More than a quarter into an eventful year, and European loans are the best-performing European credit asset class — a repeat of 2021. The performance differential versus European high-yield bonds is particularly pronounced, as can be seen in the chart below.
Why has this been the case?
Investors in broadly syndicated loans benefit from a unique risk profile in fixed income markets, which combines limited exposure to interest rate risk with a significant exposure to credit risk.
1. Credit risk
The biggest risk for credit investors is that of permanent value destruction through default. For loan market investors, this is even more relevant given the predominantly single-B-rated credit quality of the asset class. Credit risk has certainly increased as a result of the Russia-Ukraine war, but fundamentals remain robust. This has allowed credit investors to monetize the carry offered by the asset class.
a. In the new issue market, pro forma debt/earnings before interest, taxes, depreciation, and amortization (EBITDA) ratios have remained constant at just over five times for the past five years.
b. Another way of looking at leverage is to consider the share of equity as a percentage of total purchase price for leveraged buyouts (which represent 85% of primary deal flow in the European new issue market). The graph below shows that sponsors continue to constitute approximately 45% of the purchase price in equity, even as purchase price multiples have continued to creep up over the years. These large equity contributions provide a strong incentive for private equity owners to support portfolio companies when they hit financial difficulties. A great example of this dynamic was observed during the pandemic when a large number of sponsors contributed additional capital to struggling borrowers to protect their equity option value.
c. Interest coverage, defined as EBITDA/interest or EBITDA/cash interest, remains above four times, suggesting that debt servicing costs remain sustainable.
d. These strong credit statistics have been recognized by rating agencies, which have recently upgraded more credits than they have downgraded.
Default statistics for the S&P European Leveraged Loan Index also confirm the robust credit profile of the European Loan Index, with the default rate remaining close to all-time lows.
Using projections from Moody’s for European high-yield bonds in 2022, the projection is for a modest increase from the 1% default rate in 2021 to a 2% default rate in 2022. This leaves the projected default rate still far below historical averages. We expect this forecast to also apply to the European loan market given:
- The supportive marcoeconomic situation in Europe: The ECB expects real GDP growth in the Euro area to be 3.7% in 2022, moderating to 2.8% in 2023. The European Union as a whole reached its pre-pandemic level of gross domestic product (GDP) in the third quarter of 2021 and all member states are projected to have passed this milestone by the end of 2022.
- Continuing support from monetary and fiscal stimulus
This projection is corroborated by the S&P ELLI distress ratio — defined as the share of performing loans trading below 80 (typically a good predictor of the default rate), which rose to 2.04% in February from 1.92% in January.
2. Interest rate risk
In addition to continued strong credit quality, loan investors also benefit from coupons, which consist of a credit spread added to the prevailing three-month euribor rate on their investment. The floating-rate nature of the asset class means it provides protection against rising rates. This year, returns on European government bonds have been negative (the German bund index had generated -5.1% in the first quarter; the U.K. gilt index generated -7.4%). As a result of this floating-rate exposure, leveraged loans typically perform well during times of rising interest rates, as shown below:
Can this continue?
Two interrelated risks can throw the loan market’s performance off balance: geopolitical risk and inflation risk.
From the credit market’s perspective, Russia’s invasion of Ukraine does three things:
- It’s a negative shock to global growth.
- It’s inflationary.
- It will likely temper/pause central bank hawkishness.
The immediate reaction from the high-yield bond market and, to a lesser extent, the loan market, was to focus on the first of these three factors: growth. Flight to quality is typical in these situations as panic spreads across the market. However, the second and third factors—inflation and central bank monetary policy—have since become top of mind for investors as the depth and duration of the conflict became more apparent. As a result, credit spreads have been under pressure all year, with the conflict adding fuel to the fire.
Nevertheless, during the past 10 to 20 years, geopolitical conflicts have tended to be a buying opportunity for credit as many conflicts have remained localized and tended to be relatively short lived. For example, when Russia annexed Crimea in 2014, real GDP fell by -0.2% for one quarter before resuming trend growth at +0.5% the following quarter. It’s premature to draw the same conclusions at this point: The length and depth of this conflict are unclear, and this conflict strikes at the heart of NATO and could set a precedent for other countries to pursue similar strategies. But as the conflict drags on, investors will increasingly price these uncertainties into risky asset prices. Once a floor has been found, the initial rebound typically occurs quickly in markets, meaning that investors taking a sanguine view are likely to be rewarded.
Our constructive view on loan markets has hitherto been based on the view that credit markets in general — and loans in particular — can look beyond nominal policy tightening and that real policy rates have a greater impact on credit than nominal rates. This view still holds in our opinion: With global central bank rates still a long way below inflation, both on current figures and breakevens, we do not yet see a policy mistake that could bring the business cycle to an early close. In other words, due to a supportive economic recovery, we do not believe that the risks surrounding inflation and rate hikes will offset the carry offered by the loans asset class.
The risk to this view is that the European Central Bank finds itself in a position where it loses control of the inflation narrative (maybe due to the Russia-Ukraine war) and has to hike rates because of inflation risks spiraling out of control (as opposed to having to hike rates to absorb the typical mid-to-late-cycle economic growth). In that scenario, we would not expect loans to outperform high-yield bonds or investment-grade credit bonds due to the higher interest costs obligors will have to start paying on the their debt, against the backdrop of flat profitability.
To manage this risk, we focus our security selection on keeping our risk budget (market beta) under control, ensuring that portfolio diversification is strong both at the sector and security level, and identifying credits that have the best chance of passing inflation and increased input costs through to their customers. These companies are typically best-in-class operators with respectable management teams and long track records of performance.
Markets can take on a self-sustaining dynamic as negative sentiment begets more negativity. But as in the case of previous severe shocks, investors will eventually look beyond the dramatic near-term event risks. We expect European risk assets (equities, high-yield bonds, leveraged loans) to have recovered from current levels over the next three to six months as we gain greater clarity on how the situation has evolved — in particular with respect to the second-order implications of higher energy, food, and raw material prices.
As for positioning, our loan portfolios are positioned fairly closely to benchmark weights and toward the lower end of credit-rating allocations, with practically no exposure to volatile sectors such as energy or commodities or to Russia and Ukraine. Despite the possibility of wider spreads in the near term, we see the current sell-off as a buying opportunity. In particular, we will focus on allocating capital credits with strong brand names and good pricing power that are able to pass on cost increases in their supply chain to end customers.