Junk Loan Sales in Europe the Weakest Since 2010 on Rates Pain

Europe’s leveraged loan sales are headed for the worst year since 2010, when markets were still reeling from the global financial crisis.

(Bloomberg) — Europe’s leveraged loan sales are headed for the worst year since 2010, when markets were still reeling from the global financial crisis.

Even with the revival of recent weeks, companies have sold only €28 billion ($29.5 billion) of new euro and sterling-denominated loans this year, about half 2022’s total, according to data compiled by Bloomberg. It’s unlikely the tally will move much higher before the year is out given that investors start to close their books early-to-mid December, while geopolitical risks have raised volatility across global markets. 

The main culprit for the slowdown is the global rise in interest rates, which has been particularly worrisome for borrowers in this market because loans are floating-rate securities. Rather than tap the loan market for cash, they’ve either amended and extended their existing debt, or opted for other markets such as private credit, which can offer deals that allow borrowers to delay interest payments.

“The rise in cost of financing and also general market volatility has fed through to the appetite to underwrite risk,” said Craig Nicol, a strategist at Barclays Plc. As a result, borrowers have shown a preference for amending and extending their existing loans, rather than refinancing them, he added.

With major central banks signaling that rates are likely to stay higher for longer, it’s unlikely sales will recover soon. That’s bad news for collateralized loan obligations, the main buyers of the securities.

The slowdown in junk loan deals has weighed on the creation of collateralized loan obligations, with Europe’s year-to-date CLO volume the lowest since 2020. The issue isn’t just that there aren’t enough loans to buy, it’s also that the lack of supply is driving up prices in the secondary market, with returns of over 10% year-to-date. That hurts CLOs’ arbitrage — the difference between the cost of the leveraged loans managers buy and the bonds they sell — a key determinant of equity returns. 

“We still expect CLOs to be active buyers of loans, but less than before, given the CLO arbitrage has dropped to just 245 basis points from the peak of 357 basis points in February,” Bloomberg Intelligence’s Heema Patel said. 

The risk that rates stay higher for longer is also a challenge for mergers and acquisitions, which saw deals dry up when the cost of money rose, because funding the transactions through public markets became too expensive and risky. 

Barclays’ strategists — including Nicol — estimate that M&A and leveraged buyout activity has now hit rock bottom. While they expect any recovery to be gradual, they have identified reasons for optimism, with recent deals revealing investor demand for new money supply and valuations starting to correct.

“The appetite for banks to underwrite is arguably also returning,” the strategists wrote in an Oct. 6 note. “The outlook for LBOs into 2024 appears to be showing green shoots at last.”

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