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Guest Comment: Opportunities in European Secondary Loans

The European secondary loan market has borne the brunt of increased risk aversion in recent months with prices and trading activity drifting lower.

Yet it remains an asset class where investors willing to do their homework on distressed situations can be well rewarded.

Despite the recent continuation of European Central Bank bond buying, this is now colliding with a fistful of worries from commodity prices, China, Greek debt and US interest rates. The result has been a fragmentation in liquidity and volatility spikes – particularly at the lower quality end of credit – as yield spreads widen.

This has a knock-on effect on secondary loan trading, as pricing risk in these market conditions becomes much more fraught. Much like a flight to quality, in secondary loans there has been a gravitation of interest towards more transparent issuers and a trading void in others.

At the same time, while ECB bond buying has encouraged issuance, trading inventory is dwindling in secondary markets as new regulation restricts “bulge-bracket” investment banks from holding riskier assets.

This presents a challenge for the already illiquid secondary loan market, as it becomes more difficult to price underlying assets and fundamentals.

There is always the question when credit is in free-fall, whether this represents deepening distress or just a market over-reaction? Often the inability to form a strong credit view acts to prevent money managers putting funds to work.

This is where value can emerge, as investors will get paid for taking risk. It is also a time when intermediaries that can combine robust pricing, sourcing and financing of deals can demonstrate their added value.

The secondary loan market operates beneath another layer of uncertainty because trading depends on knowing when a bank is likely to dispose of a loan. This is part art, part science involving assessing the underlying credit risk, as well as the pain threshold of banks that will trigger action.

Typically there will be a lag between the deterioration in fundamentals, distress levels and loan sales. This can be seen in the oil and gas industry, where more than a year on since brent crude was last above US$100 per barrel, a new reality appears to be setting in. Initially oil producers are likely to be operating with some hedging and long term contracts in place so they can absorb the pain of lower prices. On the banks’ side, there will be some headroom on covenants and a willingness to accept volatility when there are relationships to consider. But after an extended period of weak prices, we are now seeing more pockets of distress appearing and bank patience running out.

One recent example was the collapse of troubled oil producer Afren Plc where low oil prices magnified pressure on its key Nigerian oil assets.

This highlights the need to watch for an escalation in distress when businesses have operations and assets in higher risk countries such as Africa, which is the case with a number of UK listed companies. When low prices lead to uneconomic fields being temporarily suspended, problems may snowball from an earnings miss to assets being written off altogether if governments’ requisition them.

Another consideration is to watch for shifts in the industry outlook that spark wider contagion. The announcement by Shell last week that it was taking an exceptional charge of US$7.9bn in the quarter as it ended Arctic exploration plans, backed out of a Canadian Oil Sands development and wrote down shale gas assets suggests the industry is preparing for a longer period of low prices. Rather than just capital expenditure cuts, when whole projects are mothballed this can lead to a domino effect with distress hitting companies involved in oil services and offshore support.

How banks react to such distress is typically harder to predict as another key factor is the bank’s own internal predisposition to recognize a loss or make a provision. When a loan becomes problematic there is a sliding scale of options from a waiver of covenants, to debt restructuring, a loan sale, or at the other end, a complete liquidation.

The decision making of banks, however, can include a variety of considerations, from whether or not the loan is core to a bank’s operations, its long term relationship with the issuer, to how much exposure they have to that company, sector or industry and what their pipe-line of new issuance looks like. Even here behavior can be unpredictable. For instance in a distressed syndicate, the bank with one isolated non-core loan may not sell, yet one that is core may because its overall portfolio position allows it to accept a loss. Ultimately the ability to effectively source loans requires much more than making a bid.

It requires an understanding of banks needs, discretion and the ability to build a relationship and reputation for consistently and accurately pricing risk.

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