In today’s world of generationally low interest rates, fixed income investors are scouring the markets hunting for yield. While the much talked about “Great Rotation” from bonds to equities has been slow to materialise, concerns regarding the endurance of an accommodative central bank policy continue to dominate the risk management framework for fixed income portfolios.
Duration or interest rate risk is in the forefront for the majority of fixed income managers, as they seek to protect the impressive performance delivered by the asset class in 2012 and the opening months of 2013. In fact, a new catchphrase has been coined to describe the bogeyman du jour for fixed income assets: “Fed Exit.” While the Federal Reserve, and its counterparts in Europe and the UK, continue to signal a prolonged accommodative stance, one glance at the yield curves and rates markets drives home the reality that yields have limited room to move much lower.
**Relative safety of secured credit**
So where does one seek refuge from duration risk while still earning a respectable yield? One segment within credit that has received substantial interest due to its effectiveness as a duration hedge has been secured loans: a US$1.3trn market in the US and over US$400bn in Western Europe. These loans are secured, priority-ranking, floating-rate debt instruments offered by below-investment grade corporate issuers. A common financing tool in leveraged finance, they pay interest expressed as a margin over a base rate such as LIBOR.
The base rate is typically reset on a quarterly basis and therefore secured loans have an effective duration of three months. In the US, most loans carry LIBOR floors of anywhere from 0.75–1%, an important feature to enhance all-in yield. Furthermore, they are generally secured by the assets of the issuer and rank first in right of payment in the event of default or restructuring, resulting in recovery rates superior to unsecured high yield bonds.
Closely related to secured loans are senior secured bonds. They carry the same ranking in priority of payment as secured loans, except that they are bonds and pay fixed coupons and feature call protection. Both instruments are referred to as secured credit due to their secured and first-ranking status within the capital structure. As yields continue to fall, investors are discovering secured credit strategies can add diversification, mitigate duration risk and enhance overall yield for a fixed income portfolio.
**Think globally, outperform locally**
A major theme in leveraged finance is the increase in cross-border issuance and relative value opportunities between US and European secured credit. By expanding the investible universe to include both the US and Europe, a global manager with a deep understanding of both issuer pools and superior credit selection skills can construct a diversified, “best-ideas” portfolio and also take advantage of relative value differences between the two markets. Integrated global managers with on-the-ground local expertise have a distinct advantage over their US-centric or Euro-centric competitors.
Cross-border loan issuance refers to the same issuer placing debt in both the US (via a US dollar tranche) and European (via a euro tranche) markets. According to Standard & Poor’s, the volume of cross-border issuance reached €29bn in 2012 – approximately double the volume in 2010.
The trend of European companies issuing debt in the US is largely a consequence of the eurozone crisis. As the European markets endured bouts of volatility in 2010 and 2011, European issuers sought the relative stability, depth and certainty of execution in the US capital markets. It was also prudent for a European issuer to expand its investor base into the US so they were not solely reliant on the European markets for funding. In short, financing was cheaper and more certain. By contrast, the rationale for US companies to issue debt in Europe is driven more by their preference to have a natural hedge for euro-denominated cash flows.
Furthermore, there are relative value opportunities between the US and European markets arising from a variety of drivers including differences in liquidity, investor base, transparency (public versus private reporting and ratings), company fundamentals, default rates, insolvency regimes and divergent macroeconomic backdrops. From a macro perspective, the US has been, and continues to be, more stable compared to the eurozone.
Within the eurozone, there is a distinct North–South divide in terms of GDP growth and fiscal stability. After the financial crisis, US companies were able to repair their balance sheets and restructure their cost base at a faster pace than their European counterparts. The benefits of a uniform bankruptcy code (Chapter 11) allowed many over-indebted US companies to de-lever, rationalise fixed costs and reposition themselves competitively. By contrast, the broad spectrum of insolvency regimes in Europe, from the relatively straightforward Scheme of Arrangement in the UK to the highly complex Sauvegarde process in France, has resulted in a number of over-indebted European companies and their creditors choosing to delay the day of reckoning.
