European loans have defied the naysayers, and are on course in 2023 to deliver their second-best year of returns this century. Few participants, though, think this feat can be repeated in 2024, as the market — according to analysts’ year-end predictions — continues to grapple with low new-money supply on limited M&A activity, and defaults that are increasingly moving back up to long-run averages.
In what has been a strong run into year-end, European loans are set to record their highest yearly return since the aftermath of the GFC in 2009, at roughly 12.6% (ex-currency) by Dec. 14. This result makes the asset class one of the best-performing liquid investments globally, and comes despite predictions at the start of the year of no more than a muted return after the market dislocation in 2022.
“People started the year worried that companies would struggle to pass on price increases resulting from inflation,” said one manager, adding that sponsor names were generally able to offset pressures to cashflow with price rises or cost savings.
The strong year took the average bid in the Morningstar European Leveraged Loan Index (ELLI) from 91.34 through to a high of 96.69 in September, and it looks to be on course to settle in a high-95 context by year-end, closing at 95.76 on Dec. 14.
This rally did not come on the back of a flood of liquidity into loans, managers point out, while noting secondary volumes have been shallow for much of the year. “It’s been a great year for the asset class but if you rewind the clock to the start of the year then the outlook was more uncertain,” said one manager. “A lot of people wanted to reduce loans as they feared defaults would go up.”
Meanwhile, European loans are expected to remain a CLO-dominated asset class, for the time being at least. Sources estimate CLOs make up roughly 70% of the liquidity base in Europe, and say there is little evidence of significant non-CLO interest in single-B European loans. In the main, large new allocations are likely to favour either the much bigger US market or in-vogue private credit funds.
Return ticket
The room for similarly outsized returns in 2024 from loans is also likely to be limited. “The market was able to rise on relatively little volume to produce 12% returns this year,” said a manager. “But there is a reverse ‘FOMO’ now, as no one thinks that it is repeatable for another year.”
In its Global Outlook for 2024 published Dec. 1, Barclays said it is pencilling in a slight depreciation in the ELLI for 2024 to an average bid of 95, with its forecast implying a total return for the index of 6%. This is in line with JP Morgan, which is also signalling what it calls an ‘underperformance’ at 6% for European leveraged loan returns, according to its European Credit Outlook & Strategy published Nov. 15.
BofA Securities is a little less bullish, and in an outlook piece titled ‘Collateral Thinking’ published on Nov. 20 the bank said it expects loan spreads to widen by 60 bps, for returns in a 5% context. BNP Paribas, meanwhile — according to a Global Outlook published this month — sees a 42 bps increase in loan spreads to 593 bps, and excess returns of 4.2%. Deutsche Bank is the most bearish, predicting a return of just 0.2% for European loans next year, according to its IG and HY Strategy Outlook published Nov. 29.
At the higher end of expectations, a 6% return is well down on this year’s performance, but would still be the second-highest annual return out of the ELLI since 2013. The outlook for 2024 reflects a view on the European economy that — while generally more positive than it was a year ago — is no more than cautious amid a range of potential outcomes. Barclays sums up the base case as a “muddle-through,” with economic growth neither booming nor collapsing, and inflation slowly returning to target which will allow the ECB to pivot to rate cuts in the second half of the year.
One head of credit at a global firm agreed with this projection. “There is a lot of talk about hard or soft landings. But there is a strong likelihood that a hard landing may not be as hard as people fear, while a soft landing will not be as soft as they hope,” he said. Deutsche Bank is seeing signs of this deterioration, and argues Europe may already be in the midst of a mild recession. Growth will also continue to struggle into the first half, the bank adds — but a recession is expected to be shallow, while slowing growth could take inflation lower.
Sound structure
That said, loans enter the new year on a structurally sound footing. Corporate balance sheets were generally healthy entering the downturn and sponsors have taken to the extension trail with aplomb this year, with the European market recording total amend-and-extend volume of €44.6 billion to Dec. 15, according to LCD data. There is still a stub of 2024 needs to address, though most of these are distressed or about to be repaid through other means such as M&A.
This dynamic will keep the focus on remaining 2025 maturities, and increasingly 2026 debt, while research from BofA suggests 25% of all European loans are due in the next three years, with 8% due in the next two years. At the very least, this state of play indicates that refinancing activity in Europe for 2024 will at least match this year’s level. “Sponsors have been quite pro-active and have not argued about half a point here or there,” said a manager, adding this pragmatism has secured the appreciation of the lender community.
