Governments and Central Banks continue to implement loose monetary policy and expansionary fiscal stimulus in response to the Covid-19 pandemic, inflationary pressure is rising within global markets. Consequently, treasury yield curves have steepened and the downward pressure on rates is easing. Fixed income investors are increasingly concerned about duration risk and this has already translated into heaviness in long duration assets. Overarching all of this is the persistence of low yields; 60% of Global Fixed Income is still yielding less than 1%, so the reach for yield remains a key goal. In the hunt for yield, prey is scarce, European Loans are a viable target.
With steepening yield curves and firmer base rates shorter duration assets like European Loans have fared well, benefitting from the potential of increased future income from their floating rate coupon component. Moreover, we think this theme will persist through the year. YTD 2021 European Loans are outperforming traditional Fixed Income asset classes, but this isn’t a one off. European Loans have outperformed comparable fixed income asset classes in several previous rising rate environments.
One of the reasons for this outperformance is due to greater levels of private equity support received. Contributions from sponsors on new transactions are at all-time highs averaging 52% in 2020 vs 33% in 2007. This combined boost from a top-down and bottom up perspective was crucial in restoring liquidity and curbing defaults. At this point it is worth mentioning that loans have the additional benefit of typically sitting senior in the capital structure to High Yield and being secured against assets. Importantly interest coverage has increased to 4.7x, the highest level ever seen. Though European Loan defaults increased to 2.57% in 2020 from 0.44% in 2019, this is still below long term default levels; and well below the 8% default forecast at the beginning of the pandemic.
Looking forward, fundamentals are on the mend for many sectors and the speed of the vaccination rollout will determine the performance of European economies and especially COVID-sensitive sectors. For 2021 there is consensus that both sponsor and government support will continue, and given the abundant market liquidity, we expect to see a more benign default rate of 2-4% for European Loans.
Another positive tailwind has been the steady growth of the asset class, since 2007 it has grown from €100bn to over €320bn in 2020 improving the supply and demand dynamics of the asset class. Its depth and liquidity is largely comparable to European High Yield in recent years.
In terms of income European Loan returns did compress over 2007 to 2010 but have been relatively stable since then, averaging in the 4-5% range despite negative base rates, in contrast to the continued year on year compression in Fixed Income markets. Whilst capital returns have experienced significant volatility due to the pandemic the asset class has largely recovered, albeit the average price for European Loans is c.98 (30th Apr 2021), so the potential for a pull to par remains.
Compared to most credit asset classes, European Loans arguably fulfils the fundamental objective of Fixed Income better than most, stable strong income streams with the potential of additional upside via price appreciation.
For more on this please follow the link below that leads to the European Loans paper we published last month.
Director Institutional Sales
T +49 (0) 69 / 12014 1605
M +49 (0) 162 / 2990 129
BNY Mellon Fund Management (Luxembourg) S.A.
60308 Frankfurt am Main
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