It’s been a very long while since the leveraged loans team last did anything on the blog, so here’s an update of where we see the market.

The first thing to point out is that while high yield bonds have started the year with a 10% rally (perhaps making up for the lack of a ‘January effect’ last year!), loan returns have been broadly flat. For the past 18 months, the loans market has been dominated by technicals (ie forced selling) rather than fundamentals, although a clear sectoral bifurcation is emerging – the more cyclical, economically-sensitive areas such as industrials, building materials and chemicals have underperformed those such as cable, healthcare and telco. A credit is doubly favoured by the market if it also happens to be liquid, carries a high coupon and has a high rating. If it ticks all these boxes, then it is seen as attractive to structured credit buyers such as CLOs, and will generally be trading at a 20-point premium to the rest of the market.

Investors’ preference for earnings visibility is unsurprising given the number of credit shocks and other unforeseen outcomes over the last two months. It is unarguable that the long anticipated default cycle is starting, with the US in the vanguard. By value, 4.9% of the US loan market has defaulted in the last year, but the pace has accelerated sharply. In December and January, 3.2% of loans defaulted, the highest two-month period on record, beating the 3.1% posted in May-June 2002.

Thirteen European issuers (five in December, eight in January), representing approximately €9 billion of debt, have defaulted or gone into restructuring. Some were anticipated – UK homebuilder McCarthy & Stone, for instance, while others – eg Italian yacht maker, Ferretti – were more of a shock. German auto parts manufacturers have suffered particularly heavily as it appears that their balance sheets have been strained to breaking point by working capital outflows. So we expect that 2009 will see low levels of new business and high volumes of restructuring as the scarcity of credit and global economic slowdown feed on each other.

Two other trends are worthy of note. First, banks are clearly retreating from capital-intensive businesses like leveraged finance; second, in today’s volatile, non-par market place the practice of using leverage within structured vehicles is untenable. The vacuum from the traditional buyers of loans is being filled by allocations to credit from risk-tolerant, unleveraged investors with longer time horizons; anecdotal evidence suggests that the inflows we are seeing into loans are being replicated elsewhere in the fixed income world.

As always, for institutions looking to invest, the European loan market lacks transparency – there are few public ratings (the bank-dominated European market did not require them), information is generally non-public and insolvency regimes vary widely. But these concerns need to be balanced by the fact that average spreads to maturity are in excess of LIBOR plus 10%, which we believe overcompensate investors for the risks.

A number of clients have asked us about ‘covenant lite’ leveraged loans. Our view is that the financial press has in some cases been misleading investors regarding what cov-lite actually means, and we thought it would be helpful if we put together a detailed note that explores some of the issues surrounding cov-lite leveraged loans for readers who are interested in learning more. Click here to download our short note on covenant lite leveraged loans.

Over the past few weeks, equity markets have seen falls of around 6%, and while the high yield market correction hasn’t been as severe, the iTraxx index still widened from a spread of 179/180 on February 26th to a high of 235/238 on February 28th, before clawing back some of the losses. During these turbulent times, the secondary prices traded in the European leveraged loan market remained largely stable – “rock solid” and “business as usual” according to some commentators. How has the leveraged loan market managed to remain so stable in the face of growing risk aversion?

Much of this has to do with the way loans work. As secured floating rate instruments, they are largely uncorrelated with other mainstream financial assets, providing some insulation from instability in the equity and high yield bond markets.

That said, demand continues to be incredibly strong for the asset class at present, with a clear imbalance between supply and demand (Standard & Poor’s suggest there could be aggregated latent appetite of the order of €40bn stemming from European and US CLOs, other fund investors, prime funds and repayments). This imbalance is only likely to be exacerbated by jitters in other markets, with investors seeking what they might perceive to be a ‘safe haven’ in a period of uncertainty. These factors serve to reinforce some more negative features creeping into the market – including increasingly aggressive (leveraged) transactions, and most notably downward pressure on spreads that sponsors and arranging banks are prepared to pay.

