Senior Loan Market Liquidity In Perspective

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1 Fixed Income Senior Loan Market Liquidity In Perspective Joseph Welsh, CFA Head of the High Yield Corporate Debt Team Executive Summary Liquidity, in any market, refers to the ease with which an asset or investment can be converted to cash; price is a crucial consideration in assessing liquidity. The senior loan market has experienced tremendous growth and evolved into a large, robust capital market with a wide breadth of participants and consistently strong trading liquidity. Loans have relatively long settlement times but managers have several tested and proven options at their disposal to help mitigate liquidity risk. Not FDIC Insured May Lose Value Not Bank Guaranteed I. Liquidity: The Point at Which You Find Willing Buyers and Willing Sellers In late September 2015, the Securities and Exchange Commission (SEC) proposed a comprehensive package of reforms designed to enhance liquidity risk management in openend mutual funds and exchange traded funds (ETFs). The proposed reforms include: 1. Requiring funds to implement a liquidity risk management program. 2. Having funds consider swing pricing to pass the costs of transaction activity onto the fund shareholders responsible for the activity. 3. Enhancing disclosures regarding fund liquidity. While the SEC s proposal is certainly not loanmarket-specific loans were discussed in just five sections of the 415 page document the sweeping nature of the proposal and its potential impact on many categories of mutual funds are sure to bring liquidity to the forefront of topics discussed in the fund industry for the next couple of years. Discussions about liquidity can be complex and nuanced. When boiled down to its essence, liquidity in any market is nothing more than the price point for an asset at which you find willing buyers and willing sellers. That intersection is where a trade takes place and liquidity is attained. Exhibit 1 For example, if I tried to sell my mint condition 1995 Ford Bronco (5.0 liter V8 Eddie Bauer edition) for $20,000, I suspect it would be a quite illiquid asset. If I were willing to sell it for $10,000, it would become significantly more liquid. If I offered it for $5,000, I am confident I would convert my prized truck into liquid cash by the end of the day. Liquidity increases as the price of the asset in this case, the Bronco decreases, because the number of willing buyers increases. This is true for all assets. Discussing liquidity in a vacuum, without taking price into account, is nonsensical especially in the context of highly developed capital markets. Exhibit 1 Liquidity: Price Where Willing Buyers and Sellers Meet Number of Participants Buyers Liquidity Price Sellers Price Number of Buyers

2 OppenheimerFunds 2 Every day in every capital market, be it stocks, bonds, commodities, loans, etc., buyers and sellers face off in competition to get a good deal for themselves, based upon their own individual perceptions of value, by buying low and selling high. This beautiful process is the heart of capitalism and allows market forces to determine the price and liquidity of every existing financial asset. Liquidity and price are thereby inextricably linked and decoupling them is simply not possible. The relationship between price and liquidity allows the relevant question in assessing the liquidity of any given asset to become: At what price are buyers and sellers willing to meet? When you have the answer to that question you will know where you have liquidity. Determining the price at which any given asset might trade has a lot to do with the uncertainty regarding the value of the asset in question. Difficult-to-value assets will generally display a high degree of price volatility as buyers and sellers wrestle about where to meet. Easier-to-value assets should display accordingly less price volatility. The stocks of Internet start-up companies, for instance, will fluctuate wildly as buyers and sellers struggle to determine the ultimate value of those businesses. Commodities likewise can be highly volatile when uncertainties arise about the complex factors impacting their supply and demand outlooks. Senior secured corporate loans, on the other hand, are typically one of the least volatile asset classes because their structural features senior priority, secured by collateral, not interest-rate sensitive, callable make them relatively easy to value versus most other asset classes. When loan prices drop to levels where yields offer strong value, all types of buyers such as multi-sector funds, institutional investors, and hedge funds emerge to buy loans because of the intrinsic value loans hold by being senior and secured contractual debt obligations of some of the best companies in America. Historically, it has taken only relatively modest price declines for buyers to see value in loans and become willing purchasers. Just once in the past 23 years have loans produced negative total returns for a calendar year. That powerful statistic demonstrates liquidity abounds for loans as prices drop, even just a little. In economist jargon, you could say senior loans have an extraordinarily high price elasticity of demand. If loans get cheap, liquidity soars. While an Internet startup s equity may be difficult to value and could ultimately end up worthless, default and recovery rates on senior loans are significantly easier to forecast. It is difficult to imagine an environment in which a diversified portfolio of senior and secured loans to big American companies would not be able to offer at least some value to a long-term investor. That is one of the reasons why senior loans are a formidable tool for wealth preservation. There are other nuances regarding liquidity in the senior loan market that are important for investors to appreciate. First, liquidity is not homogeneous across each loan in the market. Larger loans to better known companies are typically more liquid than smaller loans to lesser known companies. Also, loans to companies that are experiencing some level of operational difficulty naturally become less liquid as buyers and sellers work through the uncertainty of assessing the value. Second, if a loan doesn t trade frequently, that doesn t mean it is illiquid. The fear that often accompanies illiquid assets involves the perception that they are illiquid because no buyers exist. It s a very different and significantly less concerning situation if an asset doesn t trade because no sellers exist. A substantial source of illiquidity in the senior loan market is actually caused by a lack of sellers. Since loans generally have minimal call protection, buyers understandably are unwilling to pay much more than par (100 cents per $) knowing that a loan may be called by the issuing company at any moment. That structural feature usually caps bids from buyers at par a level at which sellers may have no desire to sell. Billions of dollars in loans are held by investors who have no reason or desire to sell; this causes some loans to trade infrequently. If those investors decided to sell at or close to par, those loans would be purchased by buyers quickly. The paradox is that a senior loan can be simultaneously highly liquid yet infrequently traded. While senior loans do not have the same kind of liquidity found in the U.S. Treasury market, many investors have found the liquidity of senior loans to be quite adequate since the first mutual fund designed to buy syndicated senior loans launched in More importantly, it s clear that since then trading liquidity in the senior loan market has greatly improved. As the market has evolved over the years, elements of the loan market may be as liquid as or more liquid than elements of many comparable debt markets.

