The Case for Senior Loans

Transcription

1 The Case for

2 : A Potential Opportunity for Investors With interest rates at historically low levels, these are challenging times to invest for income. At the same time, many believe there is nowhere for interest rates to go, but up. In this environment, many investors are seeking alternative sources of income, including those which have historically reacted favorably during periods of rising interest rates such as senior loans.

3 What are? Senior loans may play a valuable role in a portfolio. A key characteristic of senior loans is their floating rate feature, which resets generally every days based on prevailing short-term interest rates. It is this resetting feature that has the potential to provide protection in a rising interest rate environment. Additionally, senior loans may offer relatively attractive yields compared to traditional fixed-rate bonds, and often with less volatility. While senior loans are generally loans which have been made to below investment-grade companies, they are backed by collateral, such as property, and are senior in the capital structure of a company. Senior loans have unique characteristics that provide potential advantages for investors and that set them apart from high-yield bonds. Senior loans pay a floating interest rate Senior loans are sometimes referred to as floating rate loans because the base interest paid on a senior loan resets, on average, every days based on prevailing short-term interest rates, primarily the London Interbank Offered Rate (LIBOR). This creates potential benefits to investors in that senior loan prices are relatively unaffected by changes in interest rates (unlike fixed-rate bonds). Additionally, in periods of rising interest rates, investors may benefit as the interest paid by senior loans typically moves higher as the underlying short-term rate resets at higher levels. The chart illustrates this feature of senior loans as compared to fixed rate bonds. RISING INTEREST RATES FALLING INTEREST RATES INCOME PRICE INCOME PRICE SENIOR LOANS Resets Less Sensitive Resets Less Sensitive FIXED RATE BONDS Fixed Fluctuates Fixed Fluctuates

4 Senior loans are at the top of a company s capital structure The capital structure is how a company finances its overall operations and growth by using different sources of funds such as long-term debt, short-term debt, common equity and preferred equity. Investors may find comfort in the fact that senior loans have a senior secured position in the capital structure, thereby having a claim not only on the cash flow of a given company, but also its assets. This added security has historically offered investors less volatility in relation to the junior parts of a given capital structure. Additionally, historical recovery rates for senior loans in the event of a default tend to be much higher relative to those of junior high-yield corporate debt. The chart below is based on data from Moody s regarding recovery rates in cases of default. Average Recovery Rates Measured by Ultimate Recoveries % 63.30% 48.80% 28.20% Senior Secured Bonds Senior Unsecured Bonds Subordinated Bonds Source: Moody s Annual Default Study: Corporate Default & Recovery Rates

5 The impact of rising interest rates Most fixed-rate bonds are significantly impacted by changes in interest rates. When interest rates rise, bond prices generally fall, and vice versa. Because the base interest paid on senior loans fluctuates, they typically react differently to changing interest rates. The chart below shows how senior loans performed versus other asset classes in periods of rising rates. The periods shown were those in which the 10-Year U.S. Treasury yield rose on a monthly basis for six months or more. As you can see, senior loans have historically outperformed many other fixed income investments in those rising interest rate periods. However, senior loans may underperform in periods of declining interest rates. Comparison of Asset Class Performance in Periods of Rising Interest Rates HIGHER RETURNS JAN 94 NOV 94 Commodities Distressed Debt JAN 96 AUG 96 Commodities Distressed Debt EM Debt SEP 98 JAN 00 U.S. Equities EM Debt Distressed Debt JUNE 05 JUNE 06 Gold Commodities Distressed Debt DEC 08 JUNE 09 High Yield EM Debt ABS Commodities U.S. Equities ABS U.S. Equities U.S. Equities Distressed Debt High Yield High Yield High Yield EM Debt Inflation-Linked Gold ABS Inflation-Linked High Yield Gold LOWER RETURNS MBS U.S. Core Bonds EM Debt Inflation-Linked MBS U.S. Core Bonds Gold Inflation-Linked ABS MBS U.S. Core Bonds Gold ABS MBS U.S. Core Bonds Inflation-Linked Commodities U.S. Equities MBS U.S. Core Bonds Source: Credit Suisse Asset Management. Credit Suisse Asset Management defines periods of rising rates as those in which the 10-Year U.S. Treasury yield rose on a monthly basis for a period of six months or more. Indices used as proxies for asset classes are: U.S. Equities (S&P 500 Index); Commodities (DJ UBS Commodity Index); Gold (S&P GSCI Gold Spot Index); Inflation-Linked (Barclays U.S. TIPS Index); (Credit Suisse Leveraged Loan Index); Asset-Backed Securities (Barclays Asset-Backed Securities Index); High Yield (Barclays U.S. Corporate High Yield Index); U.S. Core Bonds (Barclays U.S. Aggregate Bond Index); Mortgage-Backed Securities (Barclays U.S. Mortgage- Backed Security Bond Index); Distressed Debt (Dow Jones Credit Suisse Event Driven Distressed Credit Hedge Fund Index); and Emerging Markets Debt (Barclays Emerging Markets Sovereign Bond Index). Indices are unmanaged and cannot be purchased directly by investors.

