October 2013

INSIDE VIEW: Making rational choices

ParisThe secured loan market has been an area of relative safety for investors fleeing interest rate risk, says Adeel Shafiqullah at Pinebridge Investments. While the Great Rotation from fixed income into equities is yet to materialise, concerns regarding the tapering of accommodative central bank policy have rattled nerves across multiple asset classes. The recent run-up in US treasury bond yields has introduced significant volatility to the capital markets. Investors have reacted by pulling money from bond funds and selling equities, with most of the money going into cash, money market funds, or elsewhere on the sidelines. Hardest hit has been long-duration fixed income, which seems perfectly rational. But one area of relative calm has been the secured loan market. This is an attractive alternative for investors fleeing interest rate risk. After absorbing some selling pressure, largely from crossover accounts that chose to sell loans as the least painful method of meeting redemptions, secured loans have held up well. A common financing tool in leverage finance, secured loans pay interest expressed as a margin over a base rate such as Libor. The base rate is typically reset on a quarterly basis and, therefore, secured loans have an effective duration of three months. In the US, most loans carry Libor floors of anywhere from 0.75% to 1%, an important feature to enhance all-in yield. Furthermore, they are generally secured by the assets of the issuer and rank first in right of payment in the event of default or restructuring, resulting in recovery rates superior to unsecured high yield bonds. Closely related to secured loans are senior secured bonds. They carry the same ranking in priority of payment as secured loans, except that they are bonds and pay fixed coupons and feature call protection. Both instruments are referred to as secured credit due to their secured and first-ranking status within the capital structure. Secured credit strategies can add diversification, mitigate duration risk and enhance overall yield for a fixed income portfolio. A major theme in leveraged finance is the increase in cross-border issuance and relative value opportunities between US and European secured credit.  By expanding the investible universe to include both the US and Europe, a global manager with a deep understanding of both issuer pools and superior credit selection skills can construct a diversified, best ideas portfolio and also take advantage of relative value differences between the two markets. Integrated global managers with an on-the-ground local expertise have a distinct advantage. There are relative value opportunities between the US and European markets arising from a variety of drivers including differences in liquidity, investor base, transparency (public versus private reporting and ratings), company fundamentals, default rates, insolvency regimes and divergent macroeconomic backdrops. From a macro perspective, the US has been, and continues to be, more stable compared to the eurozone. Within the eurozone, there is a distinct North-South divide in terms of GDP growth and fiscal stability. After the financial crisis, US companies were able to repair their balance sheets and restructure their cost base at a faster pace than their European counterparts. The benefits of a uniform bankruptcy code (Chapter 11) allowed many over-indebted US companies to de-lever, rationalise fixed costs and reposition themselves competitively. By contrast, the broad spectrum of insolvency regimes in Europe, from the relatively straightforward Scheme of Arrangement in the UK to the highly complex Sauvegarde (Safeguard) process in France, has resulted in a number of over-indebted European companies and their creditors choosing to delay the day of reckoning. Private equity sponsors are dominant players and highly influential in the market given the vast majority of European loan issuance is leveraged buyout (LBO) related. In the US, LBOs account for roughly half of secured loan issuance. The US loan market is larger, more liquid and has a deep institutional investor base compared to the smaller, predominantly bank and collateralised loan obligation (CLO) driven European market. As a result, it quickly recovered from the financial crisis as liquidity poured in from insurance companies, pension funds, loan funds, CLOs and hedge funds. CLO issuance in the US has been strong at $55 billion in 2012 with estimated issuance of $70 billion (€52.4 billion) in 2013 – making CLOs a principal source of demand. In contrast, the European loan market has been slower to recover as a result of banks retrenching, due to stringent regulatory capital requirements, as well as the lack of new CLO formation. However, European CLO issuance has seen green shoots in 2013. Given the divergent fund flows and technical drivers in the two markets, US issuers are taking advantage of the strong liquidity and actively re-pricing loan spreads lower while European spreads have been stickier. Going forward, one can expect Europe to become more attractive on a relative value basis due to technical drivers that favour European loan spreads remaining elevated. As the majority of pre-crisis European CLOs will be unable to invest by the end of 2013 and European banks continue to re-trench from the market, loan spreads should be slower to compress relative to the US. The outlook for the recovery of the eurozone economy remains uncertain given on-going fiscal imbalances and lack of sustained demand growth. Despite these headwinds, there are plenty of well-managed, strong companies in Europe that are positioned to outperform as the economy stabilises. Ultimately, a successful global credit strategy will hinge on careful credit selection supported by a thorough analysis of the macro drivers as well as insolvency jurisdiction.    Another key theme within leveraged finance has been the convergence between the high yield and loan markets. This is evidenced by the increasing prevalence of senior secured high yield bond issuance, especially for refinancing secured loans. This so-called loan-to-bond refinancing has been more pronounced in Europe, as loan issuers seek to access the liquidity of the high yield market to refinance their upcoming loan maturities. According to JP Morgan, secured bond issuance accounted for 45% of all European high yield issuance in 2012. While the underlying credit risk is essentially identical, the secured bonds and loans of the same company can trade at significantly different levels, thereby providing relative value opportunities. A robust secured credit strategy should have the flexibility for a manager to be able to play both the secured loan and bond markets in order to exploit these opportunities. Combining both US and European secured credit and adding the flexibility to exploit opportunities in senior secured bonds enables a dynamic global secured credit strategy. However, few managers have the integrated teams, global presence, local expertise and experience to deliver a successful product. So how does global secured credit stack up against the alternatives? It depends on which part of the fixed income spectrum one approaches it: with an all-in unlevered yield of 5-6%, global secured credit offers a compelling yield pick-up, versus the Barclays Aggregate Index. Global secured credit offers a compelling blend of capital preservation, diversity, yield and short duration. Adeel Shafiqullah is head of European leveraged finance at Pinebridge Investments ©2013 funds europe

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