Bank Loans: A Rate-Hedging Strategy For Today s Portfolios

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1 INVESTMENT NOTE Bank Loans: A Rate-Hedging Strategy For Today s Portfolios May 2013 Bank Loans: A Rate-Hedging The Versatitily Strategy of Short For Duration Today s High Portfolios Yield 1 Over the past year, bank loans as an investment solution for today s low yield environment has become an increasingly discussed topic of interest. Key challenges arising from aggressive Federal Reserve policies are all too clear: a lack of meaningful income from traditional bastions of safe fixed income, namely U.S. Treasuries and investment-grade (IG) credit; and an asymmetric duration risk latent within these safe asset classes. While the allocation trend over the past several years has clearly favored high yield bonds, we are seeing early signs of a multi-year shift into bank loans as a solution to these challenges. The rationale for this shift is quite simple: bank loans is one of the few asset classes that can benefit from rising interest rates and has positive carry, i.e., income. Given the latent duration risk embedded within most fixed income portfolios, allocating from IG bonds to bank loans can offer a way to mitigate duration risk and provide immediate yield pick-up. In this Investment Note, we frame the rationale for bank loans, analyze the investment attributes of the various asset classes and recommend how to prudently implement this rate-hedging strategy. Summary Investing in bank loans offers a solution that addresses the income shortfall and duration dilemma of investment-grade fixed income portfolios. Bank loans exhibited lower return volatility than various investment-grade sectors for the 10-year period through 2007, when systemic deleveraging began. Over the past 16 years, bank loans have had only one year of negative returns, which was 2008, followed by a swift reversion in Focusing on prudent income generation not total return is essential to creating a successful, low volatility rate-hedging strategy. Matt Russ, CFA Vice President Matt.Russ@ShenkmanCapital.com +1 (203) For more information, please contact: Nicholas G. Keyes, CFA, CAIA Director of Business Development Kim I. Hekking Director of Client Services Marketing@ShenkmanCapital.com +1 (203) The Real Trade-Off Two years ago the 10-year U.S. Treasury note yielded 3.60%, a far cry from today s 1.75% or the low of 1.39% in Indeed, times have changed with open-ended expansion of the Fed s balance sheet. Low nominal yields in many cases negative real yields (inflation adjusted) in Treasuries and investment-grade credit leave strategic investors in an extremely difficult spot. Today s traditional fixed income portfolios are subject not only to insufficient yields to meet benefit obligations and return targets but also to asymmetric duration risk that, sooner or later, will manifest in the form of capital losses. Take, for example, the Barclays U.S. Corporate Index with a modified duration of 7.1 years and coupon of 4.90%, as of January 31, The math is relatively straightforward: a parallel curve shift of +100 basis points (bps) in a year results in an approximate price decline of 7.10% (7.1 x 1.00%), thus overwhelming the coupon for a loss of 2.20%, all else equal. Even the Barclays Intermediate U.S. Corporate Index with a shorter duration of 4.5 years and coupon of 4.50% would experience approximate price losses equal to the coupon with a +100 bps shift. One only has to look at the month of January when 5- and 10-year Treasury yields rose 16 bps and 23 bps, respectively for an indication of how rising rates can negatively

2 Bank Loans: A Rate-Hedging Strategy For Today s Portfolios 2 impact IG fixed income portfolios (see Exhibit 1). Furthermore, yields-to-worst for IG bonds are quite meager and, in most cases, are below reasonable expectations for future inflation. Exhibit 1: Asset Class Returns, Yields and Durations 5- and 10-year Treasury rates rose 16 bps and 23 bps, respectively, in January As of January 31, 2013 Total Return Yield-to-Worst Modified Duration Sorted by Total Return January Barclays U.S. Corporate -0.89% 2.82% 7.1 years Barclays U.S. Treasuries -0.81% 0.95% 5.3 years Barclays U.S. Aggregate -0.70% 1.90% 5.2 years Barclays U.S. TIPS -0.68% 1.67% 8.0 years S&P/LSTA Leveraged Loan +1.06% 6.19%* < 9.0 days * Fixed-equivalent yield calculated by using the discount margin