The hunt for investment income continues, and the conventional High Yield bond market is looking quite fully priced. There are now no short cuts for investors seeking higher returns in fixed income markets: more substantial yields are only obtainable in exchange for giving up significant liquidity. For sophisticated investors willing and able to invest in illiquid assets, the small but growing European private loan market is a case in point
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Update on the High Yield market
European high yield bonds have delivered a 3.8% return year-to-date – by far the best return of our fixed income asset classes. Last year, price appreciation contributed around 60% of global high yield returns. Due to the amount of callable bonds, price appreciation is likely to play less of a part this year (there is little incentive to buy a bond above the call price as the issuer has the right to redeem at various intervals). Over the first quarter, 88% of total return has come from the coupon, and we expect this to continue. Spreads have widened slightly this year – after approaching their 2011 post-crisis lows – and, in our view, are unlikely to tighten much further from here. If they do, it will most likely be because underlying interest rates rise – that is, it will not be a profitable tightening for investors holding the bonds.
Given the current yield of 5.4% on the European High Yield index, and allowing for likely credit losses, we forecast total returns in the region of 5-6% in 2013. This is still a better prospective return than we envisage from most other bonds, and High Yield and emerging market bonds together remain our favourite fixed income asset class strategically. We recommend that you continue to hold your positions for the time being.
However, the days of high yield delivering equity-like upside with credit downside are probably behind us. Yield-seeking investors unwilling to go down the much higher-risk equity road are increasingly looking for new credit investment opportunities. One possibility, which is not available or suitable for all investors, is to move away from rated credit towards the more illiquid, private loan markets, which can offer commensurately higher returns on a risk adjusted basis (Figures 1 and 2).
High yield remains our strategically-favoured bond asset class, though prospective returns are likely to be lower than in previous years
Traditional lenders have retrenched
Lending to non-investment grade companies has long been a key line of business for both European and American banks, but since the crisis there has been a massive retrenchment by traditional lenders as banks look to repair broken balance sheets.
US banks traditionally occupied roughly 40% of the US private lending market with the remainder comprised of well-established non-bank lenders that included specialty finance companies, collateralised loan obligations (CLOs), business development companies (BDCs), hedge funds, and private lending funds. In Europe there has been a larger historical ownership of the private lending market by banks in the region (between 60% and 80%). Following the retreat of lenders post the financial crisis, banks are only cautiously expanding their loan books as they wrestle with the weight of regulation (e.g. compliance with Basel III) and the repair of their balance sheets.
Making matters worse for European corporate borrowers is the absence of non-bank lenders in the region. Europe has neither BDCs, which exist exclusively in the US, nor sufficient CLO volume to pick up the slack. Furthermore, the local high yield market remains an unpredictable source of funding for small and mid-sized enterprises. As a consequence, there is a large prospective lending gap in the European market.
Alternative credit providers offering flexible capital and willing to lend to European midmarket companies are currently able to negotiate bespoke lending packages across a company’s capital structure. These transactions typically include first and second lien debt as well as mezzanine securities (listed here in the order of least to most risky) and can often comprise a Payable In Kind (PIK) coupon. For example, first lien lenders have the first claim on a company’s assets, and may invoke covenants that force the stoppage of payments to more junior lenders, such as second lien and mezzanine, should the company go into financial distress.
Industry experts estimate that European direct lending returns comprise a cash coupon ranging from Libor/Euribor + 500-1000 basis points, a potential PIK coupon of roughly Libor/Euribor + 300-500 basis points and origination fees of 200-500 basis points. Interest rates charged to the borrower are usually floating, and lending packages can also often include a Libor/Euribor floor (100-200 basis points). The interest rate floor protects the lender from benchmark rates that dip below it by providing a minimum base yield in low interest rate environments.
The floating nature of such loans can also, in part, help to mitigate the risk of rising interest rates. While fixed rate investment grade debt, and to a lesser extent high yield, carries significant duration risk due to the inverse relationship between rates and prices, private loans typically move in step with interest rates, thereby protecting investors from the return erosion that would likely occur to fixed rate securities should interest rates rise.
Figure 1: Average Annual Western European Default Rates: 2003-2012
Figure 2: Average Annual Western European Recovery Rates: 2003-2012
There is no doubt that healthy European middle market companies exist despite regional macro-economic woes (northern Europe is favoured because of its lower default rates and stronger legal systems). They have substantial cash on their balance sheets and belt-tightening-induced higher operating margins but face a difficult path to future growth without access to financing. The investment opportunity is evident; the challenge for investors is its implementation.
Whereas a long history of non-bank lending in the US engendered a strong field of private debt money managers, much of European debt origination and underwriting acumen continues to reside within the banks that for so long dominated the market. However we are seeing a number of established credit specialists, with experience in direct lending, beginning to take advantage of the bank funding gap. In addition, European governments recognise the importance of ensuring mid-market companies are sufficiently financed as a means of fuelling economic recovery. In some cases they are doing this by actively investing alongside alternative direct lenders.
It is important to note that private loans can be difficult to access and are highly illiquid. They are not suitable for all investors. However, for those that believe this is a compelling opportunity, gaining access via private equity-style managers may be an interesting way to play this theme.