Loan opportunities growing in Europe’s credit market, says ECM’s Stuart Fuller

Investment opportunities for loans as part of the credit market are growing in Europe, according to Stuart Fuller, the London based portfolio manager at ECM Asset Management.

Historically, this asset class has been much more used by investors in the US, but with concerns over duration and other challenges facing European fixed income investors, it is one that is likely to pick up more investor interest, Fuller believes.

“Corporate Bonds are a reasonably well known asset class, but syndicated corporate loans less so in Europe. Loans are a dynamic part of the US credit market – there it is about four times the size of European market, but currently offers less return.”

And with expectations about interest rates going up being more a question of ‘when’ not ‘if’, investors can approach this type of asset with inflation in mind.

“The loan asset class benefits from floating rates, either Euribor or Libor plus a spread. It means a natural hedge for those worried about interest and inflation rates,” Fuller says.

Talking about loans brings up the issue of leverage. Fuller says an example would be a loan to a European corporate, with the loan based on credit metrics. There may well be leverage as part of the loan, but this is not the focus per se.

“For example, a private equity company buys an asset, such as Pret a Manger. As part of this a group of investment banks provide financing, which is used along with the PE funds to buy the company.”

“The group of banks then arrange for the company to borrow, say, 4x EBITDA, and take this to investors as the syndicated leveraged loan. As with any investments there are risks, but deep credit analysis should flag these. The loans have got covenants, which provide an ability to keep a check on the financial performance of the company.”

“The use of covenants differentiates this area from other types of fixed income. Bonds typically have incurrence covenants that say for example that if you have x amount of leverage, you cannot borrow any more money, whereas loans have maintenance covenants that say you have to keep your borrowing below x at all times.”

Europe’s more traditional sources of funding for corporates – its banks – are still deleveraging, driven to do so by a blend of market environment coupled with regulatory pressures.

This in turn means more opportunity in the market for loans that Fuller and his colleagues are looking to. The flexibility in the rates is another reason why in the current environment fixed income investors may be more open to considering the approach, he adds.

“When tapering was announced in May-June, the European High yield fixed rate market dropped 2.7% off the back of that – the fear that if interest rates went up, fixed rate bonds would therefore be relatively less attractive. The European loans market dropped 0.39%, so this part of the sub investment grade market is less volatile.”

“We are focusing on loans which are floating rate, not high yield bonds that are fixed rate. Studies may suggest that historically, high yield bonds are less sensitive to interest rate movements, but in the current ultra-low rate environment everyone is more sensitive. This should make the loans market more interesting to investors in the medium term.”

Demand in Europe is somewhat different from that in the US market, he says, because it is not currently an asset that is accessible via retail products, but is in the US.

However, drivers persist, such as private equity buyouts, where there is an estimated €100bn in ‘dry powder’ that needs to be put to work in Europe in the next few years.

On the demand side, “there is appetite among investors who are looking for something that matches their duration needs.”

Examples of investors that Fuller is coming across in this area include insurance companies, pension funds, and some high net worth individuals. In terms of presence in individual European markets, Fuller estimates that Germany, Switzerland and Scandinavia may be ones that understand the asset class better than some others, with slightly less knowledge or interest in markets such as Spain, Italy and Eastern Europe. As a result, roadshows may be one way to continue to education more investors about the opportunities, he says.

One factor that may increase investor appetite is data around default rates on the senior secured loans that are being sought in the market.

“Recovery rates are generally better than 70-80% on senior secured loans. Default rates are low with the lagging 12m rate on the S&P European leveraged loan index at 3.1%- and you can get diversity because of the number of issuers,” Fuller says.


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