6 In a persistently low interest-rate environment, we believe investors have few options to generate a high level of income without assuming significant duration risk. The duration of a bond is a measure of its price sensitivity to interest rate movements based on the weighted average term to maturity of its interest and principal cash flows. Historically, lower duration securities have tended to hold up better in rising interest rate environments than those which have longer durations. In addition, periods of rising rates often coincide with improving economic data which has been favorable historically for high-yield securities which are more sensitive to economic growth than to interest rates. We believe that there is potential for interest rates to increase which makes senior loans an attractive investment because they provide investors with the potential for higher current income but with less interest-rate sensitivity as compared to longer duration debt securities. Senior loans typically generate a higher level of income as short-term interest rates rise, providing a potential offset to traditional fixedrate bond holdings which typically come under pressure in periods of rising rates. The chart below compares the yield to maturity and duration of various fixed-income asset classes. ASSET CLASS U.S. High-Yield Corporate Bonds U.S. Investment Grade Corporate Bonds U.S. Aggregate Bond Index U.S. Government Bonds 1-5 Year U.S. TIPS 1-3 Year U.S. Treasuries YIELD TO MATURITY* 6.48% 8.58% 3.22% 2.25% 1.31% 1.17% 0.75% DURATION (YEARS)* Source: Barclays Capital, S&P Leveraged Commentary and Data (LCD), First Trust Advisors L.P. *As of 12/31/15. Indices are unmanaged and cannot be purchased directly by investors. The historical performance of the indices shown is for illustrative purposes only and it is not intended to imply or guarantee the future performance of any asset class or any fund. Past performance is no guarantee of future results. Yield to maturity represents the anticipated rate of return on a bond if it is held until the maturity date, taking into account the performance of the current market price, par value, coupon interest rate and time to maturity. Senior loans are represented by the S&P/LSTA U.S. Leveraged Loan Index. U. S. High-Yield Corporate Bonds are represented by the BofA Merrill Lynch U.S. High Yield Constrained Index which tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market but caps issuer exposure at 2%. U.S. Investment Grade Corporate Bonds are represented by the Barclays U.S. Corporate Index which measures the investment grade, fixed-rate, taxable, corporate bond market and consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. U.S. Investment Grade Bonds are represented by the Barclays U.S. Aggregate Bond Index which covers the investment-grade, U.S. dollar denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS. U.S. Government Bonds are represented by the Barclays U.S. Government Index which is comprised of the U.S. Treasury and U.S. Agency Indices and includes Treasuries and U.S. agency debentures. 1-5 Year U.S. TIPS are represented by the Barclays 1-5 Year U.S. TIPS Index which tracks inflation-protected securities issued by the U.S. Treasury with maturities from 1 and up to 5 years. 1-3 Year U.S. Treasuries are represented by the Barclays U.S. 1-3 Year Treasury Bond Index which consists of public obligations of the U.S. Treasury with maturities from 1 and up to 3 years.

