Indexing meets the leveraged loan market
PENSIOEN PRO PARTNER ROUNDTABLE
Leveraged loans have become a major force in corporate lending. Once dominated by banks, these loans to highly indebted or lower-rated companies are now attracting growing interest from institutional investors, including pension funds. The market offers an appealing risk-return profile, comparable to high-yield bonds but with lower volatility. Now, indexing is opening the door to passive investors as well.
At first glance, leveraged loans and high-yield bonds seem similar: both target riskier borrowers outside the investment-grade universe. However, leveraged loans are typically senior obligations, secured by assets and bound by contractual agreements through covenants, offering lenders additional protection.
Leveraged loans also carry risks, including lower liquidity and sometimes weaker covenant protections. Often used to finance leveraged buyouts (LBOs) and refinance existing debt, they typically offer higher returns than investment-grade bonds and have shown resilience even in volatile markets, highlighting their diversification benefits.
In recent years, the asset class has become more accessible: costs have fallen, and technological developments have made index investing a serious option. Does this make leveraged loans more attractive for institutional investors? What role can they play in pension fund portfolios? And what impact might the new Dutch pension legislation (Wtp) have on allocations to this type of investment? Pension funds, investors, and an insurance company explored the opportunities in a roundtable, organized by Pensioen Pro.
A fast-growing asset class: tactical or strategic?
The leveraged loan market has expanded significantly. As banks, constrained by regulation, are slowly retreating from loan markets, institutional investors are drawn by attractive return-risk profiles and – sometimes – illiquidity premiums. Based on Morningstar’s indices, the US leveraged loan market is now roughly $1.4 trillion; in Europe, it stands around €300 billion.
“Though still seen as risky and volatile, the strong return potential of loans, their floating rate nature, low duration, and senior secured position in the capital structure are appealing”, says Paul-Antoine Conti, Team Head European Leveraged Loans at State Street Global Advisors (SSGA). “It can be an interesting asset class for long-term investors as part of their strategic allocation.”
A quick survey, however, shows most roundtable participants still use leveraged loans mainly tactically. Martijn Vijver, Lead External Fixed Income at MN, explains: “We only have strategic exposure to European leveraged loans for some of our clients. Our global high-yield book is €10 billion, whereas European leveraged loans represent €200 million. Within our high-yield mandates, 5 to 10% can be tactically allocated to leveraged loans. In early 2022, we decided to overweight European loans versus European high yield, anticipating rising interest rates. That’s when our allocation to leveraged loans nearly doubled.”
Insurance company Lifetri Group likewise relies on relative attractiveness and other market factors to perform asset allocation, says Richard Sanders, Lead Asset Manager at Lifetri. “For insurers, the flexibility to invest in high-yield and leveraged loans makes sense. Both markets offer relative value in different ways. That said, I also appreciate those who make structural allocations — it offers more clarity and direction, because tactical calls are notoriously hard to get right.”
Tarik Nbigui, senior investment strategist, says: “I have seen that leveraged loans were part of a high-yield mandate. The manager could invest in these loans opportunistically to create alpha versus a high-yield benchmark. I could also imagine that leveraged loans at some point become a separate asset class, which would mean a more strategic move to capture diversification and long-term risk-return benefits.”
APG invests directly in the segment, says Sven Smit, portfolio manager of European High Yield and Leveraged Loans at APG. “We manage sub-investment-grade investments against a high-yield benchmark, always maintaining a strategic off-benchmark allocation to leveraged loans. Parts of the high-yield benchmark – short-dated paper trading around par with low coupons – aren’t that attractive. Instead, loans offer decent coupons and extra carry. On top of that, we make tactical calls based on dislocations between the high yield and leveraged loans markets.”
The challenge to overcome: illiquidity
Private markets are mostly illiquid, and parts of the leveraged loan market are no exception: direct lending and small, mid-market loans. But, the broadly syndicated loan segment has grown dramatically since the global financial crisis and has also become more institutionalized thanks to the growth of CLOs. On the back of that, liquidity has improved. That said, periods of volatility can still impact both pricing and exit opportunities. In times of crisis, selling can become a real challenge.
Conti believes that avoiding the smaller loans helps protect liquidity in portfolios. “If you see leveraged loans as a global opportunity set and stick to broadly syndicated loans of at least $500 million in a single tranche, you can achieve decent liquidity in the secondary market. These loans trade daily with major dealers and brokers. In a normal market, the bid-ask spread is about 50 basis points.”
Another, maybe more important challenge, Conti points out, is that active managers in the leveraged loan market struggle to beat the broad market indices, as those include around 10% of small, illiquid loans . “Our research shows that only a minority of active managers consistently beat their benchmark, after fees. In the US, less than 10% of the largest 30 managers were able to outperform, after fees, over a 10-year period.”
