Rates outlook drives leveraged loans Debt investors" continuing hunger for decent returns, which has already fuelled a boom this year in the European market for high-yield corporate bonds, is also driving renewed interest in leveraged loans. The popularity of such loans, made to highly indebted companies, lies in their high and floating interest rates. These rise in step with market rates, offering protection against looming increases. The third quarter of this year saw leveraged loan issuers bring 37 deals to the European market to raise the equivalent of €27bn, more than double the amount raised in the same period last year, according to Debtwire Analytics. Loans for the year to the end of September were up 40 per cent at €67bn through 88 deals, compared with €48bn from 56 deals in the same period last year. "A heady combination of a thawing outlook for Europe's major markets, insatiable investor demand for yield in Europe and the US, and solid operational performance from corporates contributed to a dynamic leveraged loan market," says Debtwire Analytics. Seven corporates issued leveraged loans valued at more than €1bn in the third quarter, the largest of which was €5.25bn of financing for the buyout of Dell, the US-based technology group in September. The largest single deal by a European corporate was a €2.4bn loan package raised by Schaeffler, the German automotive parts manufacturer. BlueBay Asset Management, which is owned by Royal Bank of Canada, says loans have offered investors an average annualised return of 6.8 per cent over the past 21 years, with only one year - 2008 - showing a negative return. That was a painful drop of 29 per cent, but it was immediately offset by a positive return of 52 per cent in 2009. In the event of bankruptcy, BlueBay says loan recovery rates of about 70 per cent are significantly higher than the 40 per cent historical recovery rate for high-yield bonds. Over the longer term, loans have had lower default rates (2.47 per cent) compared with high-yield bonds (3.63 per cent) and rating agencies expect default rates to remain low. Since 2006, high-yield bonds have traded at yields 103 basis points above loans. But BlueBay says the yield differential between bonds and loans is currently only about 83 basis points. "Investors therefore have the opportunity to move up the capital structure into a more secure class and gain protection from rising interest rates for a relatively small give-up in yield," it says. Peter Higgins, senior portfolio manager at BlueBay, says: "Floating rate coupons mean that loans have outperformed in rising interest rate environments. Loans outperformed following the first discussions of tapering in May 2013 and we expect them to outperform when the Fed begins tapering. ECM Asset Management, a credit specialist boutique owned by Wells Fargo, reckons that high levels of demand from US retail investors and managers of collateralised loan obligations (CLOs) has helped to reduce the "spread" over Libor at which US loans are issued by 50 to 75 basis points compared with Europe. These factors do not apply to the same extent in Europe because the ability of retail investors to invest in leveraged loans is limited because of Ucits, the European rules governing cross-border sales. The US market has been booming for CLOs, which buy corporate loans, bundle them into a single investable package and then slice them into various "tranches" to sell on to investors. They were the biggest source of funding for Europe's leveraged loan market for corporate buyouts before the financial crisis. The European market for CLOs is currently only a tenth of the size of its US counterpart, partly because of new European regulations requiring asset managers that put deals together to have "skin in the game," by holding a slice of equity in the product. Torben Ronberg, London-based head of loans at ECM, says: "European loans are currently better value than the US and should continue to outperform." Like the European high-yield corporate bond and equity markets, the European leveraged loan market has benefited from US investors who wish to rebuild their exposure to Europe, and see better value there, now that concerns about the eurozone have receded. Mr Ronberg believes global fund managers should ideally have an allocation of about 20 per cent to Europe, compared with a current level of about 5 per cent. Moody's predicts that demand for leveraged loans will continue to be enhanced by investor concerns over interest rates, even if rates remain low next year. But the rating agency believes an important development this year has been the tighter interplay in the dynamics of the high-yield and leveraged loan markets - in terms of structure, pricing and distributions - as institutional investors now operate in each market. "We expect that loans and bonds will complement each other, with companies continuing to play each option against the other," it says.