Not too hot, not too cold: 10 questions on syndicated loans

September 18, 2024

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Alex Woolrich and Stuart Fuller discuss their thoughts on current trends in the European and US syndicated loans market.

The year so far has been positive for syndicated loans. Gross issuance has remained robust, while strong demand from the collateralised loan obligation (CLO) buyer base has supported the asset class. Meanwhile, thanks to the floating-rate nature of syndicated loans, the “higher-for-longer” interest rate environment has helped generate compelling returns.

But, with rates moving lower, what does the future have in store, and why should investors still consider an allocation? We put the questions to Alex Woolrich (AW) and Stuart Fuller (SF).

How do you assess the current health of the loan market?

AW: In Europe, it has been remarkably busy. To the end of July, there was €71 billion of gross issuance, three times more than the previous year.¹

Gross issuance is historically high because of the three ‘R’s’: refinancing, repricing and recapitalisation, as opposed to new merger & acquisition-driven financings. As a result, net supply has been a lot lower than the gross figures suggest.

Demand, primarily from CLOs, has been strong, causing a supply/demand mismatch that has supported pricing.

SF: The story is the same in the US, with the busiest January and February I can remember. That pace has continued throughout the year.

AW: CLOs have established new vehicles, creating warehouses for future issuance. Arrangers know demand for loans is there, which means borrowers can come to market to refinance. This begets more supply, which means more CLOs can get launched, which creates more demand, and so on.

Can that pace continue?

AW: For now, there does not seem to be anything that could upset it. We had a slight pause when equities fell sharply at the start of August, but they swiftly recovered. It would need a much bigger market event for the level of activity not to continue into year end.

SF: Spreads offered by AAA-rated CLO liabilities are attractive versus other AAA-rated asset classes. The highest-rated CLO liabilities have proved resilient over time and are floating rate, which has helped over the past two years or so when rates were increasing.

We are also seeing demand from big banks for AAA-rated exposure because they have liabilities to match. Banks like, and are comfortable with, the CLO AAA market and that demand has had a positive knock-on effect elsewhere.

Are you concerned about the maturity wall?

SF: This often comes up in media and analyst reports but is always resolved. There is always refinancing risk for leveraged borrowers, but it only tends to be problematic for the worst-performing companies. The same is true in high yield, and we've seen issuance between the two markets, like we always do. Loan names have gone to high yield and vice versa. There is also financing available in the private debt market. There are avenues for credit worthy companies to access capital when they need it.

AW: The leveraged finance aspect of the market is what tends to cause concerns, because borrowers cannot repay debt in their capital structures through cashflows alone. They need capital markets to be open to them when they refinance. However, this has never constrained performing companies, so the maturity wall will just keep moving out. Two years ago, people worried about 2024, now they're worried about 2026, then 2028 etc. But demand is there, and over time most borrowers will find a window to refinance.

Where do you see the most value?

AW: Despite recessionary fears, demand has supported secondary prices across all industries, even cyclical sectors such as building materials and chemicals. We have not seen those sectors sell off and perhaps offer the value we would have expected.  

Instead, we look at the potential carry (all-in yield). While the European Central Bank has started cutting rates, we are still getting roughly 3.5% as a base rate with a margin on top, meaning the all-in coupon is around 7-7.5% for a single-B rated loan.²

Base rates remain high in the context of the last 10 years. They seem unlikely to decline rapidly, because it doesn't look like we are facing a recessionary-type scenario. You can construct a well-diversified portfolio to mitigate credit risk and still potentially generate historically attractive rates of carry rather than overweighting certain industries.

What about the effect of lower base rates?

AW: As base rates decline, it feeds through into the underlying contracts of the loans. Coupons will fall over time, everything else being equal. So, interest returns in 2025 in my opinion will likely be lower than this year.

At the same time, the impact can be overestimated. CLOs are the biggest investors and have floating-rate assets and liabilities. It's an arbitrage. They're still going to be the biggest buyers. They are not total return buyers such as US exchange-traded funds or mutual funds, where retail investors may think fixed-rate ETFs are more attractive than floating-rate ETFs.

The impact on returns is more about potential credit losses, which, again, would come from a severe recessionary environment or unforeseen market shocks rather than rate cuts.

Clearly, there is a relative value question for investors who can buy high yield or loans. But with loans, it comes back to the biggest buyers being CLOs and how that supports the market.

SF: Relative value is often discussed within the wider leveraged finance market. Bonds have convexity, and if rates come down, you can’t argue that bonds will not benefit. There is a lot less convexity currently in the loan market.

But, as Alex said, the all-in coupon is what protects investors. You are still not getting the same equivalent yield or carry in bonds, because they have much lower fixed coupons that were set in a different rate environment. Few believe rates are going back to zero quickly or at all.

Despite a rising rate environment from early 2022 to this year, the asset class has not seen significant inflows. Investors have sold loans because they have been their least-worst problem; they have been sitting on losses from fixed-rate government bonds. But in our market, average prices have been around 98 for some time.³ The volatility in our product versus the returns over the last 5-year period, in both the US and Europe, look better than investment grade. While it’s unlikely to last forever, it shows how relatively stable the asset class has been for the institutional investor.

Figure 1: Relative value of syndicated loans vs. other asset classes

Past performance is not a reliable indicator of current or future results.