plus the 5-year swap rate as of 1/31/13. Please see endnotes for a description of these indices. Source: Barclays, Bloomberg, S&P/LSTA, Shenkman. Bank loans offer an investment solution that addresses the income shortfall and duration dilemma of IG portfolios. With virtually no duration risk due to LIBOR-based floating coupons, the S&P/LSTA Leveraged Loan Index provides 429 bps of yield pick-up over the Barclays U.S. Aggregate and 337 bps over the Barclays U.S. Corporate, as shown in Exhibit 1. Indeed, allocating a portion of IG fixed income to floating-rate loans is not a complex solution; however, it requires taking calculated risk: swapping duration risk for credit risk. The real trade-off is accepting higher credit risk in exchange for reducing exposure to duration, while picking up considerable incremental yield and positioning to benefit from an increase in interest rates. Factors mitigating the increase in credit risk from investing in loans of below-ig companies include: 1. Seniority. Loans are typically senior, residing at the top of the corporate capital structure, and take priority among creditors. 2. Security. Loans are typically secured by a first lien on a company s hard assets, e.g., property, plant and equipment. 3. Covenants. Loan agreements include maintenance tests or incurrence tests, requiring borrowers to maintain certain financial metrics at all times or to comply with such metrics before incurring additional debt. 4. Active Management. Prudent credit selection can reduce volatility and default risk. Moreover, our analysis shows that taking this trade-off from IG fixed income to loans does not necessarily have to come at the expense of greater return volatility. Moving from IG bonds to bank loans requires taking a calculated risk: swapping duration risk for credit risk. Volatility Reversion Historically, bank loans have been a low volatility asset class, at least until the systemic deleveraging that began in That was a unique period for the financial system given the excess leverage employed by banks and financial intermediaries as well as the lack of private balance sheets to buffer liquidations of levered positions, specifically non-agency MBS and bank loans. Today, market leverage is dramatically lower than at the height of the credit bubble, as shown in Exhibit 2.

3 Bank Loans: A Rate-Hedging Strategy For Today s Portfolios 3 Exhibit 2: Significantly Lower Market Leverage = Less Risk of Forced Selling As of February Change Bridge Loans $330B $50B -85% CLO Warehouses $45B $4.5B -90% Total Return Swap Lines (TRS) $250B $100B -60% TRS Average Leverage ~8-10x ~3-4x -5.5x Source: JP Morgan. Bridge loans, which reflect committed deal financing on banks balance sheets, are a fraction of the levels seen at the peak of the LBO boom. CLO warehouses have not only declined by 90%, but the risk today is typically assumed by CLO equity investors, not investment banks. Furthermore, market-value CLOs, which were forced sellers in 2008, are virtually extinct. Consequently, with considerably lower levels of systemic leverage and favorable technical demand for floating-rate income, we expect the volatility of bank loans to continue trending in the direction of pre-2008 levels while recognizing that a new composition of loan investors could temper the reversion. The deleveraging of 2008 was an aberration that skewed long-term volatility measures, forcing us to examine pre-2008 outcomes. As shown in Exhibit 3 below, volatility of bank loans prior to late 2007 was lower than that of typical investment-grade benchmarks, like the Barclays U.S. Aggregate and U.S. Corporate indices. We expect volatility of bank loans to revert toward pre-crisis levels. Exhibit 3: Bank Loan Volatility Historically Lower Than Investment-Grade Bonds Rolling 3-year Volatility Analysis: Jan Dec % 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Prior to 2007, bank loans exhibited lower volatility than various IG sectors while TIPS had the highest volatility. Equity Market Peak: Oct 07 Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Annualized Volatility S&P/LSTA Leveraged Loan BCAP Aggregate BCAP U.S. Treasuries BCAP U.S. Corporate BCAP U.S. TIPS

