We talk to the European asset management firm about a fund that taps into the "floating rate" bond and note story – one that chimes with a world of rising interest rates.

Interest rates keep going up. Last week, the Bank of England, the US Federal Reserve and the European Central Bank hiked rates. We may be approaching the end of the cycle, but as anyone who has tried to make predictions in recent years might conclude, it’s tough to call that with much confidence. 

In this environment, investments that give a bit of hedge to rising rates seem like a smart move. Welcome to the charms of the “floating-rate debt.”

A floating rate bond or note, as the “floating” adjective suggests, is a debt instrument that does not have a fixed coupon rate, as many bonds and notes do, but its interest rate fluctuates based on the benchmark on which the bond is drawn. In many rising rate environments, bonds with a fixed coupon lose value, but “floating rate” ones do not. 

WealthBriefing recently spoke to Pieter Staelens, managing director and portfolio manager at London-based CVC Credit Partners. His fund has exposure to this asset class and one sizeable chunk of it is in leveraged loans. The fund is available as a London-listed investment trust. (The closed-ended company, which was launched in June 2013, is based in Jersey.) Net asset value has risen 12.9 per cent over five years, but fell slightly last year (source: Trustnet).

The fund finances leveraged buyouts and holds leveraged loans. (It does not lend to individual people.) That gives the fund exposure to the busy private equity space, about which investors remain bullish, which means that it is illogical to be negative on leveraged loans and be upbeat about private equity as an asset class, Staelens said. 

“There’s still lots of work to be done by investment firms to educate people. There has been a lot of negative press in the past due to misunderstanding of the asset class and debt more broadly,” he continued. 

Mention of “leverage” can make observers queasy, particularly those old enough to have been in finance during the 2008-09 financial crash. Leveraged loans, according to one definition, are loans that are extended to companies or individuals that already have considerable amounts of debt or poor credit history. Lenders consider leveraged loans to carry a higher risk of default; as a result, a leveraged loan is more costly to the borrower. Last February, US banking regulators warned of risks in the sector despite some improvements in corporate creditworthiness (Financial Times, 14 February 2022). 

The key to successful, risk-managed investment in this sort of asset class is focus on quality of the debt issuer, and genuine diversification, practitioners say. As for Staelens, he points out that the fund focuses on relatively large corporates.

“All companies in the portfolio are fairly large companies with an average EBIDTA of more than €300 million ($324 million),” Staelens said.

Debt and seniority
In a typical private equity transaction, a PE fund will buy a business with a 50/50 split of equity and debt. On the loans side of the equation, these are typically senior in the structure to equity and the riskier, subordinated debt.

“We have a much lower beta or market volatility as we are at the top of the capital structure,” Staelens continued. 

About 83 per cent of the CVC portfolio is in floating-rate products. 

The past year was difficult for investors across the board; CVC Income and Growth Ltd had its first year of losses in 2022 since the company was launched in 2013. However, leveraged loans materially outperformed other asset classes such as investment grade or high yield, he said. Investors are getting equity-like returns for credit risk, he said.

“There’s further upside in a rising rate environment as most central banks are likely to continue to hike rates as inflation is still too high. Also, many of the loans we hold were purchased during the market sell-off of 2022 when quality credits were trading at large discounts due to forced sellers,” Staelens said. The asset class is riskier than government debt but less risky than equities, although currently projected to achieve equity-like returns based on current yields, he continued.

This asset class is typically not easily available for the private retail client; because the CVC fund (CVC Income and Growth Ltd) is listed, people can tap into the sector by simply holding the stock. In this sense the fund is relatively unusual.

Staelens brings plenty of credit market experience to the table. He joined CVC Credit in 2018 from Janus Henderson Investors in London where he was involved in various high-yield strategies and a credit long/short strategy. Prior to this, he was at James Caird Asset Management, CQS, Remus Partners and Bear Stearns.  

At present most investors in the asset class are institutions such as insurance and pension funds, although CVC Income & Growth Ltd counts a number of large wealth managers amongst its shareholders, Staelens said. He is seeing continued demand from private wealth and is planning to increase interest among HNW private clients. 

Loan-to-value ratio
With the mix of bonds that the fund holds, there is a loan-to-value (LTV) ratio of typically about 50 to 60 per cent. “There is quite a bit of buffer below us in case things go wrong and there’s a recession,” he said. 

The CVC team of analysts put in a lot of work to analyse underlying credits before entering an investment.

About 83 per cent of the CVC portfolio is in floating-rate products and that means the credit coupons rise in line with interest rates – an important consideration at times such as this. This is important because most bonds lose when interest rates rise. With the floating rate paper, coupons are re-set once a quarter, protecting the underlying value of the asset.

“This is a growing asset class, which has doubled over the last five years…in the past, many of these assets sat in banks’ balance sheets. The European loans market has gone more institutional.”

Default rates in Europe have been around 1 per cent for the past five years. This is likely to rise to between 2 and 4 per cent depending on the severity of the recession – if there is a recession, Staelens said. “People ask about loss rates…due to our senior position in the capital structure, we have considerable security in the assets and can typically recover quite a bit of our money.”

With recovery rates of about two thirds if defaults were to occur, the position of investors in leveraged loans is relatively well protected in light of the exceptionally high yields on the portfolio, Staelens added.