Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Alcentra European Floating Rate Income. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Alcentra European Floating Rate Income (AEFS) invests principally in loans issued by European companies (including those in the UK). The vast majority of the loans are senior in the capital structure and secured against the companies’ assets, meaning that the historic levels of defaults are very low (AEFS has not experienced a default in the portfolio since it was launched in 2012). Furthermore, the floating rate nature of the loans means they offer a yield which rises along with interest rates and less volatile price behaviour than fixed interest bonds.
The trust yields 4.6% on a historic basis and has displayed low volatility since launch. Over five years, the standard deviation has been just 2.3% compared to 8.3% on European high yield bonds and 8.5% on US high yield bonds, using the ICE BofAML indices. The cautious sector positioning contributes to the defensive nature of the income stream.
Alcentra is a major player in the European loans market and has a long track record in this rapidly growing asset class. This gives it preferential access to deals and the ability to act as a key investor in new syndications. The manager, Graham Rainbow, and his deputy, Daire Wheeler, work with a team of eight dedicated credit analysts based in London as well as a similar team in the US. This allows them to do detailed work on the individual borrowers, which should allow them to pick superior credits. This expertise has contributed to the trust suffering no defaults since launch, while there is also a distressed debt team within Alcentra who would be able to work to recover the maximum from any default should they occur.
Loans are floating rate, meaning that they pay a coupon of EURIBOR plus a spread, and therefore the income rises and falls with interest rate changes. Most of the loans are in euros, but because the trust hedges the currency exposure back into GBP, the trust is exposed to UK interest rates. Unlike investing in US loans, where hedging removes the US interest rate benefit and has been a net cost to capital and income in recent years, this hedging has been an advantage in the euro loans market. Although interest rates are negative in Europe, euro loan coupons typically have a floor at 0%, meaning that the least that investors can receive is the spread, not the spread minus the impact of negative rates.
Thanks to the nature of floating rate bonds, the trust has a minimal duration and should not suffer significant capital losses due to rising interest rates. Unlike a fixed coupon bond, the income would rise in such a scenario rather than remain the same. It also contributes to the stable, low volatile nature of the trust.
Since the trust was launched the prospects for rate rises in Europe and the UK have fallen, and the trust has fallen onto a discount. However, the board has taken radical action to attempt to reverse this trend: from December there will be a quarterly liquidity event allowing investors to exit up to 20% of their position at a 1.5% discount to NAV (discussed in the discount section).
Given current spreads, interest rate differentials and the portfolio trading below par, the managers’ estimate there is a total return potential of 5.3% a year net of fees over the next three years, calculated from the end of April. We believe this looks attractive relative to the 5.5% yield on high yield bonds (subtracting the median OCF on the open-ended Sterling high yield sector of 0.75% from the gross yield of 6.25%) when you consider the massively reduced volatility in the loan market and the minimal interest rate sensitivity. It does, of course, rest on some simplifying assumptions, and there are risks that would reduce this return.
The floating rate nature of the loans would also provide protection in a rising interest rate environment, which we believe may well occur after the next steps in the Brexit process are clearer (BofE Governor Mark Carney has stated UK rates would be higher if it wasn’t for the political uncertainty). Meanwhile, the newly announced liquidity window limits the risks to the downside in the short run, in our view, as it makes the discount less likely to widen substantially. In the longer run, demand for the company’s shares will likely depend on the future course of interest rates, but investors have an exit clause in the form of the tender offer should the lower for longer environment persist.
|The trust offers a rising income and stable capital values in a rising interest rate environment with a potential return of over 5% a year||There is minimal capital gain potential
|No defaults and conservative credit selection along with the structure of loans means NAV volatility is low||Low levels of covenants in the market will make credit selection more important in the coming years
|A quarterly liquidity event means that the risk of a widening discount is minimal
||The trust may become sub-scale should there be significant take-up of the tender offer, although this could result in capital being returned to investors|
Alcentra European Floating Rate Income (AEFS) invests principally in loans issued by European companies (including those in the UK) and hedges out all non-sterling exposure. The loans are floating rate, meaning that they pay a coupon of EURIBOR plus a spread, and therefore the income rises and falls with interest rates. Most of the loans (71%) are in euros, but because the trust hedges this, the coupons are effectively converted to LIBOR plus a spread, and so all loans in the trust are exposed to UK interest rates, not European.