7 Historical Performance The senior loan asset class has a strong track record of providing positive calendar year returns. Looking back on the past 15 calendar year returns, the senior loan asset class has only had two negative return years, 2008 and The financial crisis affected the loan market as it did other credit and equity markets, driving senior loan returns down by about 30%. In 2009 the loan market returned 52% and has provided positive returns in each year thereafter, as credit conditions have improved. However, past performance is no guarantee of future results. The financial crisis also affected default activity with loans posting record high default rates in However, defaults have declined significantly from those record highs. The default rate on senior loans stood at 1.5% in December 2015 and is below the historical average of 3.19%, according to Standard & Poor s Leveraged Commentary and Data. However, there can be no assurance that defaults will not increase. U.S. Senior Loan Performance % 50.0% 52% 40.0% 30.0% 20.0% 10.0% 0.0% 7% 5% 4% 5% 4% 2% 10% 5% 5% 7% 2% 10% 2% 10% 5% 2% -.7% -10.0% -20.0% -30.0% -29% Source: Standard & Poor s LCD. The illustration excludes the effects of taxes and brokerage commissions or other expenses incurred when investing. This chart is for illustrative purposes only and not indicative of the future performance of the index or any fund. Figures have been rounded to the nearest percentage point. Past performance is no guarantee of future results.

8 Low Correlation Aids Diversification It is important to consider diversification when building a well-balanced portfolio. Diversification has long been recognized as a helpful way to mitigate portfolio volatility. Effective diversification requires combining assets with low correlations that is, those that have performed differently over varying market conditions. Correlation is a statistical measure that provides a way to evaluate the potential diversification benefits of combining different assets in a portfolio. Simply put, correlation measures the similarity of performance of two securities. Correlation is measured on a scale ranging between -1 and +1. A correlation of +1 means that the two investments have moved in perfect tandem with each other. Alternatively, perfect negative correlation of -1 means that when one security moves in one direction, the other security will move in the opposite direction. Investing in assets with low to negative correlation can reduce the overall volatility and risk within a portfolio and may also help to improve portfolio performance. We believe senior loans can be used as an effective means to aid portfolio diversification because of their historically low correlation to other fixed-income asset classes. The historical correlation between senior loans and other asset classes, including investment-grade corporate bonds and equities, is low. Because senior loans are not highly correlated with other asset classes, they can potentially decrease portfolio volatility, enhance overall return and provide meaningful diversification to an asset allocation strategy. Correlation of to Other Asset Classes* S&P LSTA Index U.S. High-Yield Corporate Bonds 0.81 U.S. Large Cap Equities 0.53 U.S. Investment Grade Bonds 0.35 Canadian Investment Grade Bonds Canadian Investment Grade Corporate Bonds 0.24 Canadian Equities 0.57 Sources: Barclays, S&P LCD, First Trust Advisors L.P. S&P/LSTA Leveraged Loan Index Review March 2015, S&P LCD High-Yield Weekly Review December 2015, Barclays December 2015, Russell Investments December 2015, Morningstar Direct December The historical correlation of the indices are for illustrative purposes only and not indicative of an actual investment. It is not intended to imply or guarantee the future performance of any asset class or fund. *Senior loans are represented by the S&P/LSTA U.S. Leveraged Loan Index (LLI). U.S. High Yield Corporate Bonds are represented by the B0fA Merrill Lynch U.S. High Yield Constrained Index U.S. Large Cap Equities are represented by the Russell 1000 Index which is an unmanaged index of 1000 stocks used to measure the largest and most liquid stocks based and traded in the U.S. U.S. Investment Grade Bonds are represented by the Barclays U.S. Corporate Index. Canadian Investment Grade Bonds are represented by the DEX Universe Bond Index. Canadian Investment Grade Corporate Bonds are represented by the DEX All Corporate Bond TR Index. Canadian Equities are represented by the S&P/TSX Composite Index. An index cannot be purchased directly by investors. Past performance is no guarantee of future results.

9 Summary In today s low yield environment, senior loans may provide many benefits including attractive income and enhanced diversification. Although no one knows for certain when interest rates will rise, we believe they will eventually. Because of their unique floating rate feature, senior loans typically generate a higher level of income as short-term interest rates rise, unlike traditional fixed-rate bonds which typically come under pressure in periods of rising interest rates. Senior Loan Historical Default Rates % 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Senior Loan LTM Default Rate (ex. TXU and CZR) Senior Loan Default Rate with TXU and CZR Average Senior Loan Default Rate Source: Standard & Poor s LCD. are represented by the S&P LSTA U.S. Leveraged Loan Index and based on the last twelve months (LTM). This chart is for illustrative purposes only and not indicative of the future performance of the fund. Past performance is no guarantee of future results.

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