MARKETING COMMUNICATION | OCTOBER 2020

INVESTMENT PERSPECTIVES Now is the time for European

Post the rollercoaster ride in markets Loans are supported by their We believe risk-adjusted returns for as a result of the COVID-19 crisis, senior secured status, diversification loans going forward are likely to European spreads are now at potential and strong supply- reward investors seeking yield attractive levels. demand dynamics. and diversification.

The head of our European Loans and High Yield team explains why loans remain a favourite asset class.

In a world where interest rates remain stubbornly low following the global pandemic, Jens Vanbrabant, CFA investors remain torn between seeking yield and preserving capital. European loans Senior Portfolio Manager, Head of European Loans and High Yield, WFAM stand out as an asset class that can potentially benefit investors in this challenging environment because they look compelling over the next 12 months from both a return and risk standpoint.

Unlike government yields, which continue to trade close to multi-century lows, credit spreads for European loans represent attractive value. Figure 1 shows that, despite unprecedented fiscal stimulus and central bank quantitative easing, current loan spreads at approximately 500 basis points (bps; 100 bps equal 1.00%) over the Helen Roberts, Chartered FCSI Euro Interbank Offered Rate (EURIBOR) remain approximately 100 bps higher than Senior Portfolio Specialist, WFAM where they were before the start of the pandemic.

Figure 1. Loan spreads remain higher than before the pandemic High yield vs. loans spreads 1,750

1,500

1,250

1,000

750

500 Basis points

250

0 Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Sept. 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 European BB high yield European B high yield Weighted average European loan spread*

Sources: Wells Fargo Asset Management (WFAM) Credit Europe, Bloomberg, Bank of America (HE10, HE20), S&P leveraged commentary and data and European Leveraged Loan Index as of 30 September 2020 *Spread to maturity

FOR PROFESSIONAL INVESTOR USE ONLY On the risk side, European loan rates, which Loans are typically made when leveraged buy-outs (LBOs) dropped from 5.5% per annum on average before the by private companies take place. Being senior in global financial crisis to 3% per annum on average the means that loan investors have got a between 2010 and 2019, are on track to finish at 3% cushion provided by other lenders and shareholders who for the full calendar year 2020. Although the European will absorb losses before loan investors. In Figure 3, Central Bank has never bought loans, loan investors 50% of subordinated instruments—typically high yield continue to benefit from the accommodative monetary bonds and equities—protect the loan investor before environment. This, along with the unprecedented fiscal principal impairment can occur. Note that the cushion stimulus observed across the world in 2020, has resulted has not always been as comfortable as it currently is. in continued modest default rates despite the impact Typically when market sentiment is bullish, this equity of COVID-19. and high yield bond contribution can drop as low as 30%.

Figure 2. Loan default rates have remained modest Figure 3. Loans make up the safest part of the European and US issuer-weighted loans default rates, capital structure 2007–2020 (%) Illustrative LBO structure

12

10 Senior secured loans 50%

8

Subordinated bonds 10% 6 Percent Percent 4 40%

2 Source: WFAM

0 Being a senior lender also means that loan investors Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. 2007 2009 2011 2013 2015 2017 2019 2020 co-lend alongside banks, so in market parlance, they are ranked equally (“”) with banks. As a result, Europe (S&P ELLI)—annualised default rate US (S&P/LSTA Loan Index)—annualised default rate loan investors have an information advantage because 2007–2009 average European loan default rate they are typically private and therefore receive monthly 2010–April 2020 average European loan default rate or quarterly sales and earnings before interest, taxes, Sources: WFAM Credit Europe and S&P European Leveraged Loan Index depreciation and amortisation (EBITDA) budgets and as of 30 September 2020 results. Bondholders and equity investors, on the other hand, are public and generally rely on less-frequent Five main reasons to invest quarterly or semi-annual management information.

At this point in the cycle, we believe European loans Secured means that investors are lending on a secured offer attractive risk-adjusted returns for fixed income basis. This means that when things go wrong and a investors. This paper explores in detail the five main restructuring occurs, loan investors together with lending reasons investors should consider allocating to European banks have got first claim over the borrower’s assets leveraged loans. (such as , plant and equipment, inventory and receivables) when the package includes a fixed or floating charge. Alternatively, if the security consists of a 1. The senior secured status of share , then investors have got first claim over the the asset class provides strong borrower’s equity. protection.

