Credit markets: Europe’s new sub-investment-grade asset class

Louise Bowman
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Loans and bonds managed together; Senior secured credit broadens buyer base

At the beginning of September, two London-based credit fund managers announced that they had launched innovative new funds. Those innovations were, however, pretty much identical. They revolved around managing senior secured leveraged loans and high-yield bonds within the same fund. It is said that two is a coincidence and three is a trend; given, though, that a number of firms were rumoured to be queuing up to make similar announcements by the end of the month we can safely call this a trend.

First out of the gate was ECM, the Wells Fargo-owned specialist fixed-income manager. The firm announced the launch of its new fund, which will focus on non-peripheral Europe, on September 5. This is the first time ECM has managed the two asset classes in a single fund, which has a target size of €500 million.

ICG followed close on its heels on September 12 with the announcement of its Total Credit fund, which has so far raised €65 million and is open ended. This has a core investment of senior secured loans and high-yield bonds, but will also invest opportunistically in CLO debt and European stressed credit.

"We see secondary CLO debt in Europe as fundamentally mispriced," says Dagmar Kent Kershaw, head of credit fund management at ICG.

What these funds aim to do is to take advantage of reduced bank demand for loans and the absence of new CLO activity in Europe. But they are also creating what asset managers are calling a new specialist asset class in Europe: sub-investment-grade senior secured credit. Loans and bonds offer different levels of protection and investor payoff for the same credit, creating opportunities for investors able to switch between the two. They offer very different returns for what is essentially the same risk. But with the two increasingly ranking pari passu in the capital structure (and investors lobbying for equal voting rights) they could start to look more and more alike.

The whole point of these funds, however, is to exploit the differences that remain.

"For a long time issuers have pitted bond and loan markets against each other to achieve cheaper pricing. The investor should be positioned to do the same," notes Garland Hansmann, director and portfolio manager at ICG.

Managers also hope that if more investors look at both classes of debt it will smooth the seasonality of issuance between the two and offer them greater diversification in exposure to sub-investment-grade credit. Indeed, as more and more loans are refinanced in the bond markets issuer overlap between the two will only grow.

"In Europe this is a half a trillion market when you look at it together," says Hansmann. "Companies that issue loans are the same companies that issue bonds. If you aren’t in both you are utilizing only half of the potential market to generate returns."

He points to two European firms as an example of the relative-value opportunity: paper products manufacturer Smurfit Kappa has double-B rated loans and bonds that rank equally in a default yet in September 2011 the spread premium available for investing in the bond was 258 basis points. Italian telecoms firm Wind also has double-B rated loans and bonds that rank pari passu. In November 2011 the bond offered 237bp additional spread over the loan.

Spread betting Wind Telecom bond and loan spreads

Differences in covenant and call protection will always account for some spread differential, but not of this magnitude. In Europe the difference in transparency between the public bond market and the private loan market is also a factor. The different standards of disclosure between the two instruments will be one challenge that these merged funds will have to face.

Dagmar Kent Kershaw, head of credit fund management at ICG
Dagmar Kent Kershaw, head of credit fund management at ICG 
"The conflict of interest between private and public market information is a situation that prevails in Europe and that we all have to manage around," says Kent Kershaw. "But we are very experienced and have been managing this for many years." One option is for the funds to limit themselves to buying loans on a public basis.

The real benefit of these structures is flexibility. The flow of capital into and out of the high-yield market creates periods when bond valuations are more attractive than loans and vice-versa. That is why simply having a bucket within a fund is no longer sufficient.

"This gives us much more flexibility when the loan market is quiet or when the high-yield bond market is quiet," says Torben Ronberg, head of loans at ECM. "This is not a loan fund with a basket for high yield or a high-yield fund with a basket for loans. The fund can in theory hold 100% in one or the other at any time."

The initial mix is likely to be around 65% loans and 35% high yield – and ECM says that the fund will "invest more widely as appropriate". ICG’s Total Credit fund will, however, have loans and high yield capped at 70% of the fund and aims to run with an average of 45% in each – the balance in opportunistic investments.