ELLI’s launch reflects the recent high growth in the European institutional loan market. At the end of 2004, outstanding European institutional loans stood at €24 billion, up from €18 billion at year-end 2003 and from €14 billion at year-end 2002. Over the same time period, the number of institutional investors involved in the market has also grown dramatically. At year-end 2004, there were 23 active fund managers in the market, compared to just three five years ago.
The introduction of an impartial and independent index series – such as ELLI – represents another important step forward in the European leveraged loan market’s development. The rationale for the introduction of theses indices is to facilitate comparative risk analysis between various asset classes – for example, comparing commercial loans with high-yield bonds – to demonstrate the attractiveness of the asset class. The information provided will support new participants and their fund advisers when making their asset allocation decisions. As the ELLI indices become more established, and as the transparency of the underlying market improves, they will provide an increasingly valuable performance benchmark for the European institutional investment community.
The launch of ELLI builds on the experience of the similarly constructed S&P/LSTA Leverage Loan Index (LLI) launched in the US in 2000. However, the market environment that ELLI finds in Europe is very different from that facing the LLI when it was launched.
The LLI was introduced at a time when the US leveraged market already had evolved from a traditional bank driven lending market to one dominated by various investor types – principally structured CLO vehicles and loan participation mutual (or “prime”) funds. Various key developments played their part. Significant steps had been taken to improve the market infrastructure, with guidance from the Loan Syndication and Trading Association (LSTA), including the introduction of standard form documents and streamlined settlement procedures, the institutionalization of loan and recovery ratings and the collation and distribution of dealers’ price sheets. Information relating to individual credits became more public and its transmission more efficient. During the mid-to-late 1990’s these enhancements supported a surge in activity in the secondary loan market. Between 1991 and 1998 secondary loan trading volume increased by almost 10x – a result driven largely by the leveraged loan market. As a result pricing began to respond more quickly to changes in borrower credit quality, dealer marks increasingly reflected shorter-term business prospects – especially for companies subject to deteriorating credit conditions.
This improved market architecture facilitated a major switch in the underlying lender base triggered by the fallout in the credit markets in 1998 following Russia’s default and the near collapse of Long Term Credit Management. Specifically, many pro-rata banks in the US, having adopted modern portfolio risk management techniques, withdrew from the business dissatisfied with the risk/return profile. Institutional investors, working off different risk return parameters, capitalized on the opportunity and stepped in to take up the slack.
In sharp contrast the European market remains dominated by banks with a growing – though still small – institutional segment, similar to where the US market stood a decade ago. In Europe, investment decisions are driven more by credit and a decision to make a long-term commitment to the borrower. If a credit is acceptable, spreads rarely differ, despite differences in industry sector, size or rating with the inevitable result – particularly with the amount of available debt finance in the current market environment – of high levels of oversubscriptions and scale backs. The focus on the primary market, and the buy and hold traditional style of the banks and collateral managers, has significantly restricted the secondary market’s development.
Nevertheless, while the European market is tiny in comparison to the size of the institutional market in the US (which in 2004 had over $140 billion in institutional issuance and approximately 160 institutional investors) the growth rates for these two pools have followed very similar patterns. Chart 1 shows how the volume of institutional issuance and institutional investors in the US and Europe multiplied year-on-year from a base rate set in a base year – 1997 in the US and 1999 in Europe.
In 1997, the US had approximately $28 billion in institutional issuance (against total leveraged issuance of $220 billion) and non-banks took approximately 40% of the primary market – already a 33% increase over the previous two years. In 2004, seven years later, the institutional issuance had quadrupled in the US and the institutional investor share of the primary market had nearly doubled.
In 1999 – the base year for the European market growth line – institutional issuance was €3.8 billion with non-banks taking slightly less than 12% of the primary market. Five years later, non-banks took more than double that share of the primary market and institutional issuance has grown six fold to over €20 billion.
While strong regional banks will continue to support the European leveraged loan market for many years to come, most participants expect the growth and development of the European market to be driven by the non-bank segment. Indeed, even in the last year the pace of change has picked up sharply. For one thing, the compression of loan spreads in the US has highlighted the relatively attractive levels in Europe that now exceed those in the US by a wide margin. Unsurprisingly many US firms are targeting the European leveraged market in search of greater returns, including insurance companies, hedge funds and LP’s. Also institutional fund managers are setting up new types of levered and unlevered investment vehicles that are more flexible than the Collateralized Loan Obligation (CLO) structures that have dominated the institutional market in Europe hitherto.