3 The Right Way to Invest II. The Size of the Market and Breadth of Senior Loan Investors Have Led to Consistently Strong Trading Liquidity Back in 2005, senior loans were less than a $250 billion market and had fewer regular participants. By the end of June of 2015, the loan market had grown by 300% and was about $965 billion, according to the Credit Suisse Leveraged Loan Index. 1 The senior loan market has grown over the years due to the unique structural features of the asset class which make loans appealing to both borrowers and lenders alike. For lenders (investors), loans offer relatively high yields, minimal interest rate risk, and effective diversification benefits as well as the comfort of investing in sizeable American companies at the senior and secured level. Borrowers like to raise the capital they need by issuing loans because loans offer a lower overall cost of capital and provide better flexibility with respect to refinancing than high yield bonds due to their call features. When a capital market product makes sense for both sides of the deal as it can with senior loans, you have a win-win scenario that is likely to produce continued growth. As the market has grown, so has the breadth of investors participating in the loan market. Exhibit 2 Currently, Collateralized Loan Obligations, (CLOs), are the largest participant in the market. CLOs are structured products that are dedicated, long-term investors in loans. CLOs represent sticky money as existing deals are not prone to redemptions and generally reinvest for four years. After the reinvestment period, CLOs enter their amortization period. During the amortization period, senior loans continue to be held until they mature or are called and do not, generally, become a source of selling pressure. Typically, an amortization period lasts up to about six years although deals vary. Currently, mutual funds are the second largest participant in the market at 22%. 2 In addition to senior loan mutual funds and CLOs, insurance companies, financial companies and hedge funds are investors in the loan market and represent another source of demand. Furthermore, the loan market has often witnessed significant purchases from crossover buyers, as the managers of other types of income funds, including multi-sector/strategic income or high yield funds, cross over to the loan market when they deem values are attractive. Exhibit 2 The Size and Breadth of the Senior Loan Market 2 6/30/15 6/30/05 Financial and Insurance Co. s 7% Hedge, High Yield and Other Funds 5% $228B $965B Senior Loan Mutual Funds and ETFs 22% CLO 66% Sources: Credit Suisse and S&P Research as of 6/30/15. 3

4 OppenheimerFunds A large market and a diverse group of investors for senior loans have led to strong liquidity in the secondary market; which since the beginning of 2010 has averaged $40 billion in trading volume per month. 3 Consistently strong senior loan market liquidity is evident by high dollar volumes of trading and low bid/ask spreads. Exhibit 3 High trading volume is typically an indicator for trading liquidity as more money is changing hands in the market. Low bid/ask spreads can signify more participants in the market and better liquidity. The bid/ask spread is the difference in price between the highest price a buyer is willing to pay for an asset and the lowest price that a seller is willing to sell. The diversity of the investor base and liquidity of the market was tested in 2014, when mutual funds experienced some $24 billion of retail outflows, according to JPMorgan Research. 1 While the large retail redemptions resulted in pressure on the loan market, liquidity remained strong as average monthly trading volume in 2014 was $52 billion, and total returns of major loan indices were positive. Exhibit 3 High Dollar Volume of Loan Trading 3 Monthly trade volume of loans in dollar terms $80 60 ($ in Billions) Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Source: Loan Syndication Trading Association (LSTA) as of 6/30/15. Low Bid/Ask Spreads Indicate Strong Liquidity 3 Median bid/ask spreads in the market 250 Median Bid/Ask Spreads (bps) Source: Loan Syndication Trading Association (LSTA) as of 6/30/15.