Private equity sponsors are dominant players and highly influential in the market given the vast majority of European loan issuance is leveraged buyout (LBO) related. In the US, LBOs account for roughly half of secured loan issuance.
The US loan market is larger, more liquid and has a deep institutional investor base compared to the smaller European market. As a result, the US market quickly recovered from the financial crisis as liquidity poured in from insurance companies, pension funds, loan funds, CLOs and hedge funds.
CLO issuance in the US has been particularly strong at US$55bn in 2012 with estimated issuance of $70bn in 2013 – making CLOs a principal source of demand for US loans. In contrast, the European loan market has been much slower to recover as a result of European banks retrenching due to stringent regulatory capital requirements, as well as the lack of new CLO formation. However, European CLO issuance has seen ‘green shoots’ in 2013. Given the divergent fund flows and technical drivers in the two markets, US issuers are taking advantage of the strong liquidity and actively re-pricing loan spreads lower, while European spreads have been stickier.
Going forward, one can expect Europe to become more attractive on a relative value basis due to technical drivers that favour European loan spreads remaining elevated. As the majority of pre-crisis European CLOs will be unable to invest by the end of 2013 and European banks continue to retrench from the market, loan spreads should be slower to compress relative to the US. Technicalities aside, the outlook for the recovery of the eurozone economy remains uncertain given ongoing fiscal imbalances and lack of sustained demand growth.
In addition, there is also the “Abenomics” effect: the unprecedented currency-driven support by the Bank of Japan for the country’s exporters may adversely impact the global competitive positioning of export-oriented European companies.
Despite these headwinds, there are plenty of well-managed, strong companies in Europe that are positioned to outperform as the economy stabilises. Ultimately, a successful global credit strategy will hinge on careful credit selection supported by a thorough analysis of the macro drivers as well as insolvency jurisdiction.
**Secured loans dressed as bonds**
Another key theme within leveraged finance has been the convergence between the high yield and loan markets. This trend is evidenced by the increasing prevalence of senior secured high yield bond issuance, especially for refinancing secured loans. This so-called “loan-to-bond” refinancing has been more pronounced in Europe, as European loan issuers seek to access the liquidity of the high yield market to refinance their upcoming loan maturities. According to J.P. Morgan data, secured bonds accounted for 45% of all European high yield issuance in 2012.
Senior secured bonds are generally pari passu, or rank equally in priority of payment, with the secured loans of the issuer. The principal differences between secured loans and their secured bond counterparts are threefold: covenant packages (maintenance covenants for loans; incurrence covenants for bonds), call structure (loans are callable anytime, while bonds have non-call periods and call premiums) and coupon (floating rate for loans, mostly fixed rate for bonds). Due to the stronger call protection, the bonds carry greater total return potential since their prices can trade well above par.
While the underlying credit risk is essentially identical, due to differences in market structures and technicals, the secured bonds and loans of the same company can trade at significantly different levels, thereby providing relative value opportunities. A robust secured credit strategy should have the flexibility for a manager to be able to play both the secured loan and bond markets in order to exploit these opportunities.
**Global secured credit**
Combining both US and European secured credit and adding the flexibility to exploit relative value opportunities versus senior secured bonds enables a dynamic global secured credit strategy. However, few managers have the integrated teams, global presence, local expertise and experience to deliver a successful product. So how does global secured credit stack up against the alternatives? It depends on which part of the fixed income spectrum one approaches it: with an all-in unlevered yield of 5–6%, global secured credit offers a compelling 425–475 basis point yield pick-up versus the Barclays Aggregate Index. Comparing it to the Bank of America Merrill Lynch US High Yield Index, the yield give-up to move from unsecured to the secured debt and shorten duration is minimal. Global secured credit offers a compelling blend of capital preservation, diversity, yield and short duration.
