Returns on the S&P European Leveraged Loan Index turned positive for the year as secondary markets surged last week amid optimism over progress toward a coronavirus vaccine.
The overall return, excluding currency, at 0.46% in the year to Nov. 9, 2020, is minor when compared with the 4.50% return in 2019 but remarkable given the year's events, which left markets at post-Lehman lows just eight months ago — negative 18.97% for the year-to-date on March 24. "The performance of European loans has far outstripped expectations at the start of this crisis and underscores the overall resilience of the product," said one manager.
Indeed, from a yearly low of 78.92 on March 24, the average bid on the European All Loans Index pushed past its COVID-era highs this week to reach 96.31 by the close on Nov. 13. This puts it less than 2.5 points from its 2020 high of 98.66 at the end of January, when COVID was seen as an Asian rather than a Western problem. "I don't think anyone would have believed you if you had told them in March that you would now be able to sell the market at just a four-point discount," said one account.
This performance also compares well with European equities, where major indices remain below their pre-COVID-19 highs. The comparison between European loans and U.S. equities is not so flattering, however, with U.S. equities at or above yearly highs, boosted by the outperformance of technology stocks through the crisis. In the credit world, loans have largely held their own against high yield, with performance year-to-date of both products largely similar, when looking at the value of €1,000 invested in January.
However, loans have been in the shadow of high yield since the recovery got underway in late spring. This is because high yield has been the direct beneficiary of central bank action and a rates rally that supported double-B names in particular. In loans too, the market's smaller cohort of double-B names have outperformed both single-B credits and the wider index.
In research published on Nov. 9 by Credit Suisse, analysts led by Josh Farber further pointed out that if high yield were reweighted to give the ratings composition of European loans, there is a clear outperformance from the latter. "The essentially reasonable fundamentals in the loans world, and the frankly unappealing risk/reward in single-B HY, have driven this performance wedge in our view," the analysts said in the report.
But what are the reasons for the revival of a market that looked heavily bombed-out just a few months ago? For sure, the extraordinary action from central banks has been invaluable, as has government support. "It never makes sense to bet against central banks, let alone the full force of central banks and central governments," said one manager at a global firm. In particular, the swift action from governments across Europe helped provide the necessary liquidity for many names to ride out the storm.
Markets too stepped up to deliver liquidity lines on either a syndicated or bespoke basis, while sponsors have supported their holdings with debt and equity in several cases. The impact of new liquidity on secondary prices has sometimes been spectacular, and prices on European cinema group Vue Entertainment Ltd.'s term loan have spiked by about 12 points since it disclosed in early November that it had secured a £93.4 million pari-passu liquidity line. Managers also point out that companies and private equity sponsors moved quickly to adjust costs. "Many of our holdings have bigger EBITDA margins now than they did going into this crisis," said one manager. "The question is, can this be sustained?"
This in turn has left default rates lower than many had feared — in Europe at least — at the start of the pandemic. That said, those rates are still up significantly, and LCD shows that the 12-month lagging default rate in Europe, based on issuer count in the ELLI, increased to 4.84% at the end of October, from 4.61% in September and 3.63% in the two months prior to that. "Defaults are well below the 8% or so some predicted back in March, but the economic impact of COVID is not over, and rates may stay at these higher levels for years to come," said one manager, noting that many names will leave this crisis with a significantly heavier debt burden than at the start.
For sure, there are clear signs of the long-term scarring from the pandemic. The share of facilities rated triple-C or below in the European Leveraged Loan Index, or ELLI, for example, rose to 7.74% in October from 2.68% at the end of October 2019. Again, this has not been as disruptive as projected, as secondary strength has allowed managers to exit distressed situations at some reasonable levels. Take Comexposium SA: Managers were exiting the name in the low 70s even after the French conference organizer filed for safeguarding protection in the French court and so stopped paying interest on its debt.
Last week's secondary jump has taken the gap between discounted COVID-19-battered credits and those more immune to the effects of the pandemic significantly closer still. These names were the primary beneficiary of this week's rally, with several in sectors such as cinemas, theme parks, hotels and aerospace surging by 5 to 10 points — or even more in some cases. "The moves have been extraordinary," said one manager. They also helped deliver the largest single-day percentage return in the ELLI since April.
Nonetheless, not everyone is quite ready to throw caution to the wind. "There is real buying going on but we are not about to change fundamentally the make-up of the portfolio," said one London-based manager. Others said they may take advantage of the strength from "the vaccine frenzy" to trade out of some COVID-19-exposed names, warning that the logistics of deploying a vaccine let alone the longer-term economic impact meant that this crisis was far from over.
But the ELLI's move into positive territory this week is undoubtedly a milestone and could be the start of a tightening ahead of year-end, accounts predict. Loans are without doubt technically well supported, with one manager this week estimating there are about 36 open collateralized loan obligation warehouses in Europe, of which about 12-14 are post-pandemic-onset vehicles. This is still short of the 50 or so that were open before the pandemic, and most agree inflows now are much lower from non-CLO money. On the other side, however, after a pre-election clear-out, primary is expected to remain relatively light until the new year, meaning there should be more than enough liquidity to push the market further in the run-up to Christmas.