AEFS invests the vast majority of its portfolio in senior secured loans. The loans being senior and secured means the chances of losing money in a default are minimised (the trust has not experienced a default in the portfolio since 2012). Furthermore, while the rate environment in the UK and Europe has been depressed in recent years, loans, as floating rate instruments, would offer protection should they rise - adjustment would be made through a higher coupon rather than a falling price, as on fixed interest instruments.
The managers can also make small allocations to bonds and to debt with less security when they find exceptional opportunities. However, a minimum of 80% will always be invested in senior loans, senior secured floating rate loans and cash, with a maximum of 15% in fixed rate bonds (secured or otherwise) and 15% in unsecured floating rate notes. The June 2019 asset allocation can be seen below, with 86% in senior secured loans.
Alcentra is a major player in the loans market with a sizable research team, which allows it to do detailed due diligence on borrowers and be highly selective. Risk on the portfolio is reduced by being spread across 97 separate issuers and 28 industries. AEFS will not invest more than 5% of its portfolio in the debt of a single issuer and has a maximum allocation of 20% to a single industry. Graham takes a conservative approach to credit selection and avoids issuers in cyclical sectors and industries, with minimal exposure to autos and none to shipping. The current major sector exposures are healthcare (14.2%), business equipment and services (13.8%) and financial intermediaries (9.7%). The trust doesn’t do project finance but lends to businesses backed by stable and repeatable cash flows.
Relative to the index, the trust is underweight the UK and overweight France, the Netherlands and Germany. Graham is also extremely wary of Italian issuers, although they make up a small part of the index. When we met with Graham recently he told us that he had limited concern about the impact of a hard Brexit on the portfolio – the trust does not lend to any UK companies with material exposure to exports to the EU, so any effect would be limited to whatever dampening effect was felt in the UK economy as whole.
The hedging process ensures that the portfolio is exposed to UK interest rates rather than eurozone rates. It has also enhanced the yield in recent years given the current interest rate differentials between the eurozone and the UK. Euro loan coupons have floors set at 0% plus the spread, so declining negative interest rates in the eurozone do not reduce the coupon. In fact, because AEFS effectively passes on the euro interest rate as a part of the currency swap it uses to hedge, while that rate is negative, it is a positive return to the trust which is still not earning negative rates on the actual assets it holds.
The recent moves down in European interest rates after dovish announcements from Mario Draghi have not therefore negatively impacted the portfolio, as Euribor rates were previously negative and the coupon floor activated. However, investors have benefited from the even lower cost (or positive payment) from the hedge. This is in sharp contrast to what has happened to sterling investors in US loans. In their case, the rate rises in the US have been counteracted by the extra loss on the hedge to sterling as the interest payable on the dollars they have borrowed to hedge their position has risen in lock-step. This has come about thanks to the divergence of interest rate paths following the 2016 EU referendum, after which UK rates went lower and US rates continued to rise.
Leveraged loans have been the subject of some market controversy over the past few years thanks to the reduction in the covenant cover in the market. Covenants are terms in the loan documentation which give lenders the right to call in their loan should certain financial or operational conditions not be met. They therefore offer a line of protection from defaults, by creating a checkpoint on the road of financial deterioration beyond which a company cannot travel without having to negotiate with its creditors. The reduction in the covenants typically applied to loans has been stark: in Europe, around 50% of loans were “covenant-lite” in 2016, compared to close to 100% in the first quarter of 2019, which is now in line with the High Yield bond market. Some critics have worried that this increases the risk of defaults and losses in the case of default.
