European leveraged loans offer high yields and healthy borrowers, says CQS

Regulatory and technical factors are likely to result in an evolution of the investor universe in European leveraged loans, providing significant opportunities for institutional buyers, says hedge fund CQS.

The two largest traditional investor groups for high yield loans in Europe – banks and collateralised loan obligations (CLOs) – each have pressing regulatory reasons which will likely reduce their involvement, says Craig Scordellis, senior portfolio manager for loans at CQS, which has $1.5bn in Europe’s $500bn leverage loan market.

Banks, which represent about half the current universe of buyers, are likely to reduce involvement in response to Basel III, he says.

At the same time CLOs, which represent roughly a third of investment capacity, will have a less meaningful share of the market partly because of regulations under the Capital Requirements Directive IV which will force CLO managers to retain 5% of their total CLO liabilities on their balance sheets.

Additionally, it is estimated that up to €20bn of existing CLO investment capacity will fall away by December as incumbent CLOs reach the end of their reinvestment periods.

Total European CLO investment capacity will diminish by 90% to €5bn by 2020, according to Standard & Poor’s.

Scordellis says the resulting financing vacuum is unlikely to be filled by European retail money, because of regulatory restrictions on UCITS buying European leveraged loans. In addition, the ability of Insurance companies to directly invest in European loans is unclear due to the forthcoming Solvency II Directive.

The reduction of investment capacity comes at a crucial time for Europe’s high yield borrowers. They must refinance up to US$500bn of loans that will mature by 2017, according to lawyers Linklaters.

Distressed debt funds, both from Europe and the US, are queuing up to buy loans of struggling companies, but Scordellis says many companies needing refinancing are “very viable businesses with balance sheets which can be sensibly refinanced, they are good businesses and there is a tremendous opportunity there. The opportunity is absolutely not just about restructuring.”

He adds the exit of many historically important buyers opens the door for institutional portfolios and their clients, especially with spread levels of up to 725bps.

And these buyers, he adds, will be far better than historical participants at pricing risk, “which has not been done well in the past”.

Pricing will be based more purely on credit, he says. Past providers of investment capacity in European leveraged loans had different business models which resulted in lower pricing of credit which did not exclusively reflect the borrowers’ credit risk. .

As well as better pricing, some instruments will benefit from better structures and protection for lenders.

Scordellis also notes a number of significant differences between leveraged loans, and high yield bonds.

First, loans usually have floating rate coupons, versus fixed rate for bonds. In many structures leveraged loan holders take precedence in hierarchy over bond holders, he adds.


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