For BB-rated exposure, try a fund of loans

European Credit Management (ECM), a $12 billion fixed income fund house based in London, is introducing a leveraged loan fund that offers investors access to BB-rated European credit in a more efficient manner than bonds.

Matthew Craston, ECM's head of leveraged loans, is now touring Asia to drum up support from banks and other institutions for the product's July launch. Craston joined ECM in January from UBS; he has 20 years of syndicated loans experience at UBS and JPMorgan Chase. He says interest among some Asian investors is keen because leveraged loan products do not exist in this region.

The leveraged (i.e. sub-investment grade) loans business is huge in the US, comprising some 70% of the total loan market, and rapidly growing in Europe, where it now stands at about 30% of the total loan market, or E300 billion. Moreover these markets are becoming more institutionalized. In the US, 80% of leveraged loans are purchased by institutional investors, as opposed to commercial banks, while that figure in Europe is touching 25% but rising quickly, says Craston. Most of these institutions are insurance companies or managers of collateralized debt obligations and other structured products.

ECM is a separate category, that of a fund manager creating a portfolio of sub-investment grade loans. The firm, which to date has focused on managing bond funds, is pioneering the concept of a leveraged loans fund in Europe, which it says is a more stable method of accessing the BB-rated market. Asian investors now account for 27% of its total assets under management and the firm expects to raise similar sums for the loan fund, with the goal of eventually raising E250 million to 400 million.

This is a niche business because leveraged loans tend to emerge from private equity deals, in which investors are buying businesses off conglomerates and changing their capital structure. Because these loans are sourced from private equity houses, versus public, high-yield bonds, access requires the right sort of contacts. ECM, a fund house founded by ex-Merrill Lynch investment bankers, believes it has that access.

Until now, says Craston, the only way for investors to get exposure to BB-rated debt from European companies was to invest in their high-yield bonds. Investing in a portfolio of their loans, however, is safer, because this is senior debt, and also because ECM benefits from the extraordinary due diligence private equity firms can conduct on leveraged borrowers, that is not always available for public bond deals. This, plus the need to diversify across at least 40 to 50 credits, forms the basis of a leveraged loan portfolio's risk management.

Also making this product now available is the fact that only in the past two years has a secondary market in leveraged loans developed in Europe. This provides ECM with another pool of potential credits to invest in, as well as a means of exiting positions - the fund will offer investors monthly liquidity. Nonetheless, Craston says the stability of loans is key to making this product work, as loan prices tend to trade near par, which is certainly not the case with bonds. Craston was unable, however, to provide any quantitative measure of leveraged loans' volatility. "You'd need a three or four year track record," he says.

ECM claims it can provide a return of 300bp over Euribor on leveraged loans, and is telling clients that with modest (less than 1x) leverage, it will boost that return to 350bp to 450bp over.

The European leveraged loans market is growing at $50 billion a year, providing ECM with plenty of opportunities, and also allowing it to diversify its product offering from its other European corporate and sovereign bond portfolios. The only overlap with its existing product may be from its holdings of high-yield bonds, which are often issued by the same BB-rated firms that are borrowing from bank syndicates.

Savvy investors in Asia that already have high-yield exposure should be interested in a better method of accessing the BB-rated range, says Craston. ECM is also pitching this to Asian banks, which are awash in liquidity and looking for ways to generate a return. ECM offers the fund in both floating-rate dollars and euros, and is able to structure it to local currencies if requested.