However, Graham argues that due diligence should still protect investors. Credit selection involves assessment of the likelihood of default, and that now has to take into consideration the lack of a checkpoint along the way. Indeed, he highlights that covenants have sometimes not been enforced as lenders have considered it preferable to allow a company to improve its operational performance and earn its way out of the hole. Concordia International’s 2017 default shows how some cov-lite loans can achieve a high recovery rate – in this case senior debt-holders recovered 92%.
It is true that the loans market in Europe looks more secure by other financial metrics, suggesting the chances of default are lower. Interest coverage has averaged around 4 times on the market since the crisis, compared to around 3 times in the prior decade. The equity cushion has also markedly increased over those periods, from around 35% to around 45%. In our view, if there was a market-wide deterioration in borrowers’ financial prudence then the low levels of covenants might prove to be an issue, but that is not the picture painted by current data. The same restructuring process has to be gone through whether a covenant is triggered or there is a default, so the principal concern is that a lack of covenant protection would encourage riskier practice by borrowers, of which there is no evidence as yet.
The manager points out that the trust has had no defaults in its portfolio since launch. However, defaults have occurred in the market in the past, and over the course of the cycle should be expected again. At the height of the crisis in 2009, the loss rate in the European loan market as a whole was just 4.59%. There was a second wave of defaults in the 2012 – 2014 period as loans which were restructured after the crisis then defaulted, and in 2012 the market lost 4.19% to these defaults. Across the wider assets managed by Alcentra in this market there have been defaults over these periods, albeit at a rate far lower than the market.
The portfolio is trading on a weighted average mid-price of 97.04 (as of end June), offering the potential for capital appreciation. The weighted average coupon is 6.11% and portfolio current yield 5.06%. This is achieved with a moderate maturity length of 5.13 years (weighted average).
The trust does not employ gearing to fund investments. Cash weightings reflect the opportunities in the market and flows from sales and purchases rather than reflecting market views.
In NAV total return terms, the trust has delivered a net return of 48.2% (with reinvested dividends) since launch in 2012, according to manager data (to the end of July). By comparison, the Credit Suisse Western European Leveraged Loans index is up 47.2% gross over the same period. The capital return potential in the loans market is obviously limited, although loans do trade away from par in the same way bonds do, albeit with the changing coupon limiting the sensitivity to interest rates. Nevertheless, NAV is up 6% on the launch price, with the remaining return delivered by the dividend which has varied along with interest rates and credit spreads.
As the graph below illustrates, the portfolio has displayed low volatility since launch – especially relative to the European Leveraged Loan index. Over five years, the standard deviation has been 2.3% compared to 8.3% on European high yield bonds and 8.5% on US high yield bonds, using the ICE BofAML indices. The volatility of loans is reduced by their institutional investor base as well as their lower interest rate sensitivity.
NAV performance since launch
In terms of return prospects, the manager provides the following illustrative working, using data as of the end of April. The current portfolio trades at a discount, with the weighted average price at 97.81. Should this go to par over three years, this would result in a return of 0.73% per annum from capital appreciation.
The currency swap market is currently offering a gain of 1.11% per annum from the differential between euro and sterling interest rates and the spread on the portfolio is 4.51%. This implies a three-year return potential of 6.35% per annum, gross of fees. The OCF was 1.08% last year, so that implies a return potential of 5.27% per annum. This compares to a gross yield of 6.25% on the sterling high yield market, which would be reduced to a net yield of 5.5% if we subtracted the median OCF on the IA Sterling High Yield sector.
We believe this is attractive considering the low volatility of the loan market and its protective properties in a rising interest rate environment, which is one possible path for the UK to follow post-Brexit. The risks to these estimates include a recession raising default rates, loan prices continuing to trade away from par, narrowing spreads on new issues and shifts in the interest rate differential. And of course, high yield could in theory offer much higher capital returns, the positive element of its higher volatility.
