Risk and reward on the rise in the European leveraged loan market since COVID-19
The liquidation of the European leveraged loan market in March, due to the COVID-19 pandemic, was the first test of the resilience of the asset class since the global financial crisis of 2008/2009.
As the fourth quarter begins, demand for leveraged loans remains strong, although this favorable context has led to an increase in indebtedness on loans now sold to investors. According to LCD pricing data, however, investors are indemnified for this risk.
Indeed, the total pro forma debt to EBITDA for all leveraged lending transactions since the beginning of the year (until September 30) in Europe has been multiplied by 5.5, which is the highest level since 2007. Senior debt has remained at the same level as the 2019 level, at 4.8x debt / EBITDA, remaining at a high level since LCD started tracking this data in Europe.
For transactions involving private equity sponsors, total pro forma debt to EBITDA increased to 5.8x year-to-date – the highest this measure has been since 2007, when it had peaked at 6.1x. And, just like with the measure of all trades, the top leverage on sponsored trades also reached its highest level since LCD tracked this data, at 5.2x.
However, the average leverage figure was affected by the number of entities making additional credits, as opposed to loans backed by new debt buybacks. Market participants say there haven’t been enough new structured LBOs since the pandemic to see where the true levels of leverage are in the current market.
But on transactions where the leverage is high, loan investors are compensated. The spread per unit of leverage increased to 88bp at the end of the third quarter, from 74bp at the end of the second quarter and 66bp at the end of the first quarter. This is the highest level of this measure since the second quarter of 2016.
To calculate the spread per unit of leverage, LCD divides the discounted spread of a loan, according to the S & P / LSTA Leveraged Loan Index, by the pro forma debt / EBITDA ratio at the close of each loan.
This increase in the SPL is due to the fact that, although yields have fallen, spreads against the Libor on European loans have widened. For all new loans offered in the European market at the end of the third quarter, average spreads increased to 426.9 basis points, from 416.7 basis points at the end of the second quarter, according to LCD. These figures relate to institutional loans, of the type purchased by vehicle bonds from guaranteed loans.
Meanwhile, average yields to maturity, or YTMs, fell to 4.76% in the third quarter, from 4.93% at the end of the second quarter, due to the reduction in initial issue haircuts, Where OIDs, on loans offered to investors. OIDs had exploded after the market close, ending the second quarter at 107.2 basis points on average (fees are amortized here over a three-year period), the highest since the fourth quarter of 2011. The measure had fallen to 68.8 basis points at the end of the third quarter but was only 10.7 basis points at the end of the first quarter.
Spreads on euro-denominated loans to issuers rated simple B also increased in the third quarter, reaching an average of 437.5 basis points, from 417.3 basis points at the end of the second quarter. YTMs fell to 4.85% at the end of the third quarter from 4.94% at the end of the second quarter, also due to the decrease in OIDs.
Yields have been steadily declining in the European leveraged loan market since the Great Financial Crisis and since LCD started calculating YTMs in 2009. It was after the financial crisis that the European loan market has first seen OIDs in primary pricing, as prior to this period lending transactions are typically priced at par. In December 2009, the three-month rolling average YTM for all institutional loans was 7.22%. That figure climbed to 7.85% in December 2011, but since then it has been declining, reaching an average of 3.69% in January 2020 (again, on a rolling three-month basis). However, the Euribor was much higher during this period, contributing to higher returns for investors, as the spreads on these credits are based on the interbank offered rate in euros.
Re-pricing frenzy at the start of the year
It’s almost hard to remember now, but the first quarter of 2020 featured revaluations on European leveraged loans totaling nearly € 16 billion, as debt issuers scrambled to take advantage of the low cost of loans. funds in the loan market. This activity reduced overall borrowing costs by 61 basis points on average. Then, during the market shock in March, secondary loan prices fell, with the S&P European Leveraged Loan Index, or ELLI, hitting its pandemic low of 78.92 on March 24. Since then, secondary loan prices have recovered, with ELLI reaching a weighted average supply of 94.79 on September 30, just 4 points from its 2020 peak of 98.66 in January, and up nearly 16 points from its March low. At the same time, the share of loans rated at par or above rose again in September, to 0.42%, from 0.24% in August, the first time this measure has been above zero. at the end of the month since the March reading.
“It will take some time to regain equilibrium,” said one CLO investor, providing an update on the recent trajectory of the market. “We tipped too far one way and then we tipped too far back. There has been a lack of supply and a residual demand for [CLO] warehouses – a particularly important technique, which caused things to be out of balance.
When the COVID-19 crisis hit the leveraged financial markets, the volume of European institutional loans fell from 22.9 billion euros in the first quarter to only 10.1 billion euros in the second quarter, while that the count for the third quarter only reached 9.8 billion euros. CLO’s issuance improved slightly to 4.59 billion euros in the third quarter, compared to 4.28 billion euros in the second quarter. This activity leaves the shortage of supply over three rolling months (new loan issues, as tracked by ELLI, minus repayments, minus CLO issues) at around 0.3 billion euros.
In addition to demand for CLO, investors said they still see cash inflows, mostly from existing investors, into their non-CLO funds, including managed accounts and other vehicles. Demand for the lending asset class keeps the leverage available to borrowers at a high level, and sources say the documentation is still user-friendly for borrowers.
One investor said on a recent industry panel: “I have been impressed with the disclosure around COVID-19, which goes beyond informational engagement. But we still have a long way to go on documentation. The hope for me is that the new offers taken out now will have better documentation. “
“The only restriction we see is in certain documents where EBITDA additions are capped,” said an analyst at a rating agency. “Even on new buyback transactions, we are seeing the same levels of leverage as before the pandemic.”
The story of two crises
The European leveraged finance market has performed well in the wake of the coronavirus pandemic, with the flow of transactions continuing and the price adjustment, particularly compared to 2008/09. “The GFC was a banking crisis, but now the banks are in better shape, and no longer ration credit. The financial system is in better shape, ”explained one investor.
But there are uncertainties ahead and fears of a recession, while the long-term impact of the pandemic on businesses in Europe is still not entirely clear. Meanwhile, ELLI’s 12-month default rate hit its highest level since August 2014, at 4.61%.
“Traditional cyclical businesses are doing well, but the biggest risk is a broader economic downturn and the end of fiscal stimulus,” said a market participant.