Source: Credit Suisse and ICE Index Platform. Data as of August 31st, 2024. Credit Suisse Leveraged Loan Index (CS LLI), Credit Suisse Western Europe Leveraged Loan Index (CS WELLI), ICE BofA US Cash Pay High Yield Index (J0A0), ICE BofA Euro High Yield Index (HE00), ICE BofA US Corporate Index (C0A0), ICE BofA Euro Corporate Index (ER00), ICE BofA US Treasury Index (G0Q0) and ICE BofA German Government Index (G0D0). Indices selected as best available proxies for the respective sub-asset classes. Index performance is for illustrative purposes only. You cannot invest directly in the index. Muzinich views and opinion for illustrative purposes only, not to be construed as investment advice.

Lagging 12-month default rates have fallen in 2024. Can this continue?

AW: Defaults are at a relatively low level, and I don’t believe they will fall much more. Moody’s continues to forecast a relatively benign default environment for the next 12 months for European speculative-grade asset classes.⁴

In my view, we are unlikely to see a big spike and are probably at a point where each default will be idiosyncratic, where something is wrong with an individual company rather than a particular market or sector running into trouble.

Leveraged borrowers have operated through peak base rates, which are now falling. That makes interest coverage easier. These businesses have already changed their operations to address cost inflation and maintain margins, set their cashflows correctly and dealt with higher borrowing costs.

SF: It comes back to credit fundamentals. Many companies were able to pass on inflation costs to their customers to maintain earnings. As a debt investor, you have got to be in the right place in the capital structure, at the top in the most senior-secured tranches. This is where loans sit.

If you asked credit professionals where defaults would be given the various shocks and scenarios we have experienced (from the global pandemic to inflation) in recent years, I would be surprised if anyone would have predicted them to have been this low. It shows the robustness of the market.

What are your views on the ongoing prevalence of covenant-lite structures?

SF: All deals today are covenant lite but retain controls on what a borrower can and can’t do.

It is incumbent upon credit managers to push back on poorly drafted loan agreements, especially on things we can control, like eliminating whitelists, shortening settlement times, lowering minimum transfer amounts and other things you get in documentation that aren't necessarily maintenance covenants. Make sure you can transfer the risk if you need to and protect yourselves in a worst-case scenario.

I’m involved in a working group set up by the European Leveraged Finance Association to improve market standards.

Private markets have experienced significant growth, but more recently, we have seen private deals refinanced in the loans market due to cheaper costs. Is this a sign of things to come?

AW: Private debt taking what would have been syndicated loan business was a feature of the post-pandemic environment before public markets found their feet again. Private credit stepped in to finance and refinance transactions because they could guarantee an outcome, and it became a question for borrowers as to which market could get the deal done. Irrespective of cost, there was no guarantee of execution in public markets.

The private credit market is huge, but it exists alongside functioning public markets and is having to price more competitively to get transactions done. This year, public markets offer lower-cost financing for more straightforward transactions. Traditional leveraged buy-out financing is not going away.  But if someone needs more certainty of execution or bespoke structural features, private credit can offer solutions.

What new trends do you expect to emerge over the coming months?

SF: We expect more M&A activity. From an internal rate of return perspective, a falling rate environment makes it more attractive for private equity (PE) to get their businesses financed at cheaper rates.

PE got used to doing deals at cheap interest rates, and now must get used to doing deals at slightly more expensive rates. But from all our conversations with the investment bank community, they've had a busy summer period in terms of new M&A.

That's not going to reach our market until next year, because banks underwrite transactions well in advance. But it does mean we expect more new issuance, which should make pricing relatively more attractive.

I recently looked at the average margin over the past 13-14 years in the European market. It was about 408 basis points above EURIBOR. While it goes up and down, it always comes back to around 408 basis points.⁵

AW: We do not forecast any significant changes for the time being. We have plenty of supply and demand from a long-term buyer base. CLO managers opened many warehouses and seem prepared to keep launching vehicles well into next year. These technical factors should help us ride out any short-term periods of volatility.

 

References

1. Pitchbook Leveraged Commentary & Data (LCD), European Credit Markets Monthly PlayBook and CLO Research, as of August 1, 2024.
2.Credit Suisse - Credit Suisse Western European Leveraged Loan Index, data as of July 31, 2024
3.Credit Suisse, as of August 22, 2024
4.Moody’s Investors Service, June 2024 Default Report, as of 15 July 2024
5.Credit Suisse - Credit Suisse Western Europe Leveraged Loan Index (CS WELLI), as of 30th July 2024.

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of September 2024 and may change without notice.

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Index Descriptions

CSLLI - The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market, with an inception date of January 1992. The indices are rebalanced monthly on the last business day of the month instead of daily rebalancing.

CSWELLI - The Credit Suisse Western European Leveraged Loan index is designed to mirror the investable universe of the Western European leveraged loan market. Loans denominated in US$ or Western European currencies are eligible for inclusion in the index. The index was incepted on January 1998 and is published weekly and monthly. The index is rebalanced monthly on the last business day of the month instead of daily rebalancing.

J0A0 - The ICE BofA  US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.  Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

HE00 - The ICE BofA  Euro High Yield Index tracks the performance of EUR dominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.  

C0A0 - The ICE BofA  US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

ER00 – The ICE BofA  Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million. 

G0Q0 – The ICE BofA US Treasury Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule, a minimum amount outstanding of $1 billion and at least 18 months to final maturity at the time of issuance.

G0D0 – The ICE BofA  German Government Index tracks the performance of EUR denominated sovereign debt publicly issued by the German government in the German domestic or Eurobond market. Qualifying securities must have at least 18 months to maturity at point of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 1 billion.

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