical questions - such as ongoing problems in Russia, the Ukraine and Iraq may also intensify, making markets more volatile than they have been in recent times.
Beyond these important factors we feel the introduction of new regulation could have the single biggest impact on the sector. The aftermath of the 2008 financial crisis has seen a wave of new regulation sweep the banking sector. Some regulations - such as the Basel III rules in Europe - will not fully come into effect until 2016-2019. When new risk retention rules come into effect in the US, such as the Volcker rule, these will also have a much bigger impact on domestic lending and credit particularly in areas such as the CLO market.
Whatever challenges do lie ahead we do believe the current credit/lending market continues to offer attractive opportunities to institutional investors. However, this is a highly specialised area which requires dedicated expertise from experienced managers who can provide robust investment selection and credit analysis.
1. High-yield corporate bonds could repeat 2013’s performance. FT Adviser. 11.02.14
2. Retail investors dump high-yield bond funds. FT. 25.07.14.
3. Credit bubble fears put central bankers on edge. FT. 02.04.14.
4. CLO sales surge to seven-year high. FT. 09.04.14