Furthermore, a tailwind from generally higher-than-expected CLO volumes in 2023 has supported the year’s extension wave, and bankers note that no deal has struggled due to reinvestment period pressures. That said, Barclays says 30% of European CLOs are now out of their reinvestment periods due to a lack of reset activity, and this share — already at a record high — is only expected to increase. For the moment bankers do not see this as a problem, but fear it could become an issue unless activity steps up. “Are we getting too complacent on extensions?” asks one manager. “Certainly people are waking up to tricks like snooze drag,” they add. Either way, Barclays highlights WAL tests for CLOs as a potential problem, even if initial concerns were “potentially overblown”.
The success in the extension trade, along with such factors as interest-rate hedges and sponsors’ willingness to provide cash for their over-levered but otherwise performing companies, has also kept default rates subdued — however, they are now off their historically low levels.
From a high point at the end of 2022, JP Morgan notes that the deterioration in European credit has been “shallow and uneven,” coming primarily from an erosion in EBITDA. The pain has also been felt more severely in some sectors, notably transportation (which enjoyed strong profitability in the pandemic), and chemicals (which has been going through a savage destocking cycle).
Overall, BofA points out that default rates have risen by three-times through the year, to 1.3% (by par) on its measure. There is general agreement that higher-for-longer base rates will inevitably push up loan defaults further, and that these are likely to exceed defaults in high yield — even if most analysts have stepped back from last year’s notably bearish stance.
In 2024, BofA is penciling in a rise in European loan defaults to 2.5%, Barclays is looking at loan defaults of 3%, against 2.5% in high yield; JP Morgan is predicting loan defaults of 3%-4%; and BNP Paribas 4%. Previously a notable bear, Deutsche Bank projects European speculative-grade defaults will reach 4.2% by year-end 2024, and 5% by the end of 2025.
But what managers want is supply. The overall size of the European loan market as measured by the ELLI has grown this year, but has shrunk by number of issuers. This is not yet a problem for CLOs, but will increasingly become one if issuer diversity does not improve, say managers. “Every CLO vintage needs to be different and without fresh primary supply there starts to be too much overlap,” noted one manager.
Mind the gap
The year has brought windows of opportunity for M&A supply, but sponsor-to-sponsor deals — the mainstay of the European market — have never really got going. This situation has come amid a failure of buyers and sellers to agree on valuations, and while sources say this gap is closing, it remains the most significant barrier to new transactions. There are some large processes in the works such as Techem, but the best guess from bankers is that there will be no real change in M&A activity until the second half of 2024.
For their part, managers weary of promises of higher M&A-related deal volume say this is now just an arbitrary timeframe. “When they [bankers] say ‘the second half’ it means they just don’t know,” summed up one long-standing manager. What’s more, even when M&A is agreed, distributed markets face fierce competition from private credit, which has financed deals this year for borrowers including Constantia Flexibles and Adevinta that would have almost certainly been financed via syndicated loans or bonds prior to 2022.
Analysts concur with this view, and point to what Barclays calls a “slow healing” of the LBO market, while also noting lenders’ increased appetites to underwrite. Following two years of exponential growth, bankers concede private credit is now a permanent fixture of the European market, which means there should be opportunities for both direct lenders and underwriters to work together on larger financing packages.
In Cinven’s take-private of Synlab, for example, direct lenders provided a €500 million slug of PIK alongside a €1.45 billion syndicated bond and loan. “We understand that we’re no longer the only game in town, and that there is reasonably peaceful co-existence,” said a banker.
There is still opportunistic supply to look forward to though, and BofA expects roughly €15 billion of its predicted €30 billion to €35 billion of new-money loan supply in 2024 to come from this source, which would suggest a 5%-10% increase in new-money issuance from this year. Barclays is a little more hopeful, and is forecasting a 25% increase in gross leveraged loan supply to €40 billion. But while this would represent a decent jump on the year’s volumes, it would still put issuance at historically low levels given the size of the market.
To take volumes back to anything close to the levels seen before Russia’s invasion of Ukraine, a significant — and not just tentative — return of M&A-related deals is required. And this does not just mean jumbo deals such as Worldpay coming to market, which dominate the headlines but are only ever limited in number. More important is the more-modest deals with a €700 million or €1 billion debt quantum that provide the required churn to feed the CLO machine and support overall market growth.
Bankers and investors point out that private equity has significant stores of dry powder and will eventually have to return capital to investors beyond money from NAV loans secured across portfolios. But for active buying and selling to return, more certainty is needed on rates, which has perhaps been the dominating factor across all leveraged finance markets over the past two years. “The cost of capital needs to come down to make the IRR work for both buyers and sellers for deals beyond a few take-privates,” said a manager. A banker agreed, going on to sum up the past 12 months. “We’ve had a pretty volatile year but availability of financing has not been the problem,” he concluded.
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