By Hamlin Lovell, NordicInvestor

Mandatum has an active, contrarian, opportunistic and benchmark-agnostic approach to investing in credit, in the broader European and Nordic leveraged loan space as well as Nordic small and mid-cap club style LBOs and CRE deals, and other special situations.

Leveraged loans have staged a strong recovery in 2020, with the broad LCD European Leveraged Loans index (ELLI) bouncing from a trough of 79 in March 2020 to the mid-90s by this summer. Mandatum Life Insurance Company’s Head of Loan Strategy, Alexander Gallotti, finds this easy to explain: “These are secured instruments offering great yield with excellent downside protection given the entry levels. Forced selling was exhausted and then other buyers like ourselves, and for example distressed and opportunistic funds stepped in with others following shortly after. Many businesses are operating without any material impact from Covid and some have even benefitted. Central bank and government stimulus around the world did ultimately however change the general investor sentiment rather quickly”.

Although central banks are not directly buying leveraged loans (the Fed is indirectly exposed via CLOs), they have an indirect impact because their purchases of investment grade debt have driven yields down to around 0.6%, which pushes investors out into riskier paper such as high yield bonds offering 4% and leveraged loans offering 5%. Says Galotti;

Loans continue to offer some yield pickup partly because there is less speculative and fast money chasing the asset class….”

Indeed, some 50-60% of demand for syndicated loans comes from CLOs, which are longer term holders than mutual funds or ETFs, offering daily or intraday liquidity, that are more important for high yield bonds. Though CLO issuance is picking up, it has not yet reached pre-Covid levels. Most of the remaining buyers are institutional investors and banks.

Credit quality, Defaults and Recoveries

Credit ratings downgrades have hit roughly one third of the ELLI index, and expanded the size of the ‘B-‘ category while the ‘CCC’ category has also ticked up from tiny levels pre-Covid. This will discourage some ratings-driven or constrained investors from investing in loans, but not Mandatum. “We don’t really base our investments on the ratings per se and can do both rated and unrated. We have no strict limitations thereof but of course we do use the reports to support our own credit work, and do have a view how our ratings split should generally look like in our portfolios”, says Mandatum Life Insurance Senior Portfolio Manager, Kimmo Salokoski. “But indeed, amid the negative rating actions this year, good to bear in mind that not all names got downgraded and many businesses are still performing as is or some even better.”

In any case, the wave of downgrades may now be stabilizing and some names are even seeing some upgrades. There are differences of opinion on default forecasts, which range from 5% to 8.5% over the next 12 months, though some banks have recently revised down their forecasts to 3-4%. This would still be somewhat higher than the 2-3% seen at present in Europe. (The US has higher default estimates partly because its sector split contains more energy and retail).

We broadly expect default rates will be above historical levels over the next two years, but rather than a sudden spike in defaults we expect that defaults could be spread over several years, due to government support, cost cutting, liquidity in the credit markets – and the lack of maintenance covenants in some deals could also delay defaults….”

Central bank liquidity and government support cannot indefinitely avert insolvency in some companies however. “What we are also focused on right now is what are the long-term prospects of the business and how sponsors/owners and lenders react and support companies that are muddling through. And it’s not just a question of liquidity as has been for now but also solvency going forward as frequently commented by market participants over this year, adds Salokoski.

“It is too early to say if recovery rates upon default will change from historical averages of 60-70% for the 1st lien. Recovery rates will vary between sectors and companies, and how companies have been capitalized over this crisis, and now Covid-19 may also lead to more structural changes in some sectors that can have a long-term impact on their recovery and valuation prospects”, says Salokoski.

But long-term investors should not necessarily pay too much attention to the headline recovery rate averages: “the reported recovery percentages, which reflect prices around the default event, are often the low point, and not necessarily the end game because investors who participate in restructurings and debt for equity swaps may end up with much higher returns.

Some distressed investors would expect to double their money in these situations….”

“We are comfortable with our positions as they are a result of careful credit picking resulting in a fairly conservative and defensive portfolio with limited (but still some) exposure to the hardest hit sectors such as leisure and travel”, says Gallotti. Mandatum was fortunate to have been underweight of these sectors before the pandemic due to general concerns about their cyclicality. The manager expects that the market could remain quite bifurcated for some time, between more defensive sectors and those hit by Covid related restrictions. Mandatum Life Senior Loan strategy was only down 1.3% for 2020 to the end of August (versus -2.1% for the ELLI index) and has had no defaults to date.

Overall, Galotti judges loan yields to be attractive because: “they are above historical levels, higher than on high yield bonds, and there is potential to add value through credit picking: there are a lot of high-quality companies in the loan market from which you can create a portfolio with very good risk/reward characteristics”.

Volatility also spells opportunity: Mandatum Life Opportunistic Loan strategy was up 20% on drawn capital as of the end of August (launched at end of March). As per end of November the fund’s gross MoIC was 1.23x and 50% IRR.

The fact that reference rates for loans are floored at zero, protects yields against any further rate cuts, while still offering some optionality of rates ever return to positive territory.

Searching for Additional Value alongside the wider syndicated loan market

Though the asset class is broadly attractive, investors can seek yield pickup and/or more attractive creditor protection in various ways.

For instance, “the Nordic club style leveraged loan LBO markets is mainly small and mid-cap issuers, with around a dozen syndicated loan issuers. The companies tend to have lower leverage and offer more investor friendly terms, such as maintenance covenants with margins at par or higher than the broader syndicated loan market”, says Gallotti. As such they could offer more attractive risk-adjusted returns.

“The Nordic commercial real estate backed markets, including club deals and self-originated deals, can offer a yield premium partly because being some of those being outside of banks’ core focus and appetite, due to risk weighting regulations, and high existing exposure to real estate. We use our own real estate team to evaluate the underlying assets and projects and identify deals with an attractive risk/reward”, says Gallotti.

“Nordic currency loans, on average, do not necessarily offer additional yield as there is natural demand for them, but some individual issuers can provide extra spread”, says Gallotti

“GBP denominated loans yield somewhat more (even after factoring in currency hedging costs) as there is a smaller buyer base, and investors remain wary of Brexit risks”, says Gallotti.