This underperformance inspired SSGA to launch an indexed strategy that excludes smaller, less liquid loans. While Conti acknowledges that indexing is harder to implement in complex and less liquid markets, he says: “A well-designed and implemented indexed loan strategy focused on an effective sampling of larger, more liquid loans, may actually deliver the desired index beta while minimizing transaction costs and tracking error compared with active strategies.”
Can indexing reshape the market?
Conti explains that limiting the index to loans of at least $500 million is not the only active choice. “Indexing doesn’t mean a totally passive replication of the index. We can customize benchmarks to meet clients’ requirements, for example by focusing on specific credit quality, excluding distressed credits or applying an ESG framework. We then select a sample of loans that align with these characteristics.”
Nbigui shows interest in the advantages of index strategies. These could convince pension funds that believe in purely passive investing to invest in a market that is also potentially interesting for them. He does raise a concern about the constructed index. “If you invest only in large, liquid loans, don’t you miss the small-cap and illiquidity premium?” Conti acknowledges: “Smaller loans in the broad index offer a bit more premium, but not enough to justify the trade-off – lower liquidity and greater price lags in volatile market conditions. Holding them doesn’t materially boost portfolio returns over the long term.”
Sanders notes another risk: in a crisis, fund managers often sell the most liquid assets first to meet redemptions. “This leaves remaining investors with a less liquid portfolio. I have experienced this — after a market upheaval, it was decided to sit it out. It took a while to exit, and through swing pricing, it was necessary to accept some losses.
Sanders also points to default risks. What happens when a loan defaults: “Investors either sell at a loss or join a workout. Does anyone see participating in workouts as a return driver?”
Indexing reshapes access to leveraged loans
Smit answers: “We are not distressed investors, but if a situation arises, it’s a case-by-case call. Workouts can be resource-intensive, but exiting the transaction is not always the best choice.” Conti highlights that a custom-indexed strategy may help mitigate such risks: “By focusing on loans above $500 million, we moderately reduce triple-C exposure versus the broad index. But we can even leave that part out entirely and focus on single-B and double-B loans only. If downgrades to triple-C occur, we are not forced sellers and can manage exposure individually.”
The label of high-volatility
Many people unfamiliar with the asset class think leveraged loan returns are extremely volatile, says Conti. “But if you look at U.S. senior loans over the past 30 years, 27 years produced positive returns. And when returns were negative, they were usually less negative than in the high-yield bond market, for example, in 2015 and 2022. Since the great financial crisis, volatility and dispersion in loans have been relatively low overall.”
The term “leveraged” doesn’t help the asset class, notes Nbigui. “Board members could get suspicious hearing ‘leveraged loans.’ Companies with high leverage? Then it’s up to us to explain that it refers to the size of the loan relative to the profits of the company. Yes, there’s a lower credit rating, but a better label would be secured loans – that could be easier to understand.”
Smit adds: “The word leveraged is associated with risky investments, but it is a relative game. Average annual default rates in leveraged loans are between 2 and 3%. Secured creditors may recover 60, 70, or 80 cents on the dollar in a default scenario, but usually there’s a shareholder who lost everything.”
He also stresses that the leveraged loan market, now almost as large as the European high yield bond market, is too big to ignore. “If you invest in sub-investment-grade products and skip loans, you exclude a lot of opportunities. Moreover, the sector makeup is different. Defensive sectors like healthcare and software are overrepresented in the leveraged loan market in comparison to the high yield market, providing interesting diversification benefits.”
Nbigui: “You also get diversification to other fixed income asset classes because of the floating rate. There’s little to no interest rate risk, and you can benefit from diversification between high yield and leveraged loans.”
The need for further cost reduction
As with other complex, private and illiquid markets, investors must be mindful of higher costs. Indexing in broadly syndicated loans is one of the ways for investors to get cost-efficient exposure to the asset class and save their fee budget for more active, specialist strategies such as direct lending and private credit.
Smit sees another issue in leveraged loan markets. “The settlement process is still fairly archaic compared to high-yield bonds, where T+2 is standard. In loans, especially in Europe, settlement can take much longer. That adds to the costs. Optimizing the settlement process is probably the biggest opportunity to reduce costs for both active and passive investors.”
Conti agrees: “That’s another reason to focus on global loans, especially in the U.S., where settlement times are shorter. I fully agree with you on Europe – there, the average is over 30 days. To circumvent these issues, our strategy focuses on costless new primary issues as much as possible, and we offer monthly – rather than daily – liquidity to investors”.
Vijver shares this concern: “We only invest in European loans through an active manager. The settlement process is very lengthy, and the fees are simply too high. Although it involves more credit work due to the lack of publicly available information and is operationally more complex, the managers and credit research teams that manage leveraged loans and high-yield bonds are typically the same. Therefore, it feels odd that the fees for leveraged loans are much higher than for high-yield bonds.”
Most participants conclude that some disruption by newcomers would be welcome to create a more efficient European loan market.
Leveraged loans with an ESG twist: data quality is key
ESG is still a relatively new topic in the leveraged loan market, and developments in the U.S. do not merit much confidence in ESG reporting by U.S. companies. Yet, Conti believes investing through an ESG framework remains possible with the right data provider. He also points to initiatives by the Loan Market Association (LMA) and the European Leveraged Finance Association (ELFA) to harmonize ESG reporting standards for leveraged loan borrowers.
Smit, however, remains unimpressed by the current ESG data quality in loan markets. “When data providers do offer coverage, it’s often poor. The relevant information is frequently missing. But we benefit from our analyst team; they can reach out to these companies. These situations are mostly private, limiting access to investors who are lenders. Moreover, investors’ ESG requirements differ widely; there’s no one-size-fits-all solution.”
Vijver agrees. “Recently, we found that only 17% (as a percentage of market capitalisation) of companies in the European leveraged loans index report carbon emissions (according to MSCI data). That level of coverage doesn’t encourage our larger clients to invest.” With the EU slowing its ambitious reporting plans and U.S. ESG sentiment weakening, Vijver sees a challenge ahead. “We assumed that more companies would adopt sustainable practices, so we set requirements for reporting. If they don’t report, we may have to divest.”
Sanders adds that crises can sometimes accelerate change. “In the leveraged loan market, it’s challenging for individual investors to negotiate ESG terms with sponsors or issuers. Interestingly, just after COVID, CLO managers, who are dominant investors in leveraged loans, were facing a scarcity of financing. They were able to push sponsors to provide at least minimal ESG documentation, like exclusion policies and reporting.”
Smit acknowledges the difficulty but sees momentum building. “Fortunately, pressure isn’t only coming from us but also from CLO investors, private equity investors, and sponsors. It’s trickling down from several directions. Still, sponsors and issuers have their own interests, and it remains a long, gradual process. We think the ability to have direct access to issuers will remain key.”
Leveraged loans offer strategic and tactical advantages
Market expectations
Asked about market expectations for the next five years, Conti expects more demand from an increasingly sophisticated investor base. “The past 15 years have shown a significant growth and institutionalisation of the investor base as well as a strong resilience of the asset class. I don’t have a crystal ball, but I expect investors will increasingly contemplate the segment as part of a diversified strategic allocation framework.”
Will the new Dutch pension system (WTP) impact the segment? According to Nbigui, this depends on the contract. “With the flexible contract, you have to be aware of liquidity — leveraged loans are less liquid than high yield, which could have an effect. Under the solidarity contract, I don’t expect much impact. Pension funds won’t change their portfolios significantly. Also, capital requirements will no longer apply, giving more room for asset classes like private debt.”
Smit agrees: “One result of the pension reform is that pension funds will have more room to invest in return products. That could lead to higher allocations to spread products in general — and high yield and leveraged loans offer relatively high spreads.”
Vijver: “For us, it’s likely we will move towards a larger return portfolio for our clients (and therefore smaller matching portfolio), including equities, private equity, spread products like leveraged loans, high yield and emerging market debt, infrastructure debt and private corporate debt, and real assets as well.”
Smit adds: “Although we are an active manager, index products can help grow the market by attracting investors who otherwise wouldn’t have the resources or scale to invest.” Nbigui summarizes his point of view: “The market is improving, and the developments we see are promising — they are laying the foundations for leveraged loans to become a structural part of institutional portfolios.”
Conclusion
Participants agree that indexing can make leveraged loans more accessible to passive investors and may contribute meaningfully to market growth and maturity. While leveraged loans offer diversification benefits, challenges remain, including inconsistent ESG data, lengthy settlement times, and limited liquidity during crises. They could become an integral part of strategic portfolios over time, but cautious and deliberate implementation remains essential given the asset class’s structural complexities.
Contact us
For more information on how to incorporate leveraged loans into your portfolio:
Sabine van Solingen
Head of Benelux Institutional
Client Group
T +31 6 50 01 70 99
Delegates:
→ Paul-Antoine Conti, Team Head European Leveraged Loans at State Street Global Advisors
→ Tarik Nbigui, senior investment strategist (spoke in a personal capacity, formerly worked for Blue Sky Group and Philips Pensioenfonds)
→ Richard Sanders, Lead Asset Manager at Lifetri
→ Sven Smit, portfolio manager European High Yield and Leveraged Loans at APG Asset Management N.V.
→ Martijn Vijver, Lead External Fixed Income at MN