We’ve seen sub-investment-grade-rated company results reported in recent months being weaker as a result of the pandemic. The senior secured status of loans therefore remains of huge importance to investors. What exactly does it mean to be a senior secured creditor?

2 As a result of being senior and secured, loan investors typically 2016, the European Loans Index has more than doubled benefit from the following advantages: in size to €220 billion. Over the same period, the number of issuers rose from 212 to 320. Because the majority l There are stronger lender protections in the senior loan facilities agreement than in high yield bond indentures. of these are only present in the leveraged loan market, they provide a genuine opportunity to diversify l The credit rating of a loan is typically one to two notches investors’ sub-investment-grade portfolio. higher than that of an unsecured or subordinated high yield bond. Figure 5. The European loan market has grown to more l There are stronger recovery rates. Figure 4 shows that than €200 billion over the 33-year period from 1985 to 2019, the recovery European sub-investment-grade debt outstanding rate on European first-/senior secured loans was 69.7% versus a range of 9% to 49% for different classes of 250 bondholders. 200 150 100 Figure 4. Recovery rates were highest on European EUR (billions) 50 first-lien/senior secured loans 0 2003 2005 2007 2009 2011 2013 2015 2017 2020 European issuer-weighted recovery rates, 1985–2019 (%) (Sept.) Loans Recoveries (%) Sources: WFAM Credit Europe and S&P European Leveraged Loan Index as of 30 September 2020 First lien (senior secured loan) 69.7 Senior unsecured loan 50.7 We believe European loans offer diversification benefits Senior secured bond 49.1 becausetheir performance is predominantly driven by Senior unsecured bond 38.7 bottom-up considerations and remains less affected by top-down macro considerations as equity and bond Senior subordinated bond 34.0 markets. The benefit has been a consistency of returns Subordinated bond 37.0 over several credit cycles. Junior subordinated bond 9.0

Sources: WFAM Credit Europe and Moody’s as of 30 September 2020 As a proof point, Figure 6 shows monthly returns for the Past performance is not indicative of future results. Credit Suisse Western European Leveraged Loan Index for the last eight years, a period during which a number 2. European loans provide investors of macro and geopolitical events caused significant volatility in financial markets. The average monthly with diversification benefits. return over the period since the start of 2012 has been We believe the growing European loans market now offers 26 bps. The number of negative months has been limited more diversification opportunities as it has evolved from (and far fewer than for high yield bonds) because the a funding source accessible only to issuers with asset- running coupon provides loan investors with a meaningful heavy balance sheets in a limited number of industries to buffer to withstand volatility. Although the March 2020 a fully fledged exchange with issuers from every country, COVID-19 sell-off was unprecedented in size and speed, industry and sector. Figure 5 shows that since the start of the rebound has been equally quick, confirming its status as a mean-reverting asset class in terms of spreads.

Figure 6. European loans have got a history of being a mean-reverting asset class in terms of spreads Total return of Credit Suisse Western European Leveraged Loans Index

6.5 6.5 China and Average monthly 4.5 growth BoE CBPS* return 26 bps 4.5 concerns 2.5 2.5

0.5 Percent Macro growth concerns -1.5 (high yield sell-off) Trade war concerns US “taper tantrum” Oil-price-related broad Brexit vote -3.5 market volatility Trade war and quantitative tightening fears COVID-19 downturn -5.5 March 2020 -14.3% 2012 2013 2014 2015 2016 2017 2018 2019 2020 Total return Average return *CBPS = Purchase Scheme Sources: WFAM Credit Europe and Credit Suisse as of 30 September 2020 3 Past performance is not indicative of future results. 3. European loans offer strong 5.1% and 4.9% per annum, respectively. Therefore, we view European loans as an attractive opportunity in this current risk-adjusted returns. environment, though one not without volatility along the The COVID-19 crisis brought with it the second-largest way, at least in the short term. drawdown in the history of European leveraged finance Figure 8. Historical spreads for European loans markets, which stretches back 25 years (the weakest levels were reached in early 2009 during the global European loans spreads versus 1-, 3- and 5-year financial crisis). forward returns 650 Figure 7 shows the current credit spread and realised 30 September 2020 annualised volatility over the last five years for a number 600 of credit asset classes. It illustrates the attractive risk- 550 adjusted return profile of European loans compared with other fixed income asset classes following the COVID-19 500 sell-off observed earlier this year. 450

