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

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.

The impetus for these new fund structures has come squarely from end clients such as pension funds, which in their hunt for yield have increasingly been looking at sub-investment-grade investments.

Catering for pension funds

"A lot of the thinking behind this has strongly come from our discussions with pension funds," says Kent Kershaw. "A number of funds said that they weren’t close enough to the asset class to know what to allocate to loans and high yield."

This is the case for the ECM fund as well.

"We have had reverse enquiry from investors interested in both asset classes; and more and more transactions are being configured with both in the same capital structure," says Ronberg. "We would say that the two asset classes are both subsets of the senior secured market."

The likelihood is that more and more credit managers will now structure funds that offer maximum flexibility to investors.

"Breaking down silos within funds is important," says Richard Ryan, manager of M&G’s Alpha Opportunities Fund in London – adding that his firm has been combining asset classes on an institutional level for five years. But although these funds might not be suited to every pension fund they are very suitable for some.

"Loans and high yield achieve slightly different things," Hansmann says. "For a very conservative investor maybe pure loans are right for them even if they are leaving a bit of return on the table. And if everything you invest in has to be Ucits-compliant then maybe high yield is right for you. If you are unconstrained, however, then this is the right way to go."

Certainly the attractions of sub-investment-grade exposure for pension fund trustees struggling to find yield are not hard to fathom. At the end of 2007, spreads on double-B corporate credit were around 340bp while today they are more like 435bp; for single-B names the comparison is sub-500bp with 880bp, and triple-C credit that was pricing inside 800bp in 2007 now carries a spread of 1,200bp or more. Indeed, the European high-yield market has returned a total of 20.1% so far this year. Compare that with the S&P500 (up 15.8%), the Euro Stoxx50 (10.4%) and the FTSE 100 (4.8%) and it isn’t hard to see the logic of this. But portfolio managers argue that the attraction of the product goes far further than just yield.

"Sub-investment-grade credit doesn’t just provide yield, it also provides stable long-term growth-like returns," says Hansmann. Fixed income is a duration product but sub-investment grade is more credit driven so it also has a fairly low correlation with other mainline asset classes.

But, as ever, the intense focus on high yield (given the dearth of return elsewhere) brings its own set of risks for the pension funds.

"There are periods where grabbing yield makes sense and they are when markets are valued appropriately," warns Ryan at M&G. "There are other times when these conditions are not met. Then you should not be buying risky assets."

European high yield now yields around 7.3% to maturity, not a million miles from its 10-year low of 5.3% in February 2005. So is this the right time for investors that might have previously focused on loans to broaden their mandate to include the high-yield market?

"This would have been a more attractive market 15% ago," concedes Hansmann. "But this is a strategic investment not a market-timing investment," he emphasizes.

It is nevertheless an investment that should be entered into by pension funds with care.

"Credit spreads are attractive in aggregate but there is not good value everywhere," says Ryan. "There are periods of time when you want to take risk and periods of time when you don’t."

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