The Case for Leveraged Loans

Transcription

1 The Case for Leveraged Loans As the market grew, banks and institutional investors sought to diversify and actively manage their loan portfolios by An Attractive Source for Uncorrelated Returns increasing exposure to some companies and industries while December 2010 divesting from others. This led to the development of an active David Frey, Managing Director and Portfolio Manager secondary trading market beginning in the late 1990s. Since Julian Qin, FRM, Senior Risk Analyst then there has been a substantial increase in the liquidity of the loan market. This is a result of robust growth in secondary loan trading, the development of standardized trading, documentation and settlement protocols, and improvement in the availability of third party pricing, which have made the loan market more efficient and transparent than it was in the Introduction Leveraged loans are the senior most debt obligations of noninvestment grade corporate borrowers. Because they blend the current income and contractual principal payment of traditional fixed income securities with a logical hedge against rising interest rates and inflation, loans represent a unique asset class for investors, especially during the current period of historically low interest rates. While investors are increasingly interested in corporate credit, many are participating through the bond market, which includes an imbedded interest rate bet. Because loans are floating rate, they have minimal interest rate duration. A further benefit to loan investors is the low correlation of loan returns to bonds and equities, which is helpful in diversifying risk and enhancing the overall expected returns of a portfolio. Even more impressive, except during the extraordinary and abnormal events of the recent credit crisis, leveraged loans have generated better riskadjusted returns than many other asset classes, as evidenced by their higher Sharpe ratios. Over the past ten years, leveraged loans have evolved to become a mainstream, investable capital market asset class, not just an alternative or opportunistic investment. The investor base has expanded beyond commercial banks to a market where more than half is held by a broad range of institutional investors including insurance companies, mutual funds, pension funds and hedge funds. We believe large cap, broadly syndicated senior secured loans are well positioned to continue to offer investors attractive risk adjusted returns for the reasons discussed below. Large, Actively Traded Market The birth of the non investment grade loan asset class coincided with the increase in leveraged buyouts in the early 1980s. This new form of lending was distinguished by a cash flow based lending model, as opposed to a collateral based lending model. Non investment grade cash flow lending activity grew throughout the 1980s and 1990s and was bolstered by the same investment thesis as for high yield bonds: while the risk of each loan individually is higher than an investment grade or well collateralized asset based loan, a substantial portion of these risks can be mitigated in a well diversified, actively managed portfolio, thus yielding attractive investment returns. past. Loans now trade like securities, with secondary prices driven by similar factors of underlying company performance and outlook, supply and demand, relative value and overall market sentiment. The non investment grade institutional term loan market is estimated by Credit Suisse to be about $763 billion, which is comparable to the estimated $1,012 billion high yield bond market 1. According to the LSTA 2, secondary trading volume of the term loans in the roughly $500 billion S&P/LSTA Leveraged Loan Index now averages approximately $417 billion annually or 83% annual turnover. This compares to roughly $1,600 billion of secondary trading or 160% annual turnover for the high yield bond market. Senior Secured Protection As the economy continues to reflect uncertainty, senior secured loans remain the safest part of the corporate capital structure. First, loans are generally senior and secured, with a first priority lien on all of the borrower s assets. Their place in the capital structure is highlighted by an average recovery rate of 70.6%, compared with recovery rates of 43.5% and 36.1%, for senior unsecured bonds and senior subordinated bonds, respectively 1. The second key distinction is that loans are typically governed by a credit agreement that includes maintenance covenants. Maintenance covenants are intended to help protect the lender from deterioration in the credit, as a borrower who is unable to maintain compliance with these predetermined ratios must seek to have them amended. The amendment process allows lenders to impose greater discipline and constraints on the company s management and may allow lenders to demand prepayments, additional equity or other necessary changes to the capital structure and receive higher interest payments and amendment fees. We Expect Favorable Risk Adjusted Returns Compared to Other Assets Despite the recovery, many challenges and uncertainties remain, including constrained consumer and small business credit availability, lingering high unemployment, elevated

