European leveraged loan pricing has declined faster than most expected so far this year, and the tightening cycle may have further to run. For arbitrage investors such as CLOs this is not yet a problem though, as they too have enjoyed a similarly sharp decline in their liability costs as global risk assets continue to rally.
Indeed, the European loan market has put in a close-to-flawless performance so far in 2021. The year has yet to see an upward revision in pricing of any loan during syndication, while 68% of all deals launched have reverse-flexed through tighter margins or offer prices. Furthermore, this tightening has come in a year that has brought more-than-respectable volumes. Total issuance in January, for example, at €11.3 billion delivered the largest monthly total for the European loan market since January 2020. “We’re in a take-or-leave-it market,” summed up one account. “In basic terms, there is just too much cash chasing too few deals.”
The downward flex magnitude for January's leveraged loans stood at an average of 39.8 basis points, taken across spread and OID flex amounts — which is the highest reading for this measure since September 2018, according to LCD.
For the typical trouble-free, single-B-flat rated European leveraged loan, this dynamic has taken margins from a rough E+400-425 area at the end of last year to E+350, often offered at par. This level is reserved for those credits in the mid-part of the B rating segment, and still leaves B-/B3 rated or more storied names pricing wider. Overall, the average spread on single-B rated term loan Bs settled at E+392.4 for a yield of 4.16% for the three months ended Jan. 21, according to LCD. This level is in from E+411.7 and 4.44% at the end of 2020, and from E+442.2 and 4.95% at the end of the third quarter.
What's more, the market could have further to go, agree sources. “It’s hard to call if yields will continue to fall,” said one manager. “We have tried to draw a line in the sand on some deals, but there is more than enough liquidity to support pricing at this level,” he added.
The European secondary market has been a one-way bet this year, and the average bid on the S&P European Leveraged Loan Index, or ELLI, is now only a touch away from its 2020 pre-lockdown high, at 98.58 as of the close on Feb. 17. And while few new deals are running too far away from their reoffer in secondary, even sharp primary pricing cuts are no barrier to par-plus quotes. The new, Ba2/BB- rated E+275 term loan from ASDA Group Ltd., for example, is quoted in a rough 100.500/100.875 market, from par reoffer last week. “It’s not necessarily worth arguing about 25 bps on the margin as the market is giving capital appreciation of a half-point or so gain on the break,” said one manager.
For the moment, however, the E+350 margin level is holding as a barrier that single B-flat names are struggling to cross. So far this year, only B+/B2 rated AlixPartners LLP has breached this benchmark, after the borrower closed the €344 million portion of its cross-border recapitalization at E+325 with a 0% floor at the end of January. Alix is a borrower that can command premium terms and since then, investor sources say, arrangers have attempted to push other names toward this level but have so far been unsuccessful.
The strength of market liquidity suggests that it may only be a matter of time before Alix's benchmark is matched, however. On the supply side, the market is set to slow from its recent pace following the closing of banner M&A deals from borrowers such as Asda and Apleona GmbH. “The new-issuance calendar is not as full as we would like at this point, so we can expect repricings and refinancings to step in,” said one manager. Just this week, for example, Solenis International LLC went out with a repricing to its €783 million term loan that seeks to trim the firm's E+425 with a 0.5% floor margin costs to E+400-425 with a 0% floor.
More importantly still, managers of CLOs — the predominant investor segment in leveraged loans — admit that a similarly dramatic fall in their liabilities means that such loan pricing still works for their arbitrage calculations. These falls in liabilities also show little sign of slowing, and triple-A spreads ground tighter still this week with the 80 bps print achieved for Permira's Providus CLO V. This compares with spreads of 83 bps on the previous two CLOs to price in Europe, which — along with KKR at the start of February — matched pre-pandemic levels.
This action takes the weighted average cost of capital (WACC) for new European CLOs into the 160 bps region, which together with the typical 200 bps average spread vehicles need to provide the necessary return for their equity investors, means the arbitrage for new deals still works for CLO managers. Of course, these sums become more challenging for a portfolio ramped at E+350 only, but the market is also offering opportunities into the 4%-yield area for more complicated stories from borrowers such as Klöckner Pentaplast GmbH and CDK International.
That all said, CLO managers admit that a further fall in spreads could cause them problems, and force them to consider creative measures around such things as fees. “There comes a point that the market will not go past, but we're not there yet,” summed up one manager.
Loans do not operate in a vacuum, and the tightening in the asset class is part of the global rally in all risk assets. In this way, managers note that a 3.5% return for single-B credit risk in euros may be well inside what was on offer last year, but that it still holds up against returns available in other assets. “In absolute terms yields are being pushed, but on a relative basis loans still look attractive,” said one manager. (See "Relative pricing in spotlight for European high-yield bonds and leveraged loans").
Even so, this situation is not leading to a sudden rush of new money into the European market from non-CLO funds, say sources, who do nevertheless report a step up in interest from investors such as Asian banks and SMAs. The market is also said to be benefiting from a shift in allocation from multi-asset strategies which are starting to move away from duration into loans amid a pick-up in long-term rates. “This is a clear change from last year,” comments one manager, though others caution that the point should not be overstated, given recent high-yield new issuance has found notably stronger demand at the longer end in terms of duration.
New European fund flows are also modest when compared with inflows in the U.S. this year, as retail funds return to loans amid rising inflation expectations. According to Lipper data, net inflows to U.S. loan funds totaled $5.1 billion for the year-to-date to Feb. 11, leaving total assets at these funds at $52.8 billion.
But still, this backdrop leaves conditions for European borrowers at their most favorable since the start of 2018. What's more, borrowers are not just benefiting from tighter headline pricing, but also looser terms around documentation that are reversing some of the gains won by investors over the past year. “Frankly I wonder what is left for the lawyers to come up with,” said one manager. Investors add that attempts to trade off headline pricing cuts with improvements around areas such as margin ratchets and holidays have only been partly successful this year, meaning that even the tightest-priced deal may soon be paying a lower spread.