Figure 7. European loans versus other asset classes in 400 terms of their risk and reward trade-off 350 Spread and volatility (hedged to €) for major fixed income assets 300 Discounted spread (3-year life) life) (3-year Discounted spread 650 250 B-rated European high yield bonds 600 200 European leveraged loans 550 US high yield bonds 150 500 US leveraged loans -30 -25 -20 -15 -10 -5 0 5 10 15 20 European high yield bonds Total return (% annualised) 450 Contingent capital European loans spread vs. 1-year forward returns 400 European loans spread vs. 3-year forward returns EM corporate hard currency BB-rated European European loans spread vs. 5-year forward returns 350 high yield bonds EM sovereign hard currency Sources: WFAM Credit Europe and S&P European Leveraged Loan Index 300 as of 30 September 2020 250 The attractive risk-adjusted returns are essentially a Option-adjusted spread to maturity (bps) Option-adjusted spread 200 reflection of the asset class’ strong fundamentals. 150 As a result of the COVID-19 crisis, multiples European US investment grade 100 investment grade for new deals in the primary market have declined this year (Figure 9a). Meanwhile, the debt stack is supported 50 5-year developed government bonds by higher equity cushions provided by private equity 0 0 2 4 6 8 10 12 sponsors (Figure 9b), which have resulted in loan-to-value Annualised volatility percent (last five years) percentages of around 50%, quite a bit below the long- Sources: WFAM Credit Europe, ICE Bank of America credit indices term average of 60%. Further, interest coverage ratios for (EG0V, ER00, EMGD, EMUB, HE00, COCO, H0A0, C0A0), S&P leveraged European sub-investment-grade companies also remain commentary and data and Bloomberg as of 30 September 2020 at elevated levels—4 times versus the historical average Option-adjusted spread and annualised volatility are not currency hedged. For illustrative purposes only. of 3 times—because the cost of servicing debt is currently at a historical low (Figure 9c). Another way of looking at this is by checking what historical returns have been when spreads traded around current levels. Figure 8 shows that since 2003, when spreads traded within 50 bps of current spread levels, the European loans market has generated a positive return 94% of the time over the course of the following year. Furthermore, positive average returns were achieved in 100% of the subsequent three-year and five-year periods. The average returns for the one-, three- and five-year periods following the point in time when spread levels traded within 50 bps of current spread levels were 5.5%,

4 Figure 9a. Leverage multiples in European loans 4. European loans benefit from have improved favourable supply and demand Leverage evolution (total debt/EBITDA) dynamics. 6 Along with demand for loans from traditional open- 5 ended funds, the market has also been given a boost by the growth of the European collateralised loan obligation 4 (CLO) market since 2013 when new rules were introduced for that market. Under these rules, CLO sponsors need to 3 co-invest alongside CLO investors. The size of the required investment is 5% of the overall CLO size. On a typical €400

Leverage multiple Leverage 2 million CLO structure, the sponsor has got €20 million at risk (skin in the game). This feature is attractive from the CLO tranche investors’ point of view because it aligns the 1 interests of the sponsor and the CLO investor. In 2019, the European CLO market set a new post-crisis record 0 for primary issuance, with €29.9 billion in new issues— 2015201020052001 2020 (Sept.) a 9% increase over 2018’s total. Despite this year’s market First Lien/ Second Lien/ Other Debt/ EBITDA EBITDA EBITDA disruption, at the end of September, the CLO market had Sources: WFAM Credit Europe and S&P LCD as of 30 September 2020 already seen in excess of €13 billion of new issuance.

Figure 9b. Average contributed equity has improved Figure 10. Demand for loans supported by burgeoning Europe: Average contributed equity CLO market Leveraged loan and CLO issuance volume 60

50 Volume (€ billions): Leveraged loan CLO 200 Mezzanine 35 40 180 30 30 160 Percent 20 140 25

10 120 20 0 100 CLO 201920172015201320112009200720052003 2020 Q3 80 15 Europe 60

Sources: WFAM Credit Europe and S&P LCD as of 30 September 2020 loan and mezzanine Leveraged 10 40 Figure 9c. Pro-forma interest coverage in European 20 5 loans transactions are better 0 0 2019201820172016201520142013201220112010200920082007 2020 Average pro-forma EBITDA/interest (Sept.) 6 Sources: WFAM Credit Europe and Standard & Poor’s “European Quarterly Review” and “Global Databank” as of 30 September 2020

