In this feature we discuss what are considered to be the risks associated with the secured loan asset class.
We focus on price volatility, credit losses and how they compare with the yield on offer.
How does the volatility of secured loans compare to other investment products?
Secured loans have proven to be significantly less volatile than other risk assets and have been a much more resilient asset class even in the midst of the recent market turmoil. The 3-year annualised volatility to April 2012 of the European Leveraged Loan Index was 7.7% versus 13.6% for the European High Yield Index and 14.2% for the European Equity Index (DJ Stoxx 600).
Credit losses compared to yield
Has the default rate increased as a result of the current unstable markets and thinner demand for assets from banks? We believe not. The average difference between the 3-year discount margin and the default loss rate has increased disproportionately. Secured loan investors are getting paid a much higher return for a similar loss rate. The result is that the expected return, net of the expected loss, is particularly high, with the average difference between the two over the period 2009-12 being 748 basis points (bp) in comparison with an average difference of 335bp over the period 2004-08.
Sustainability of returns
Currently the returns available are extremely high; with primary deals launched at Libor plus 500-550bp, and the secondary market trading at an average price of mid 80s – potentially a large capital appreciation for investors. Are these returns destined to erode over time? We believe they are here to stay.
Primary deals are being launched at Libor plus 500-550bp for many reasons – the principal being that secured loans need to compete with other asset classes to attract money and are therefore required to be attractively priced.
The serious compression to spreads that took place during the historical boom of 2006-07 was more specifically due to the high amount of leverage in the market (through collateralised loan obligation vehicles or CLOs), which allowed an incredibly high amount of money to flow into the institutional side of the market. The lack of bid from structured products going forward is expected to deliver a much more disciplined pricing.
In addition, Basel III and the new regulations being imposed on banks effectively generate a floor to the returns for secured loans, with banks requiring to have adequate returns for the risk they take and the capital they are required to set aside.
Finally in terms of the secondary market and the capital appreciation available therein, on average the erosion of capital appreciation will be replaced by higher coupons. An example would be a borrower that asks to extend their secured loan maturity offering in exchange a coupon increase of, for instance, 200bp. Such a significant coupon increase will bring the price in line with the market and, therefore, to par or closer to par. For the remaining term of the secured loan the investor will not have capital appreciation but will continue to enjoy the coupon boost itself. In short the source of returns will change but will continue to be there.
In conclusion we believe secured loans to be a stable asset class offering diversification away from other more traditional investments, limited relative volatility and excellent returns for comparatively low credit losses.