5 The Right Way to Invest III. Settlement Times for Senior Loans Are Longer than Other Asset Classes but Redemption Requests Are Regularly Met via Numerous Liquidity Sources While senior loan market trading liquidity has been strong, settlement times tend to be long. This is because each loan s credit agreement the legal contract between borrower and lender is negotiated individually and the transfer of ownership after a loan is traded is documented manually; transfers are not automated. It is a slow manual process for some legitimate reasons (issuers sometimes need to approve who is participating in their loan in order to ward off hostile takeover attempts) and some weaker reasons (manually processing each transfer is profitable for administrative agent banks and lawyers). According to the Loan Syndication Trading Association (LSTA), the industry average for the amount of time it takes a loan to settle after its trade date is around 22 days, or T+22 in debt parlance. It is important to note that new issues are included in that settlement time average. New deals that come to market tend to extend industry average settlement times as they settle further out than existing loans that trade in the secondary market. Loan managers that are subject to daily redemptions typically don t sell new issues they just purchased to meet redemptions, so it is prudent to focus solely on the settlement times in the secondary market when considering liquidity risk. Some senior loan managers, through back office persistence, do better than the industry average and have the ability to settle loans around T+12 on average. It is important to note that ownership risk is transferred on trade date and not settlement date. Therefore, price fluctuations after trade date and before settlement date are borne by the new owner of the loan, not the seller. Historically, longer settlement times have not caused issues for loan mutual funds in terms of satisfying daily redemption requests. This is because mutual fund managers have developed and utilized several different liquidity sources. The following liquidity sources have been effectively used by senior loan mutual funds for years to meet their redemption requests: Exhibit 4 Cash on hand Debt securities with shorter settlement times Dedicated credit lines Principal and interest payments Exhibit 4 Liquidity Sources for Managing Longer Settlement Times Cash on Hand Principal and Interest Payments Credit Line Debt Securities with Shorter Settlement Times 5

6 OppenheimerFunds Some degree of cash is typically kept on hand by all mutual funds as part of its basic operations and senior loan funds are no different. Senior loan funds can also hold some amount of high yield bonds or other securities which settle in T+3. Many senior loan funds have substantially sized dedicated lines of credit for the express purpose of bridging the gap between trade date and settlement date when they need to fund shareholder redemptions. And finally, a lesser recognized but fairly obvious source of liquidity used by loan funds is the regular interest payments and principal amortization periodically received from the borrowing companies. These can be surprisingly substantial in 2014 alone, the loan market had approximately $265 billion in principal payments and $43 billion in total coupon payments, which makes up about 30% and 5% of the overall market, respectively. 4 It is still far too soon to tell exactly how the SEC s newly proposed liquidity rules will be enacted and how they will impact all mutual funds including senior loan funds. With respect to the loan market, my hope would be that the regulators focus their efforts on prodding industry participants to standardize settlements times at T+3, and minimize the amount of burdensome, highly discretionary, and potentially confusing disclosures required regarding liquidity. The senior loan market has served both investors and borrowers well for decades. Any regulations that would restrict or impair the retail investor s access to the market would be a disappointment, while any reforms that would modernize the settlement process would be a welcomed improvement. Most senior loan mutual funds are managed by reputable managers that are keenly aware of the need to always be able to promptly fund shareholder redemption requests. They have each utilized some combination of the above liquidity sources in managing their funds and the process has worked smoothly for decades. 6

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8 Joseph Welsh, CFA Head of High Yield Corporate Debt Team Joseph Welsh is co-portfolio manager of Oppenheimer Senior Floating Rate Fund and Oppenheimer Senior Floating Rate Plus Fund. He has specialized in non-investment-grade investing since Visit Us oppenheimerfunds.com Call Us Follow Us 1. The Credit Suisse Leveraged Loan Index and the JPMorgan Leveraged Loan Index both track the performance of U.S.-dollar-denominated senior floating rate bank loans. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Each index is unmanaged and cannot be purchased directly by investors. Past performance does not guarantee future results. 2. Mutual funds and ETFs represent only 22% of the loan market, as of 6/30/15, according to the Credit Suisse Leveraged Loan Index. 3. Source: Loan Syndication Trading Association (LSTA) as of 6/30/ Source: Credit Suisse as of 12/31/14. Total coupon payments is calculated by multiplying the average coupon rate of the market by the total face value of the market. Senior loans are typically lower rated and may be illiquid investments (which may not have a ready market). Senior loans are subject to credit, interest rate, prepayment and liquidity risks. Diversification does not guarantee profit or protect against loss. These views represent the opinions of the Portfolio Manager at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are subject to change based on subsequent developments. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling CALL OPP ( ). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY OppenheimerFunds Distributor, Inc. All rights reserved. RC December 3, 2015