5 The supply of loans has similarly been very strong. Given the choice, private equity sponsors prefer loans 4 rather than high yield bonds as a funding instrument because of the less-restrictive call protection. Loans 3 are typically callable at a price of 101 after a six-month non-call period, whereas high yield bonds are usually only 2 Interest coverage ratio coverage Interest callable after two to three years at a price in the range of 102 to 104. 1

0 1999 2002 2005 2008 2011 2014 2017 Q3 2020 Average Median Range between 1st and 3rd quartiles Sources: WFAM Credit Europe and S&P LCD as of 30 September 2020 5 5. European loans offer an attractive structures. Investors should consider carefully whether the approximate 200-bp premium1 offered by direct lending alternative to an investment in US investments over loan investments is large enough to loans or European private debt. compensate for these risks.

Here we look at the relative merits of investing in European Second, unlike the European market that has gone through loans compared with both US loans and private debt. two default cycles during the last 12 years (the 2008–2009 global financial crisis and the European sovereign and European loans versus US loans banking crisis in 2011–2012), private debt managers have not yet had to contend with a default and restructuring When assessing the relative value between the two cycle. This limited experience will only become apparent markets, investors should bear in mind that currency when managers begin working through the next default risk hedging costs need to be taken into account. As of cycle. The risk is that in order to get invested, managers will 30 September 2020, European investors looking at have had to make many borrower-friendly concessions and US loans on a currency-hedged basis should subtract concede covenant-light deal documentation. Are private approximately 1.3% from the yield expressed in US-dollar debt managers’ investment teams and restructuring terms to convert it to a euro-equivalent yield. After teams strong and experienced enough to work through hedging currency risk, an investment in US loans offers a a prolonged downturn? That question is more difficult to yield that is lower than an investment in European loans answer in the private debt space than in the loans market. (see Figure 11). Similarly, for sterling-based, yen-based and won-based investors, currency-hedging costs favour an allocation to European loans because the currency- Conclusion hedged yield is higher. Because yields remain low on a historical basis, investors continue to search for investment opportunities to add Figure 11. Currency-hedging costs favour an allocation return without undue risk. to European loans over US loans As an answer to this conundrum, we believe investors may Investor base currency want to consider an allocation to European loans. Evidence has shown that the asset class currently offers attractive Asset class EUR GBP USD JPY KRW risk-adjusted returns, helped in part by continued robust European loans 4.9% 5.7% 6.3% 5.2% 6.0% fundamentals despite the impact of the COVID-19 crisis. Looking ahead, we expect this thesis to remain in place US loans 4.4% 5.1% 5.7% 4.6% 5.4% over the next three years.

European loans offer investors several advantages along Sources: WFAM Credit Europe and S&P as of 30 September 2020 with their yields. From a credit perspective, they have got European loans versus European direct lending the advantage of being senior in the capital structure and providing diversification benefits. Finally, market technical The European private debt market (defined as direct factors such as supply and demand trends are supportive lending to small and medium-size enterprises) has grown of this asset class. rapidly over the last 10 years. Why loans may be a good strategy to consider Whilst proponents of the asset class argue that private debt has got the added benefits of tighter structures, Who may benefit Why better lender information than in the public debt markets and better regulatory treatment for insurers under the For pension funds, European loans have offered attractive yields and have European Union’s Solvency II directive, these arguments provided benefits in rising rate Pension funds need to be put in the context of the record amount of environments. These loans have also cash that European private debt managers have left offered diversification from many uninvested. Indeed, a rule of thumb is that it typically traditional asset classes. takes two years for 80% of an investor’s direct lending Due to the relatively consistent income that the asset class has historically commitment to be deployed in actual investment Insurance clients provided, loans have been used in cash- opportunities, whereas a loan investment can typically flow-driven portfolios. be ramped up in a matter of weeks. The absence of a European loans can be made available meaningful secondary market means that a private debt Private wealth to private wealth clients using the new allocation is less liquid than an investment in European managers European Long-Term Investment loans, which is typically accessed via open-ended fund Fund Structure.

1. Per S&P October 2020. First lien (senior secured) comparable. 6 We want to help clients build for successful outcomes, defend portfolios against uncertainty and create long-term financial well-being.

l To learn more, contact us at [email protected].

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