European Leveraged Loans: An Allocation That’s Here to Stay

JUNE 2022

European leveraged loans:

An allocation that’s here to stay

JUNE 2022

Executive Summary

We believe the European leveraged loan market is one of the most compelling yet underappreciated asset classes within the sphere of global credit. Over the past two decades, the asset class has evolved into a distinct opportunity set, while also building a performance track record that stands out among competing asset classes. For example, European leveraged loans have generated a higher average rolling five-year Sharpe ratio over the past ten years compared to U.S. loans, U.S. and European high yield bonds, emerging market corporates as well as U.S. and European equities1. Additionally, the asset class has produced 10 consecutive calendar years of positive total returns, delivering 4.6% on an annualised basis2. We believe this leading risk-adjusted performance is positioned to continue if one considers the current market environment. The asset class consistently offers one of the highest yields across the public credit markets, while an exclusively institutional investor base should support a stable return profile given their longer-term investment horizon as well as the pricing power of CLO investors.

The credit performance of European leveraged loans has been a notable driver of the attractive risk-adjusted return profile. The asset class has achieved lower average defaults and higher recovery rates compared to other segments of the leveraged credit markets3. Furthermore, the rate of improvement across these metrics has also been superior3. This could be attributed to the underlying borrower base that increasingly consists of larger and more mature companies in addition to tenured private equity sponsors. Structural and compositional features of the asset class have also promoted the credit performance. For example, the asset class is almost entirely categorised as first lien, while the opportunity set is well diversified across countries and sectors, with notably large allocations to industries that are generally less cyclical in nature. Notably, European loans typically bring diversification across a broader portfolio given that there is a limited amount of overlap when compared to the companies that appear in European equity and high yield bond markets.

The rate structure of the asset class is another key factor when considering risk-adjusted performance. Negative underlying base rates impact the all-in yield of fixed rate bonds; however, this dynamic is negated in the loan market through Euribor floors. Moreover, fixed rate bonds are negatively impacted by upward moves in interest rates, while loans are insulated from this impact given their floating rate characteristics.

The significant increase in “cov-lite“ loans has been a notable change to the asset class and is arguably a detrimental development from a lender’s standpoint. However, this dynamic provides an issuer with more flexibility to focus on navigating through difficult periods thereby potentially improving the investor’s default experience. Additionally, we believe the increasingly important integration of ESG factors by both borrowers and lenders could be a large driver of change within the asset class, but will ultimately make loans an attractive place for those investors who are focused on sustainable investments.

This paper demonstrates an attractive investment opportunity that we see in the European leveraged loan market, making the case that the asset class should be considered as a core holding in a well-diversified portfolio.

1. Source: ICE BofA, Credit Suisse, Bloomberg. Data covers ten years to December 2021. See Endnotes for additional information.
2. Source: Credit Suisse. Data as of December 2021. European loan represented by the Credit Suisse Western European Leveraged Loan Index.
3. Source: Credit Suisse. Data as of December 2021. European loan metrics are superior when compared to European high yield, U.S. high yield and U.S. loans.

European leveraged loans: An allocation that’s here to stay

The evolution and compelling performance of European leveraged loans

• A large and increasingly liquid opportunity set
• Leading risk-adjusted returns
• Returns going forward are supported by attractive yields
• Institutional ownership promotes stability

The attractive risk-adjusted return profile is driven by:

(1) strong and improving credit performance

• Low default and high recovery rates
• Maturation of the borrower base
• Seniority in the capital structure
• A diverse opportunity set
• Defensive sector composition

(2) the rate structure of the asset class

• Protection from negative rates
• Well-positionedfor rising rates

Shifting market dynamics that investors should be aware of

• The prevalence of covenant-lite loans
• Growing focus on Environmental Social and Governance (“ESG“) considerations

European Leveraged Loans: The Basics

European leveraged loans are a form of debt issued by companies that typically hold a publicly available credit rating below investment grade. They are floating rate instruments that pay a Euribor base rate, which resets periodically (usually every three months), plus a spread that provides investors with a satisfactory level of compensation for the additional credit risk that they are assuming, compared to a “risk-free“ investment.

Leveraged loans are generally classified as secured 1st lien instruments, which means that a loan investor has first claim on the company’s assets and cashflows in the event that the company defaults on their debt repayments.

The evolution and compelling performance of European leveraged loans

A large and increasingly liquid opportunity set:

With over €350 billion outstanding and around 500 individual issues, the European leveraged loan market has evolved into a distinct segment of the financial markets. The asset class has seen considerable growth having more than doubled in size over the past five years (Figure 1).

The combination of significant growth and a larger pool of issuers across which to invest has led to increased liquidity within the asset class. This dynamic is evidenced in Figure 2, which shows a 206% increase in quarterly trading volumes across 15 major sell-side banks since the fourth quarter of 2014. As a result, large-scale investment managers can potentially trade loans in the hundreds of millions of euros over the course of a few days.

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