In a press briefing at its Canary Wharf offices in London, Fitch Ratings discussed its new report that examines the high growth in European loan funds. Alastair Sewell, head of EMEA & APAC Fund and Asset Management at Fitch Ratings, commented that the sector had not received a great deal attention due to the paucity of data available on it, and that the report was an attempt to shine a light on it.
Open-ended Europe-domiciled loan funds have had an estimated growth of 50-60% in the past five year. While that does come from a low base, the report estimates total assets of €40bn across all European open-ended funds at end-June 2016, with most investing in US and European leveraged loans rather than having a pure European focus.
The report noted that loan fund assets in the US are greater than in Europe, at around US$110bn as of end-June 2016. Sewell noted that, as was the case in Europe, the peak of activity in the US market was in 2014. A key reason for loan fund assets being greater in the US is that the market is approximately four times larger than that in Europe. Additionally, Europe’s UCITS fund regulation states that loans are not eligible assets, which precludes retail investment. In contrast, loan funds in the US are actively sold to retail as well as institutional investors.
Wider sector approaches collateralised loan obligations (CLO) levels
Fitch estimates that collectively the share of new issuance acquired by loan funds and separately managed accounts in Europe is now only marginally smaller than that of CLOs. This makes funds and mandates collectively a significant institutional loan investor group.
According to the report, European CLOs and loan funds mostly invest in the same sectors in approximately the same proportions. Despite this, differences do exist. European loan funds can, and do, have greater maximum issuer and industry exposures. They are also more able to invest in non-base-currency exposures, which may support diversification while introducing foreign exchange (FX) risk. European CLOs primarily invest in euro-denominated leveraged loans.
Liquidity and charges
The liquidity terms of European loan funds are interesting as this has been largely untested. Redemption terms on open-ended European loan funds are typically longer than for fixed-income funds more broadly. Most loan funds offer monthly liquidity with a notice period, whereas most bond funds offer daily liquidity with T+3 settlement. Sewell noted that while the 30-day notice period for loan funds was good, it was far from a panacea. It is far from certain that funds could sustain liquidity in the event of severe market stress, especially given potentially long loan settlement times in Europe. Liquidity risk is a structural risk in the loan fund market.
Lower capital charges are possible on loans that are not publicly rated, as they are treated as unrated exposures under Solvency II’s standard formula. Therefore they carry lower capital charges than would be assigned to ‘BB’ or ‘B’ rated credits of similar duration. They also carry significantly lower capital charges than even the shortest duration and most senior tranches of type 2 securitisations, such as CLOs.
Solvency II has an effect in the CLO market, as the regulation makes it impossible for insurance companies to invest in CLO debt. In another warning about the CLO market, Matthias Neugebauer, head of European structured credit and European-domiciled loan funds at Fitch Ratings, noted that if CLOs witnessed the same fall now as in 2008 (where they dropped by around 40%) redemptions would stop. For European loan funds, however, the future looks good thanks to their shifting investor base.
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