The European leveraged loan market is probably the clearest example of a market that has not yet found its post-August 2007 equilibrium five years after the start of the crisis, according to Fitch Ratings.
The credit ratings agency (CRA) said that Europe’s banks and collateralised loan obligations (CLOs) face another funding cliff in 2014, when both the long-term refinancing operation (LTRO) and CLO reinvestment periods are scheduled to expire. Market participants need to accelerate efforts to attract new sources of capital to the speculative-grade loan market.
Nevertheless, pre-2007 CLOs can still reinvest; and this money, together with cheap funding from European Central Bank (ECB) LTRO facilities, allows surviving CLO managers and regional banks to continue to support secondary market pricing and the modest primary market averaging €50bn per year.
Various central bank schemes that have continued cheap financing, the largest of which is the ECB’s LTRO, have reduced the urgency for reform towards cross-border pan-European capital markets for speculative-grade corporates. The original intention was for capital market funding to replace LTRO funding of European banks by the time the facility expires in 2014. However, 80% of the market participants in Fitch’s last European investor survey expect another LTRO. This would save some leveraged borrowers from default, but would further delay a long-term solution.
The CRA notes that before the crisis, leveraged loan demand in Europe and the US was fuelled by cheap lending from CLOs and regional banks. On 9 August 2007 that came to a grinding halt: BNP Paribas Asset Management temporarily stopped redemptions on three funds invested in structured credit commercial paper because it could not value the assets nor find buyers at acceptable prices.
True market funding has not come back for leveraged borrowers, and primary market volumes continue to fall, even though the CLO model has continued to perform, with no defaults to date on Fitch-rated European CLO liabilities. The collapse of cheap, short-term funding from structured investment vehicles and asset-backed commercial paper conduits triggered a sustained rise in European bank credit default swaps and a corresponding fall in secondary market prices for most credit products, including European CLO liabilities and leveraged loans. Europe’s inter-bank funding-dependent banks turned to central banks for financing, setting the Bundesbank’s claims within the TARGET2 interbank payments system among eurosystem central banks off on their climb to the present €750bn.
The different responses in the European and US markets to the collapse of the elaborate non-bank carry trade since 9 August 2007 have been marked in terms of banking system support and developing unlevered capital market alternatives for most credit asset classes; mainly through CLOs, unleveraged leveraged loans funds and a deep, liquid high-yield bond market. There has not been one primary market CLO transaction in Europe since that date. Alternative loan funds have been slow to develop, not least because they must compete for assets against cheap-funded legacy CLOs and LTRO-funded regional banks. Although the European high-yield bond market may exceed €50bn for the first time this year, it remains focused on large, liquid bb-rated issuers, and demands high spread premiums for refinancing legacy leveraged buyouts (LBOs).
By contrast, the US leveraged loan market has had a much better recovery, with both the CLO and unleveraged investors returning to provide more sustainable support to secondary market pricing and primary market volumes. Access to non-bank capital reflects the US market’s better transparency through SEC reporting, public ratings, greater liquidity, established creditor rights and risk-adjusted pricing. According to Fitch, if the European market were to become equally transparent, liquidity from traditional unlevered credit investors such as global pension funds and insurance companies will follow, and eventually capital market pricing and access would improve.
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