The trust pays out all its income, net of fees, in quarterly dividends. The income paid on the loans the company owns depend on interest rates and credit spreads, both of which were lower in 2017 and 2018 than previously. This means full year dividends have been down on previous years, which for the first five years since launch were between 5p and 5.5p. Last year’s dividend of 4.51p implies a yield on the current share price of 4.5%. The first quarterly dividend of the 2020 financial year has been paid at a rate of 1.12p, consistent with last year’s level. The historic yield is 4.6%.
The trust has been managed by Graham Rainbow since it launched in March 2012. Graham joined Alcentra from Barclays in 2008, where he had been in charge of loan syndication. He is Head of European Loans and sits on the European Investment Committee at Alcentra. Daire Wheeler joined Alcentra in 2014 and was appointed deputy manager on AEFS in 2018. He previously worked at Oak Hill Advisors, an alternative credit firm.
Alcentra’s European Investment Committee manages $25.2bn out of a total $38.5bn assets run by the firm. As a leading player in the European loan market, Alcentra is a major counterparty for all the banks in the market, giving them excellent access to new deals and an advantage in negotiating terms. Alcentra partakes in deals from a variety of sources. While it can and does take part in the secondary market and general syndications, it can also gain access to deals at a pre-primary level, thanks to strong relationships with underwriters and sponsors. It can also deal directly with borrowers on occasion through advisory relationships.
Graham and Daire draw on the work of eight credit analysts, based in London and organised by sector under head of credit research Kevin Lennon, who has 29 years’ experience in the field. Their fundamental research is central to the investment proposition, which leans heavily on gaining an edge through analysis and understanding of the risks of borrowers. The analysts work across the capital structure, giving them further insight into the health of each business and its relative valuation. The team conducts a detailed three-stage research project into each potential investment, which requires sign off by a majority of the investment committee before funds are committed. This involves bespoke financial models being built of the company and internal credit and recovery ratings estimated as well as face-to-face meetings with company management. This diligent approach is designed to generate alpha and to minimise the likelihood of default – the low levels of defaults across Alcentra’s book compared to the market demonstrates it has been successful.
There is also a distressed debt team which could potentially be employed to help restructure the debt of any issuers which default, although the fund has not had any defaults in its life so far. There is a team of similar size in the US based in Boston and New York covering the US loans market.
The trust is trading on a discount of 4.1% and has traded below par since the start of 2016. The board has conducted share buybacks in an attempt to limit the discount, but has recently announced more drastic action. A liquidity event will be offered each quarter starting at the end of December allowing shareholders to sell back 20% of their position to the company at a discount of 1.5% to NAV. The hope is that this will keep the discount tight in the short-term and make it clear there is investor appetite for the strategy. We understand the board and the manager agree that once there is more clarity on the Brexit process, the path to higher interest rates in the UK will also become clearer and therefore the attractions of the trust should stand out and the discount should be structurally tighter regardless of the liquidity window. However, we would note that at £122m market cap, should there be significant take-up in December and then in March, the viability of the trust may be called into question.
Discount / premium
The trust traded on a premium after launch, but since 2015 has traded on a persistent (albeit small) discount. Initially, this was caused by concerns about the high yield and loans market due to the fall in the oil price, which led capital to flow out of the US loan market overall. European loan markets followed suit, even though the exposure of the European loan market to the oil and gas sector was minimal. In late 2015, the US started to raise interest rates and the market reacted nonchalantly; given that the hiking cycle was expected to be shallow and slow. Then in 2016, the result of the Brexit referendum reduced rate expectations in the UK, meaning demand for floating rate loans to protect against rate rises also moderated. Concerns about cov-lite issuance, discussed in the portfolio section, may also have contributed to the discount.
The ongoing charges are 1.08%, which compares to an average of 1.26% for London listed debt and loan fund peer group. This includes a management fee of 0.7% of net assets. The KID RIY figure is 1.17%, significantly below the sector average of 1.68%, although methodologies can vary.
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