2 household debt levels, reduced household wealth, and weak risk and should act as a hedge against rising rates and inflation, housing markets. Extensive government deficits eventually as the rising LIBOR component provides an additional source imply greater tax burden, contractionary spending cuts and higher interest rates. We believe these factors will persist and cause economic growth to be below trend for the next several years, and thus high rates of return will be difficult to achieve of return. Many newly issued loans have LIBOR floors of 1.5 2%, which pay this higher rate even if LIBOR is lower, and provide incremental return for total yield buyers during periods of abnormally low interest rates. without taking on a disproportionate amount of risk. In this environment, we believe stable, income producing assets will outperform, especially on a risk adjusted basis. The past 30 years of declines in US interest rates have been very supportive to fixed income returns, as shown in Exhibit 1. However, with interest rates at historical lows, this trend seems likely to reverse, and may result in a significant headwind and potential source of capital loss for fixed income securities going forward. Exhibit 1 18% 16% 10 Year US Treasury Yield Loan Spreads Remain at Historically High Levels Excluding 4Q08, non investment grade loans have fairly consistently generated 5 8% annual returns with low volatility, as shown in Exhibit 2. Returns have typically been higher than normal for several years following recession. The global credit crisis affected loans as it did other credit and equity markets, as extraordinary forced selling, deleveraging, capital constraints and panic drove returns of the Credit Suisse Leveraged Loan Index to 28.8% in 2008 and back up 44.9% in A patient investor with the resolve to hold on would have netted +3.2% over this period (using the Credit Suisse Index as a proxy for loan returns). Exhibit 2 14% 50% Credit Suisse Leveraged Loan Index Return 44.9% 12% 40% 10% 30% 8% 20% 6% 4% 10% 6.8% 11.2% 10.3% 11.0% 8.9% 7.5% 8.3% 5.3% 4.7% 4.9% 5.6% 5.7% 7.3% 2.6% 1.1% 1.9% 6.5% 2% 0% 0% % Source: Bloomberg Minimal Interest Rate Duration Risk Loans are generally floating rate and pay interest based on a spread over LIBOR, which is typically re set every 3 months. While investors are increasingly interested in corporate credit, many are participating through the bond market, which includes an imbedded interest rate bet. With a bond, both the interest coupons and the principal at maturity are fixed. Therefore, if interest rates change, the market price of the bond fluctuates to adjust the yield to the new market rate. When interest rates go up, the value of the bond goes down. For a loan, the principal payment is fixed but the interest coupons fluctuate based on changes in market interest rates. When interest rates go up, the current income received from a loan goes up and the principal value tends to remain constant. Loans therefore tend to have minimal interest rate duration -20% -30% Source: Credit Suisse *YTD through 9/30/ % Current secondary market spreads of 615bp 3 are meaningfully wider than the 411bp historical average and remain near the peak of the prior credit crisis in , despite recent improvement in the economy and capital markets, as shown in Exhibit 3. Loan spreads are also attractive relative to high yield bond spreads, as the difference is only 27bp as compared to historical norms of bp. This is especially notable considering that high yield bonds are fixed rate and are unsecured or subordinated obligations that are junior in right of payment to senior secured loans and thus typically have * 2010 YTD

