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How Will the Vote for Brexit Continue to Affect the European Leveraged Finance Market?

A t S&P Global Ratings' annual leveraged finance conference on July 7, 2016, in London, participants discussed key developments influencing the European leveraged loan and bond markets, and presented their views on trends following the U.K. electorate's majority vote to leave the EU (Brexit).

The economic backdrop to this year's conference was particularly unusual, including negative interest rates and bond yields in major developed economies and increasing political uncertainty in Europe. Here, we review the highlights and present frequently asked questions from investors and others present at the conference.

Frequently Asked Questions

How has the European leveraged finance market dealt with the outcome of the Brexit referendum?
Although overall deal volumes are down on 2015 amid ongoing political and economic uncertainty, the effect of vote hasn't been immediately catastrophic. The average bid on leveraged loans slipped following the leave result, but it has recovered remarkably in July. As of end-July, it was 35 bps above par and perched at a 12-month high. Similarly, yield compressions observed in the high-yield secondary bond market during July has been noteworthy. The yield curve for high-yield nonfinancial firms in Europe has drifted below the pre-referendum levels.

Issuance in the leveraged loan primary markets halted immediately following the referendum, and although activity in the loan market has resumed, panelists at the conference said that volumes are unlikely to match levels in 2015, given the prevailing uncertainty in the markets. They also speculated that the structuring of new collateralized loan obligations (CLOs) could be slow, but on account of the changing nature of the market, rather than the fallout of the Brexit vote. Since the conference, however, the market has seen six new CLOs priced, showing the resilience of this asset class after the Brexit vote, contrary to initial expectations.

What is the expected longer-term impact of the Brexit vote on the European leveraged finance market?
The panelists were unanimous that they do not expect the outcome of the Brexit referendum to have a prolonged influence on pricing and issuance volumes in the European leveraged finance market. Moreover, the chances of financial stress and defaults seem fairly minimal, as conditions in the loan market remain borrower-friendly, while historical evidence shows that CLO defaults in Europe are a rare occurrence. However, the panelists expressed the following longer-term concerns:

  • The expected slowdown in the U.K.'s economic growth in the coming years owing to the anticipation of Brexit will pinch consumer-facing sectors in the U.K. and Europe.
  • New deal structures could emerge for both loans and CLOs. Signs of this emerged briefly before the Brexit referendum, as banks introduced clauses to change agreed pricing (through "flex" language) on transactions if the U.K. electorate voted to leave the EU. Although loan structures are unlikely to change substantially in the run-up to Brexit.
  • For CLOs, it is not clear how the existing European risk-retention framework for sponsors would affect U.K.-based CLO managers following the potential changes to European financial passporting rules after the U.K. officially leaves the EU. However, the majority of the panelists indicated that, although these regulatory and legal changes could prove challenging, there is resounding confidence among portfolio managers that they can design new deal structures to address these changes without major disruption.
  • Sterling-denominated loans and bonds could become even more illiquid, since historically, liquidity in these instruments has been low.

How have the leveraged loan and high-yield bond markets performed during the first half of 2016?
Speakers were of the view that the markets offered a wide range of investment opportunities in terms of quality and risk reward prior to the Brexit referendum in June 2016. According to data from LCD, an offering of S&P Global Market Intelligence, the pricing of the institutional tranches of speculative-grade loans in the first half of 2016 reflected the variation in credit quality, with yield to maturities (YTM) ranging from 3.85% to 7.36%, for more difficult credits. One participant stated that although volumes in the leveraged loan market have dropped since 2015, the most pleasing development of 2016 was that new issuers have been tapping the market, and not just to refinance existing debt. This is in contrast to 2014, when issuance was primarily driven by refinancing activity.

Speakers also noted that recent covenants have been borrower-friendly, as investors have been competing aggressively for new deals due to muted activity in the primary markets. Even in deals where covenants have been altered in investors' favor during the marketing stage, the final agreement may still seem borrower-friendly on a historical basis.

How are CLOs adapting to the changing market dynamics following the volatility in the leveraged markets in February and June 2016?
CLO market participants are becoming increasingly cautious and actively trying to minimize mark-to-market loss triggers, which can arise when managing the deal structuring process in the face of market volatility as a drop in the price for assets can trip certain market value triggers embedded in the arrangement or "warehouse" agreements. At the same time, demand from investors in CLOs remains healthy, making it easier to arrange financing for the CLO. CLO managers have managed to gain investors' confidence by handling their portfolios efficiently during the recent bouts of market volatility. However, panelists agreed that CLO ramp-up periods are likely to last longer than in 2015, as short primary market supply could make it harder to find assets for portfolios.

The U.S. continues to offer greater diversification for investors than the European markets. European CLOs typically offer access to 70-120 credits, compared with 120-150 credits in the U.S. markets. Consequently, there is a greater overlap of company exposure among European managers of CLOs. Managers of European CLOs agree that more cross-border deals and greater understanding of the relative value of loans and bonds in portfolio construction can help achieve greater diversification in Europe.

How have direct lenders' relationships with the banks changed over the past few years, and how are they finding a competitive advantage as more lenders enter the market?
Some funds involved in direct lending that used banks a few years ago to facilitate larger transactions and keep funding costs down no longer need to do this as they now have larger assets under management. Although the relationships between funds and banks are now less formal, funds generally still partner with them. In fact, they are more likely to partner with a variety of banks, instead of having a formal partnership with one bank specifically. As more pension funds and insurance companies have been actively investing in direct lending funds, competition for investment opportunities has increased and there are now 50-60 funds looking for assets, as opposed to a handful in 2012.

In the context of a tougher bank lending environment, borrowers appreciate being able to work with one or two funds and are more certain of closing the deal. However, direct lending funds are still building a track record and remain realistic and cautious about how they invest, with one direct lending fund asserting that they avoid deals if the only competitive advantage would be to structure it more aggressively from a credit perspective. The direct lending investors explained that their origination teams stay with deals from structuring to repayment and generally achieve better recovery rates than banks.

How are the European leveraged finance markets likely to evolve during the coming months?
Issuance volumes in the leveraged finance markets will be slightly lower than last year. In the run-up to Brexit, a drop in leveraged buyouts (LBOs) is likely in the U.K., and, as U.K. transactions constitute a large part of the European LBO market, this drop is likely to reduce leveraged loan issuance.

However, trends since the 2008 financial crisis show that the leveraged loan market is fairly resilient to shocks. The ongoing monetary easing measures by the European Central Bank and the prospect of the Bank of England lowering its base rate are likely to boost market activity.

The European leveraged finance loan and bond markets will remain favorable for borrowers, as reduced primary market supply, coupled with investors' quest for yield, will encourage more high-profile buyers to tap both markets. European pension funds and insurance companies have been actively buying leveraged debt, as shrinking yields in all debt markets--particularly for sovereign bonds--has led to investors seeking alternative ways of generating greater returns. Japanese investors have also been actively participating in the European leveraged loan and bond markets for the same reason, which participants expected would continue.