Pricing and terms for European loans are back to, if not through, their pre-pandemic ranges amid a sharp retraction in loan spreads during the first three months of the year. Given a similarly significant step back in CLO liabilities, these levels still make sense for investors, even if some caution that the depth of demand and market liquidity are increasingly eroding documentation and other protections.
The year's strong showing from Europe's loan market is a reversal from last year, when surging demand for bonds and equity left the product lagging. "Loans started the year about 100 bps over bond spreads, so there was bound to be a contraction," said one fund manager. Already this year the average bid on the S&P European Leveraged Loan Index (ELLI) has moved through its pre-pandemic 2020 high to touch levels last seen in November 2018. Total returns were running at 2.12% for the year by mid-March.
A rock-solid base of CLO buyers is underpinning the market. "The year started with huge pent-up demand from CLOs so there was a certain amount of catch-up in the early months," a fund manager said. This came on the back of a glut of CLO pricings in the closing months of 2020, with 22 vehicles printing in the fourth quarter — the highest quarterly number in the 2.0 era. Activity has continued apace this year, with 16 vehicles so far printing in the first quarter of 2021, as of March 18.
A move away from the chronic phase of the pandemic has also shifted the economic conversation this year. Specifically, the vast sums from central banks and stimulus programs have brought fears of an uptick of inflationary expectations, which in turn has led to volatility in equities and at the longer end of the bond yield curve. "Bonds are suffering from the duration effect and we think [as a house] that they will underperform for the rest of the year as Treasury yields rise," said one manager at a multi-strategy institution.
A floating product such as a loan offers a clear hedge against inflationary expectations, so should benefit from shifts in global asset allocations. And for sure, the U.S. has seen strong inflows from mutual funds all year that ran to a $7.5 billion net inflow in the year to March 11, according to Lipper data.
Europe does not benefit from retail flows and the market has been heavily CLO dominated this year, sources say. "There is a lot of talk of the global reflation trade and how this is boosting demand for loans," said one manager at a big-ticket global player. "And yes, we see this in the U.S. where the market tends to be purely yield driven, but we haven't seen such a large impact on Europe — though there has been some benefit from large global mandates," he added.
Even so, the weight of CLO demand has been more than enough to keep the European market tilted firmly in borrowers' favor this year. Net CLO issuance, for example, has been larger than net loan supply every month since June last year, apart from January. New loan issuance, however, has been more than respectable this year, with year-to-date institutional volume at €20.71 billion — a little behind where it was at this point last year. Moreover, even if final first-quarter volume does fall a little short of last year, the quarter will still have brought the second largest volume tally since the second quarter of 2018.
That said, a good deal of this supply has come through refinancings or recapitalizations, meaning the actual level of new money has not been as high as these volumes suggest. Indeed, some of the year's most eagerly awaited new deals have disappointed in terms of actual paper delivered. The Issa brothers' and TDR's carve-out of British supermarket group ASDA Group Ltd., for example, only brought an €840 million term loan, with the buyers relying on sterling high yield to do most of the heavy lifting for its £3.5 billion-equivalent drawn debt requirement.
Some deals even brought a net repayment. SCM Biogroup-LCD, for example, reduced its reliance on loans with its €2.5 billion debt refinancing after the French labs group folded in roughly €1 billion of secured and unsecured bonds into its debt stack. "A good deal of new supply has been opportunistic and managers have little choice but to roll in most cases," said one account. "The market has yet to be truly tested with a game-changing, single-B new money deal," he added.
This has all kept conditions tight and sent average pricing on loans back to levels seen before the pandemic hit. Spreads for a decent B/B2 credit are in a firm E+350 area, with B-/B3 and trickier credit stories moving to E+375-400 and beyond. So far there has been resistance to push margins for B flat names beyond this level, despite some attempts. Sources say, for example, that lead banks floated an E+325 margin on the €765 million term loan backing PAI's buyout of Apleona GmbH but found little support. A repricing of a June 2026 term loan from B/B2/B rated company April SA did hit a ratchet-linked E+325 margin, though the loan has since encountered little support in secondary and has dipped below the reoffer.
But CLO managers admit that these pricing levels still work, even they are a little tight. Triple-A spreads on CLOs have fallen from a low of around 105 bps in December to a low of 77 bps in March, leaving the average WACC at roughly 168 bps, from 192 bps. This in turn suggests an average margin requirement of roughly E+370 once the typical 200 bps arbitrage need is factored in. "A vehicle ramped at E+350 is not going to work, but there are still higher yielding opportunities on offer," said one manager. "It all comes down to credit selection," he added. Another manager agreed. "The arbitrage is pretty tight but it's been a lot worse," he said.
The headline margin is, however, only part of the story, and lenders note that borrowers have been able to take advantage of the rush for loans to push through increasingly punchy terms away from just price. "Demand is so broad based from CLOs and banks that no individual ticket is going to be big enough to strip out an unliked clause or term," said one manager. These moves have reversed much of the gains of the past year around documentation, which most now agree is as loose as it has ever been. Some managers admit they no longer even bother to push back on many highly aggressive terms given there is now only a limited chance of revision.
Margin ratchets, for example, have become increasingly generous this year, now sometimes kicking in at close to opening leverage levels once the initial holiday is over. "The spread works at today's levels but a lot of issuance features an effective repricing mechanism that could leave the market looking less compelling in six months when compared with high yield," said one manager who pointed out that call protection means bond investors benefit from capital appreciation even when yields are tight.
These are perhaps minor quibbles against a market that some are comparing to 2017, when both demand and supply sides were moving in complementary directions. Moreover, despite the difficulty in standing against the force of demand, lenders did this week notch one win, when Belgium-based technology group team.blue agreed to amend the margin ratchet on its first-lien loan from three to two steps at larger leverage intervals, with a holiday extended from six to 12 months.