3 Spread In Basis Points 1,800 1,600 1,400 1,200 1, Large Cap Loan much lower recoveries in the event of default. The Probability for Positive Credit Events Remains High The economics of holding existing loans should improve with Exhibit 3 more amendments and amend/extends, which provide Credit Suisse Leveraged Loan and High Yield Index Spreads increased spread and amendment fees. Prepayments have been high and offer substantial capital appreciation to holders High Yield Spread To Worst Leveraged Loan DMM of discount assets. Companies and equity sponsors are highly focused on cash generation, improving their balance sheets, and extending their maturities. We expect company free cash flow to improve and be used primarily for debt repayment. 642 While high yield bond spreads also remain wide, absolute coupon levels are low relative to historical norms and interest 615 rates seem poised to rise. Companies are likely to continue to take advantage of a strong high yield market to issue bonds to repay bank debt, extend maturities and secure long term covenant lite capital at attractive rates. Stronger financial Source: Credit Suisse. Loan discount margin to maturity (DMM). Current average maturity markets should drive a return of M&A activity, asset sales, and for the CSLL is 3.83 years as of 9/30/10 even IPOs, potentially providing a further source of positive credit events and prepayments. Jan 86 Jan 87 Jan 88 Jan 89 Jan 90 Current spreads imply attractive returns, and when supplemented with capital appreciation from any fundamental spread tightening, positive credit events and favorable technical factors, loans appear poised for healthy returns. We see new issue loans as even more attractive, as many loans are being priced at L bp with a LIBOR floor of 1.5 2% at a price of 98 or 99, which implies a yield to maturity of 6 8%. We believe the institutional loan buyer base is shifting from spread based buyers like CLOs (who have low cost, LIBORbased funding and are looking to capture a spread differential) to total yield based buyers like managed accounts, high yield and loan mutual funds, and other institutional vehicles, as shown in Exhibit 4. As a result, we are optimistic that favorable new issue pricing will continue. Exhibit 4 80% 70% 60% 50% 40% 30% 20% 10% 0% Jan 91 Jan 92 Jan 93 Jan 94 Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Share Of Loan New Issue Market By Investor Type (Excluding Banks)⁵ Q 3Q10 CLO Finance Co. Crossover investors * Insurance Co. Prime Rate Fund *Hedge funds, high yield accounts, distressed investors and non traditional players Source: S&P LCD Jan 08 Jan 09 Jan 10 Defaults are Declining We believe one reason that loan pricing remains elevated is that the memory of recent high defaults and credit loss remains in investors minds. However, rather than looking backward, investors should look forward, and we believe the outlook for defaults and credit loss is more benign. The sharp and sudden deterioration in the economy and credit markets had their expected impact on leveraged loan default rates and recoveries, with the trailing twelve month default rate reaching a high of 8.25% of issuers and 10.81% of principal outstanding in November 2009, according to LCD, as shown in Exhibit 5. However, the pace of defaults is slowing and the default rate is falling, with the trailing twelve month default rate declining to 4.53% of issuers and 3.55% of principal outstanding at September 2010 according to LCD. However, we estimate current market spreads imply an 8.8% expected annual default rate for the next 4 years 4. Companies have impressively cut costs, shed excess capacity and reduced inventories, and the economic outlook, although moderate, appears positive. Those companies that have survived are better positioned for the upturn and the laggards and problem credits are easier to spot. Economic improvement, stronger financial markets, enhanced liquidity and company cost reduction should reduce the likelihood of default, and we expect the default rate to continue to decline over the next several years. Seasoned, active managers should be able to significantly outperform the default rate of the broader market. The back side of the default cycle is traditionally a very good time to invest in non investment grade loans.

4 12% 10% 8% 6% 4% 2% 0% Large Cap Loan Exhibit 5 coincide with the end of the reinvestment periods of a substantial portion of the $247 billion CLO market 7 LTM $Defaults / Outstanding Par Amount that was 10.81% (Nov. 2009) also largely raised in However, the capital markets are already addressing the refinancing cliff in a very impressive fashion. As shown in Exhibit 7, the combined loan maturities have been reduced by 55% to $112 billion from $249 billion over just the past 21 months, through amend/extends, high yield bond issuance and free cash flow prepayments. Companies are now beginning to address the 3.55% (Sept. 2010) 2014 maturities. We expect these actions to continue, and 0.15% (Jun. 2007) they are likely to make the refinancing cliff manageable when the time comes, with or without new CLOs, as we believe institutional investors, retail mutual funds and renewed bank interest will provide adequate demand. Jan 99 Jul 99 Jan 00 Jul 00 Jan 01 Jul 01 Jan 02 Jul 02 Jan 03 Jul 03 Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Source: S&P LCD Less Volatility Than Other Assets Largely because of their senior secured protection and floating rate attributes, loan prices have tended to be less volatile than other asset classes (as shown by their lower standard deviation of returns in Exhibit 8). This tends to lead to better investment performance during periods of financial stress, as shown by Exhibit 6. Exhibit 6 Peak to trough price swings during market meltdowns⁶ Source: S&P LCD LCD flow name S&P HY vs S&P 500 vs Loans Bonds 500 Loans Loans Terror attacks, Fall % 9.10% 11.60% 3.6x 4.6x Corporate scandals, Summer/Fall % 17.30% 27.90% 4.0x 6.5x Subprime meltdown, June % 4.80% 9.40% 1.0x 2.0x Bear merger, February % 7.40% 6.40% 1.6x 1.4x Lehman Bankruptcy, September % 28.90% 35.70% 1.1x 1.4x Recession/default spike, 4Q08/1Q % 23.90% 27.50% 1.5x 1.7x European Sovereign Crisis, February % 11.51% 15.88% 2.1x 2.8x Refinancing Risks are Declining Some investors are concerned about the significant loan market maturities in 2013 and 2014, resulting from the peak of the LBO boom in These maturities currently $600 $500 $400 $300 $200 $100 $ Exhibit 7 Million Source: S&P LCD 12/31/ /31/ /1/ Leveraged Loan Maturity Profile Total Risk/Return Profile In this report, we present historical data since the origination of the Credit Suisse Leveraged Loan Index in 1992 through September 30, We also present the data excluding the September 2008 July 2009 period, as the unprecedented stress in global financial markets caused most asset classes to become highly correlated and has thus significantly obscured prior historical relationships. This is particularly the case for leveraged loans, as extraordinary forced selling, deleveraging, capital constraints and panic drove loan prices to unprecedented low levels in the fourth quarter of We believe data excluding this extraordinary and abnormal period is more relevant to investors, and therefore reference these figures in the discussion. Historical data for the full period are shown in the Appendix. Leveraged loan performance compares quite favorably to other major asset classes, as shown in Exhibit 8. While the average annual return is comparable to other asset classes, the lower volatility of loans produces higher Sharpe ratios and risk adjusted returns. The investment merits of loans also lead to better performance in periods of financial stress, as discussed earlier

5 Exhibit 8 As shown on the efficient frontier in Exhibit 10, diversifying 20 percent of an investment in the Barclays Capital Aggregate Bond Index with the Credit Suisse Leveraged Loan Index increases the portfolio return by 0.4 bp (0.06%) while Jan 1992 Sept 2010, excl Sept 08 July 09 Annualized Return Standard Deviation Return/Risk Sharpe Ratio Credit Suisse Leveraged Loans 6.47% 2.90% Credit Suisse High Yield 8.90% 5.91% Merrill Lynch Investment Grade 7.20% 4.53% Barclays Aggregate 6.55% 3.63% S&P % 13.69% MSCI World 8.24% 13.42% Year US Treasury 6.22% 6.93% Beyond the favorable risk/return profile, a major attraction for investors is the diversification that leveraged loans provide. From a logical perspective, a floating rate high yield security should provide diversification to the typical investment grade fixed income portfolio, but the empirical evidence is striking. The correlation of the Credit Suisse Leverage Loan Index returns to the returns for the Barclays Capital Aggregate Bond Index is only 0.09%, as shown in Exhibit 9. Exhibit 9 Total Return Correlation Jan 1992 Sept 2010, excl Sept 08 July 09 CS LL CS HY MLIG BC Agg Credit Suisse Leveraged Loan 1.00 Credit Suisse High Yield Merrill Lynch Investment Grade Barclays Aggregate (0.09) S&P 500 MSCI 10 Yr Treasury S&P MSCI World (0.03) Year US Treasury (0.23) (0.06) (0.12) (0.16) 1.00 decreasing the annualized return volatility by 19.9%. This results in an impressive 25.0% increase in risk adjusted return (return/standard deviation). Exhibit 10 Annualized Total Return 6.56% 6.55% 6.54% 6.53% 6.52% 6.51% 6.50% 6.49% 6.48% 6.47% The diversification benefit of blending loans and equities is also helpful. As shown on the efficient frontier in Exhibit 11, diversifying 20 percent of an investment in the S&P 500 Index with the Credit Suisse Leveraged Loan Index reduces the portfolio return by 46bp (4.8%), while decreasing the annualized return volatility 18.7%. This equates to a 3.9 to 1 ratio of decrease in risk to decrease in return. Exhibit 11 Annualized Total Return Risk Return Profile for CSLL and Barclays Aggregate 20% CSLL 80% BC Agg 100% BC Agg A 20% allocation to Leveraged Loans results in a 19.92% Risk Reduction while adding 0.4bp (0.06%) to Return 6.46% 2.0% 2.2% 2.4% 2.6% 2.8% 3.0% 3.2% 3.4% 3.6% 3.9% Standard Deviation of Returns Jan 1992-Sept 2010, excluding Sept 2008-July % 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% Risk Return Profile for CSLL and S&P % CSLL 80% S&P % S&P 500 A 20% allocation to Leveraged Loans results in a 18.70% Risk Reduction costing only 46 bps (4.84%) of Return 2.5% 3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5% 10.5% 11.5% 12.5% 13.5% 14.5% Jan 1992-Sept 2010, excluding Sept 2008-July 2009 Standard Deviation of Returns

6 Conclusion The distinct structural characteristics and historic performance of leveraged loans make an attractive case for investment. The investment attributes of floating rate exposure, impressive Sharpe ratios, the relatively low correlation of loan returns with equities and fixed income, and protection from loan s senior secured collateral position and financial covenants provide unique benefits and merit further consideration by a broad array of investors. We believe large cap, broadly syndicated senior secured loans are well positioned to continue to offer investors attractive risk adjusted returns. About Highbridge Principal Strategies Highbridge Capital Management, LLC ( HCM ) is a global alternative investment management firm founded in Since its inception, the firm has developed a leading, diversified investment platform that includes hedge funds, traditional asset management products and private equity. With over 353 employees, including approximately 110 investment professionals, HCM manages approximately $20 billion of assets for sophisticated investors, including financial institutions, public and corporate pension funds, endowments, foundations, family offices, and individuals (as of September 30, 2010). The firm is based in New York with offices in London, Hong Kong and Tokyo. HCM is a wholly owned subsidiary of JPMorgan Asset Management Holdings Inc., which is a wholly owned subsidiary of JPMorgan Chase & Co. Given the recent convergence of the hedge fund and private equity fund asset classes, HCM formed Highbridge Principal Strategies, LLC ( Highbridge or HPS ) in 2007 to focus on managing debt and equity investments with long term holding periods. HPS has developed a series of alternative investment funds, each with a disciplined and patient outlook and flexibility to take advantage of opportunities across business cycles. HPS now manages $6.4 billion (including leverage) of corporate credit assets including non investment grade loans, high yield bonds and privately negotiated mezzanine debt (as of September 30, 2010). HPS s extensive capabilities across a full spectrum of non investment grade corporate credit strategies provides broad market insights, enhanced research capabilities and a deep network of investment sourcing relationships. We believe the ability of the various HPS funds to buy mezzanine debt securities, bridge loans, high yield bonds and senior secured loans makes the firm a valuable financing partner for private equity sponsors and underwriters and provides HPS with broader access to investment opportunities. HPS also benefits from the scale, global resources, trading volumes and robust infrastructure of HCM. Contact Information Highbridge Principal Strategies, LLC 40 West 57 th Street New York, NY Lauren Studenberg , lauren.studenberg@highbridge.com David Frey, Managing Director and Portfolio Manager , david.frey@highbridge.com Notes: 1 Credit Suisse 2010 Leveraged Finance Outlook and 2009 Annual Review, 1/22/10 2 As of 10/1/10 and the 2Q10 LSTA Secondary Trading Study, 8/5/10. 3 Credit Suisse, as of September 30, Calculated using the spread to maturity of the Credit Suisse Leveraged Loan Index as of September 30, 2010 and the historical average risk premium for the Credit Suisse Index of 411bp, assuming 3% historical defaults and a recovery rate of 65%. 5 S&P LCD 9/21/10. 6 S&P LCD Quarterly Review 2Q10, July Wells Fargo Securities, 10/1/10.

7 APPENDIX Exhibit 12 Jan 1992 Sept 2010 Annualized Return Standard Deviation Return/Risk Sharpe Ratio CS Leveraged Loans Index 5.97% 5.61% CS High Yield Index 8.55% 8.18% ML Investment Grade Index 7.21% 5.52% Barclays Aggregate 6.59% 3.79% S&P % 15.03% MSCI World 6.55% 15.17% ML 10 Year Treasury Index 6.22% 7.41% Exhibit 13 Total Return Correlation Jan 1992 Sept 2010 Credit Suisse Leveraged Loans Credit Suisse High Yield Merrill Lynch Investment Grade Barclays Aggregate S&P 500 MSCI World 10 Year US Treasury Credit Suisse Leveraged Loans 1.00 Credit Suisse High Yield Merrill Lynch Investment Grade Barclays Aggregate (0.02) S&P MSCI World Year US Treasury (0.30) (0.12) (0.09) (0.13) 1.00

8 Exhibit % 6.6% 6.5% 20% CSLL 80% BC Agg Risk Return Profile for CSLL and Barclays Aggregate 100% BC Agg A 20% allocation to Leveraged Loans results in a 15.19% Risk Reduction while costing only 8 bps (1.29%) of Return Annualized Total Return 6.4% 6.3% 6.2% 6.1% 6.0% 5.9% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% Jan 1992-Sept 2010 Standard Deviation of Returns Exhibit 15 Annualized Total Return 8.0% 7.5% 7.0% 6.5% Risk Return Profile for CSLL and S&P % CSLL 80% S&P % S&P 500 A 20% allocation to Leveraged Loans results in a 16.75% Risk Reduction costing only 17 bps (2.24%) of Return 6.0% 5.5% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 11.0% 12.0% 13.0% 14.0% 15.0% 16.0% Jan 1992-Sept 2010 Standard Deviation of Returns

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