
The Insight: Conversations – European Credit at a Turning Point
The Memo by Howard MarksFri Sep 08 2023
European Credit Financing Methods:
- Banks in Europe and the US have become more conservative with leverage since the global financial crisis.
- Syndicated loan market is an institutional asset class, with collateralized loan obligations (CLOs) being the most active and prominent owner of syndicated loans.
- High-yield bonds and investment-grade bonds are also used for corporate borrowing in Europe, but high-yield bonds are more institutional-focused.
- Private credit is a growing sector in Europe, with a focus on institutional investors. Retail vehicles like business development corporations (BDCs) are not as common in Europe.
Trends in European Credit Market:
- Over the past decade, private credit has filled the gap left by banks in Europe, resulting in a shift from 80% bank-led to 180 degrees the other direction.
- Recovery from events like Ukraine invasion and energy crisis has led to increased confidence in lending and finding risk spectrum that companies are comfortable with.
- Light new prime issuance and refinancing-based activity have been prevalent this year, with receptive capital markets for good quality companies.
- European market spreads were wider than the US due to pessimism about worst-case scenarios, but there's now a belief that high-quality part of European market is stronger than US.
Private Credit Risks:
- Flight to quality has been central in private credit, leading to defensive positioning and de-stocking by intermediary companies.
- Companies that were heavily leveraged during easy money era without hedging face challenges as interest rates rise.
- Labor shortage is a concern, impacting industries like healthcare and causing retrenchment by companies trying to right-size their cost bases.
- Artificial intelligence (AI) poses both risks and opportunities for businesses, potentially changing industry dynamics and power balances.
Jurisdiction Differences:
- Political factors play a role in underwriting risk, such as Brexit uncertainty or macroeconomic challenges faced by Germany.
- Structural issues can vary between jurisdictions, affecting the availability of financing options and creating a vacuum for private credit.
- Differences in lending laws across European countries make pan-European execution difficult.
Near-Term Default Risk:
- Maturity-driven default risk is limited due to companies finding ways to refinance or having healthy performance.
- Impaired companies that were operationally challenged prior to COVID are more likely to face substantial defaults.
- US high-yield bond market has higher default risk compared to European markets due to aggressive leverage profiles and elevated cost of borrowing.
Final Thoughts:
- Opportunities exist within the fallout of recent events, with potential returns outweighing risks for companies expected to recover well.
- Fundamental shifts like interest rate changes and AI adoption call into question short-term indicators and require medium-to-long-term thinking.
- Savvy investors should consider opportunities presented by sea changes and changing assumptions, while remaining active in their investment approach.