In the final part of this short blog series, we look at how to approach cov-lite lending in Europe. Covenant-light, or ‘cov-lite’, lending is now the norm in both the US and Europe, but there are as yet few tests of the difference that may be felt in times of stress. Well-established lenders nevertheless understand that they need to exercise caution when evaluating each loan opportunity to ensure they are getting paid for the risks, including when the cycle turns.
Getting paid for the risks
Lenders need to ensure that the expected return of each loan sufficiently compensates them for the risks being undertaken.
Applying a rigorous research and analysis process to loan transactions, whether the loan has a full covenant package or not, can help to identify and mitigate potential risks before investing or indeed result in a decision to decline an investment. Investors are becoming more aware of the potential consequences of overlooking certain terms in documentation and need to ensure ‘loopholes’ are not placed in legal terms without knowledge.
Selectivity on which loans make it into a portfolio is very important – experienced, well-resourced lenders can provide investors with exposure to large, stable businesses, while also bringing diversification and liquidity benefits to a loan portfolio and a lower level of defaults compared to the overall market.
Looking at the default premia comparison of European leveraged loans and high yield bonds, we find that the loss-adjusted spread of loans is superior to high yield bonds, owing to higher loan recoveries, as the security position of loans protects the downside better than bonds. These outcomes, which are based on stressing both asset classes for the average and best defaults of the last decade, assume that this differential between loans and bonds can persist.
European loan and high yield bond spreads and default spread premia (%)
Source: M&G, BofA Merrill Lynch High Yield (HPIC) OAS and Credit Suisse W. European Lev Loan Index 4-year DM at 31 July 2018, S&P, Moody’s default data for loans and bonds 2008-2017, Estimated recovery rate 40% bonds, 70% loans based on data from S&P, Moody’s and M&G.
Merits of being private-side
Europe is a relationship-driven market and therefore requires extensive, dedicated resources for successful long-term investing. Having well-established and stable relationships with key market stakeholders (such as private equity sponsors, issuers and banks) can give loan managers unrivalled access to assets and create an ability to be selective.
The onus is on lenders to perform the necessary due diligence of an investment opportunity as part of a robust credit process. This is best done by going private, in our view, as the chances of insulating future returns for investors and minimising default risk are highest. Lenders receive private information from issuers on a regular basis (formally and/or informally) through the life of the investment, often outside of the regular reporting cycle, which can help to flag any performance issues early on. So, even without covenants to offer contractual protection, there is still time for lenders to exit if they feel uncomfortable about the borrower’s ability to service the debt it owes.
For large-cap loans, there is a decently-liquid two-way secondary market, with turnover of 30-40% per annum, according to Thomson Reuters and Loan Market Association statistics.
In the case that an investment does not perform as expected, having restructuring resources on hand can help to protect value. This is typically achieved by keeping the company as a going concern and, potentially, becoming an active shareholder for a period. At M&G, we are able to draw on the expertise of our in-house workout team, that incorporates legal and restructuring specialists, who can negotiate on M&G’s behalf to seek the best possible recoveries.
Assuming that a loan manager is alive to the robustness of the borrower’s credit profile and the inherent protections of seniority and security – and assuming efforts to push for excessive documentation flexibility can be successfully resisted or declined – there remains a strong rationale to invest in this relatively stable, high income-generating part of fixed income, despite the late-cycle position of developed markets.
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The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested.