Alcentra European Floating Rate Income 05 September 2019
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