It also shouldn’t be forgotten that we are talking about the debt of sub-investment grade companies; true, leveraged loans have had a recovery rate of 80% in the event of default, which is much higher than the 40% recovery rate seen in the high yield market, but senior loans are still rated B/BB and credit default risk is therefore very real. We are therefore continuing to be very selective in choosing which new loans coming to the market we should invest in. Quality is key, more so now than ever.

Jim has nagged me into finally making my maiden blog entry. Given his revamped M&G Global Macro Bond Fund has just taken a 14% position in European leveraged loans (see yesterday’s blog article), it’s actually a good time for me to give a brief introduction to the asset class and our thoughts on valuation and risk.

Leveraged loans have been an increasingly popular asset class for institutions and hedge funds over the past five years (in addition to the banks, who have been active participants for some time), and are gradually making their away into the retail space as the regulators become more familiar and comfortable with the asset class. Retail bond funds are now allowed to hold up to 10% of their assets in leveraged loans via something called a Collateralised Loan Obligation (CLO), which is a form of structured credit. Richard’s M&G Optimal Income Fund, for example, has a small position in an M&G-managed CLO, while Jim has bought the M&G European Loan Fund for his M&G Global Macro Bond Fund, thanks to his fund’s NURS structure.

So what exactly are leveraged loans? Leveraged loans are floating rate instruments that are issued by companies to finance corporate restructuring, such as leveraged buyouts (LBOs). After an LBO, private equity companies have to issue a large amount of debt to fund the transaction, and this is then placed on the target’s balance sheet. A relatively recent example was Malcolm Glazer’s takeover of Manchester United in 2005. Following the takeover, Manchester United approached a number of institutions in the City asking if they were interested in buying the loans. As it happened, we decided not to (and that’s not just because I’m a Leeds United fan). Other companies to have issued loans include Gala, the AA, Lego and United Biscuits.

Senior leveraged loans occupy the most senior position in the company’s capital structure, which means that if the company fails and defaults on its debts, then leveraged loan holders are first in the queue to recover their money. The average recovery rate for a senior loan holder has historically been around 80%, significantly higher than the 40% recovery rates that are typical for the average high yield corporate bond holder in event of default. Even though senior leveraged loans occupy the highest position in a company’s capital structure, though, they typically have a credit rating of double-B or single-B, which reflects the sub-investment grade equivalent rating that would apply to the borrowing companies. Typically a European loan might pay investors money market rates plus 2.25% (currently 7.85%) compared with around 7.50% for a high yield bond, so given the lower risk profile for loans, they currently look good value.

Another advantage of leveraged loans is that they are floating rate assets rather than fixed assets. In other words, the income paid from leveraged loans is a fixed basis point payment over a reference interest rate, and so the total income paid duly rises and falls in line with interest rates. Leveraged loans therefore have no duration (or interest rate risk) and are therefore particularly attractive in a rising rate environment.

The surge in LBO issuance over the past few years has inevitably resulted in the rapid growth of the European leveraged loan market. In addition, institutional investors have increasingly been able to gain access to the primary market for loans, and now represent 49% of the market, up from 40% in 2005 and 25% in 2004. Interestingly, we have seen US retail loan funds (known as ‘Prime Rate’ funds) enter the European market, as the US managers have increasingly recognised the relative value offered by European leveraged loans. Hedge funds have also become major players, attracted by the high yields, the floating rate feature and the exceptional risk/return characteristics the asset class has demonstrated.

One market development that we’re watching closely is the potential for rising risk within new leveraged loan deals, which has been possible due to the soaring demand for the asset class. Although encouragingly, while average debt/earnings was higher at the end of 2006 than a year earlier (with debt standing at 4.25 times earnings, compared with 4.01x in 2005), there was a gradual fall in leverage within transactions as the year progressed (4.23x at the end of Q4, down from 4.43x in the third quarter). Our analytical vigilance is as important now as it has ever been – but this is a very interesting asset class right now.