4 Bank Loans: A Rate-Hedging Strategy For Today s Portfolios 4 The low volatility of bank loans translates into an impressive performance record: over the past 16 years the asset class has had only one year of negative returns, which was This drawdown was short lived and quickly reverted in Correlation, Credit and Rates It almost goes without saying that floating-rate bank loans are negatively correlated to U.S. Treasuries. But what is interesting about the analysis in Exhibit 4 below is that correlations to Treasuries for both bank loans and IG corporates declined under the post-2007 deleveraging regime. This was due to credit being the primary driver of returns for spread product after the 2008/2009 dislocation. Given today s more normalized credit spreads, we expect the positive correlation of IG corporate credit to Treasuries to strengthen toward pre-deleveraging levels as interest rates once again drive returns. Conversely, credit should continue to drive bank loan returns, which should remain negatively correlated to Treasuries. Over the past 16 years, bank loans experienced only one year with a negative return Exhibit 4: High Correlations of Investment-Grade Bonds to U.S. Treasuries Rolling 3-year Correlation to US Treasuries: Jan Dec Correlation Pre-Deleveraging Regime Deleveraging Regime Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 S&P/LSTA Leveraged Loan BCAP U.S. Corporate BCAP Aggregate BCAP U.S. TIPS One of the newer features of bank loans is LIBOR floors, which have been beneficial for current income and thus returns. Approximately 70% of the bank loan market has LIBOR floors that average 128 bps versus today s 3-month LIBOR of 28 bps. While bank loans with floors will not experience an immediate step-up in coupon when LIBOR begins increasing from current levels, they are well positioned for a sustained upward trend in short-term rates. For point of reference, 3-month LIBOR averaged 4.15% from 1997 to TIPS are worth mentioning because they are often seen not only as a hedge against inflation but also as a hedge against rising rates. The principal of TIPS adjusts with the Consumer

5 Bank Loans: A Rate-Hedging Strategy For Today s Portfolios 5 Price Index (CPI), so coupon payments rise with inflation. However, TIPS as a hedge against rising rates only holds true if nominal Treasury rates are rising due to higher inflation expectations (i.e., real rates remain steady). With real rates currently negative across most of the Treasury curve, normalization of real rates toward positive territory would be detrimental to the return of TIPS. Considering that TIPS have an 8-year duration and high positive correlation to Treasuries (see Exhibit 5), capital losses from rising real rates could easily overwhelm CPI adjustments to the principal of TIPS. This distinction between inflation protection and interest-rate hedge is important to understand when building a rate-hedging strategy. Exhibit 5: Bank Loans Have Negative Correlation to Treasuries Over the Last 15 Years Correlation Matrix S&P/LSTA Barclays U.S. Barclays U.S. Barclays U.S. Barclays U.S. Oct Dec 2012 Leveraged Loan Aggregate Corporate TIPS Treasuries S&P/LSTA Leveraged Loan 1.00 Barclays U.S. Aggregate Barclays U.S. Corporate Barclays U.S. TIPS Focusing on prudent income generation not total return is essential to creating a successful, low volatility hedge against IG duration risk. Barclays U.S. Treasuries Prudent Implementation Like anything with risk, details matter. How an investor implements a rate-hedging strategy with bank loans is critical because when moving down the credit spectrum, drivers of return change and risk of principal loss increases. Hidden within the bank loan universe are credits that, in our opinion, are not appropriate investments for most high yield investors, let alone investors allocating from IG bonds. Focusing on prudent income generation and money-good credits is how investors can mitigate the risk of principal loss and ultimately implement a successful, low volatility hedge against rising interest rates. Exhibit 6: CCC-rated Loans Increased Volatility Without Commensurate Return Risk-Return Analysis Pre-Deleveraging Period Entire Period July 2001 Sept 2007 July 2001 Dec 2012 Annual Annual Sharpe Annual Annual Sharpe Return Volatility Ratio Return Volatility Ratio S&P/LSTA Leveraged Loan 5.08% 2.52% % 7.60% 0.46 BB Loans 4.53% 2.05% % 6.57% 0.38 B Loans 5.70% 2.95% % 9.20% 0.41 Avoiding the volatile CCC segment of the loan market is necessary for sleep at night portfolios. CCC Loans 4.68% 7.19% % 14.35% 0.25