Hedge funds have begun to make their presence felt, most prominently in the nascent subordinated second lien market. But they have also become active in the senior term loan market attracted by the high floating rate spreads, the seniority of the instrument and the benefits of low price volatility in a rising interest rate environment. Also living up to their name, they have been building arbitrage positions in anticipation of a market setback by aggressively bidding for senior debt while simultaneously buying protection through credit derivatives on a high yield bond issued by the same entity.
New Investors Need Liquidity
A key benefit of the growing diversity of participants in the European loan market is the greater liquidity that they should generate in the secondary loan market – an important development if funds and investors are to adopt a more active investment style. Increased liquidity in the secondary market would encourage a move away from the buy-and-hold mindset that currently presides in Europe. Pricing would become more responsive to current credit quality changes and market value returns would become a key driver for performance. Ironically while the European market adheres to the typical buy-and-hold approach, relying on returns generated from interest accrual alone and the lack of price volatility that this entails, this can only exacerbate the supply and demand imbalances that are a feature of the market today.
The European market does pick up some volatility and performance potential over the US market, however, with respect to its multi-currency composition. Currently the broad ELLI index is unhedged, making the real-time effect of currency fluctuations part of the multi-currency return. This multi-currency ELLI incorporates Sterling and US dollar facilities in addition to its predominantly Euro denominated credits. In 2003, those currencies underperformed the Euro, resulting in a negative drag of 1.66% and a total return of 3.21%. Through December 2004, the market value and interest components of the multi-currency index provided a return of 5.88% – 89% of which was interest return and 11% being market-value return. However, the non-Euro segments, representing around 17% of the multi-currency index, continued to underperform the Euro and erased 44 basis points, or about 8%, to that return to bring the total return to 5.44%. S&P also provides a Euro-denominated index in order to present returns without the effect of currency.
However, the underlying price volatility of the European loan market is minimal compared to the US market. For example as of the end 2004, the average bid in ELLI was 100.07 with a standard deviation of only 1.17 points. In the US performing index, which excludes the most volatile credits (those in default) the average bid is not far adrift at 98.07 but the standard deviation is 15.1. Consequently over the two-year history of ELLI market value returns represented only 9% of total returns in Europe compared to 41% in the US.
Furthermore, in contrast to the US, in Europe there is no differentiation in pricing to reflect fundamental differences in credit quality. To illustrate the point, as highlighted in Chart 2, at the end of 2004 BB/BB- institutional loans cleared the US market at an average of Libor plus 196 basis points, compared to Libor plus 255 basis points for B+/B loans. Looking back to 1998, the new-issue spread of BB/BB- loans was, on average, 65 basis points inside B+/B loans. Yet such consistent differentiation is not found in Europe. Over the six months ending December 2004, the average spread at which BB/BB- institutional loans cleared the European market was Libor plus 297 basis points: virtually the same as B+/B rated loans.
This lack of differentiation has been a feature of the European market for as long as ratings have been available. The reason is clear. Nearly every leveraged loan in Europe, regardless of size and rating, is priced at Libor plus 225 basis points on the revolver and term loan A (seven year), Libor plus 275 basis points on the B (eight year) and Libor plus 325 points on the C (nine year). This resembles the late-1980s and early-1990s in the US, when Libor plus 250 basis points was an unassailable standard for LBO loans.
There are encouraging signs that the European market is responding to the growing demands of the investor community to reform. Recent deals have begun to be structured to enable greater flexibility in pricing by incorporating reverse flex language into the senior loan agreements, and the occasional transaction has been priced at below normal market levels. ELLI’s role is to provide greater transparency and foster greater investor participation in the market. In large part ELLI’s success will be judged by the degree to which the European leveraged loan market embraces the disciplines of a relative value trading culture that is the hallmark of highly developed and efficient financial markets.
Paul Watters is Head of Standard & Poor’s European Loan Ratings. Paul joined Standard & Poor’s in January 2002 and has been responsible for rolling out the new Recovery Ratings scale for secured debt in Europe. Prior to 2002 Paul spent almost fifteen years working in debt capital markets in senior trading and research roles with both Lehman Brothers and Nomura International. Paul read Economics at St. Catherine’s College, Cambridge and is CFA charterholder.
Ruth Yang is a Director for Standard & Poor’s Leveraged Commentary & Data (LCD). She is responsible for services to the European market, including ELLI. Ruth originally joined the group in 2000 when it was still Portfolio Management & Data, LLC. At that time she focused on loan recovery analysis and research, as well as the S&P/LSTA LLI – ELLI’s US counterpart. In 2002 she moved to the Loan Syndications & Trading Association as the Director of Market Data. She returned to LCD in 2004. Ms.Yang studied at Harvard University and completed graduate studies at the University of Colorado, Boulder.