6 Bank Loans: A Rate-Hedging Strategy For Today s Portfolios 6 Bank loans are fundamentally well positioned as an asset class given a low default environment, stronger corporate balance sheets and valuations that imply a significantly higher default rate than current market expectations. However, investors should not be complacent with the day-to-day management of credit risk. First, from a portfolio management perspective, investing in first-lien loans with high-quality, hard asset collateral can help reduce risk of principal loss. Second, avoiding the volatile CCC segment of the loan market helps to dampen mark-to-market volatility (see Exhibit 6), which we believe is necessary for constructing sleep at night loan portfolios. Even for high-quality bank loan portfolios, fixed-equivalent yields of 4.50% to 4.75% still provide attractive yield pick-up over IG bonds. Conclusion As a result of unprecedented monetary policy in the U.S., duration risk has become asymmetric: the 5-year Treasury rate has a higher probability of going from 0.75% to 1.50% than to zero. Bank loans provide a practical solution for today s low yielding, rate sensitive investment-grade portfolios it is one of few asset classes that can benefit from higher rates and has positive carry (i.e., income). Allocating a portion of IG fixed income to high-quality bank loans provides immediate yield pick-up, effectively eliminates duration risk and positions investors to benefit from a rising rate cycle. With U.S. monetary policy dependent on improvement in the labor market, no one truly knows when interest rates will ultimately normalize, not even the Fed. Yet, bank loans as a low volatility rate-hedging strategy provide meaningful income while waiting for this day of reckoning. Disclaimers and Notes 1. Shenkman Capital is the marketing name for Shenkman Capital Management, Inc. and Shenkman Capital Management Ltd. Shenkman Capital Management, Inc. is registered as an investment adviser with the U.S. Securities and Exchange Commission. Shenkman Capital Management Ltd, a wholly-owned subsidiary of Shenkman Capital Management, Inc., is authorized and regulated by the U.K. Financial Conduct Authority. This material is provided to you because you have been classified as a professional client or eligible counterparty by Shenkman Capital Management Ltd as defined under the U.K. Financial Conduct Authority s rules. If you are unsure about your classification, or believe that you may be a retail client under these rules, please contact Shenkman Capital Management Ltd and disregard this information. 2. The S&P/LSTA Leveraged Loan Index reflects the market-weighted performance of U.S. dollar-denominated, senior secured institutional leveraged loans with a minimum initial spread of 125bps and term of one year. The Barclays Capital U.S. Corporate Index tracks the performance of U.S. dollar-denominated investment-grade corporate and non-corporate debt publicly issued in the U.S. domestic market. The Barclays Capital U.S. Aggregate Index represents the U.S. dollar-denominated, investment-grade bond market inclusive of government and corporate securities, mortgage pass-through securities, and asset-backed securities. The Barclays Capital U.S. Treasuries Index tracks performance of public obligations of the U.S. Treasury with remaining maturities of one year or more. The Barclays U.S. TIPS Index tracks performance of inflation-protected securities issued by the U.S. Treasury with at least one year until final maturity. These indices are unmanaged, not available for direct investment and do not reflect deductions for fees or expenses. 3. Third-party information contained this presentation was obtained from sources that Shenkman Capital Management, Inc. considers to be reliable; however, no representation is made as to, and no responsibility, warranty or liability is accepted for, the accuracy or completeness of such information. 4. The information and opinions expressed in this paper are for educational purposes only. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services or an offer to sell or a solicitation to buy any securities. This paper, including the information contained herein, may not be copied, republished or posted in whole or in part, without the prior written consent of Shenkman Capital. 461 Fifth Avenue New York, NY (212) Harbor Drive Stamford, CT (203) St. James s Street London, UK SW1A 1JT +44 (0) Copyright 2013 Shenkman Capital Management, Inc. All rights reserved.