Leveraged Loans: Where Skilled Analysis Makes a Difference

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1 This is for institutional and wholesale clients only and should not be relied upon by retail clients. Investment Insights August 2014 Leveraged Loans: Where Skilled Analysis Makes a Difference Investors ongoing quest for income and concerns about the prospects of rising interest rates have increased demand for investments with higher yields and less interest-rate risk. The result has been strong demand for leveraged loans 1 the senior, secured, short-duration debt of non-investment-grade borrowers. While some have expressed concern that the leveraged loan market may soon experience a reversal in trend, FMR Co has a view that is more favourable for the next one to two years. The following article focuses on the current conditions in the leveraged loan market, the role of loans in investors portfolios, and FMR Co s outlook for leveraged loans in light of current market conditions. The appeal of leveraged loans The strong returns of leveraged loans following the financial crisis of 2008 led to increased investor demand during the past several years. The category produced nearly double-digit (9.6%) returns in 2012, and in 2013 leveraged loans returned 5.3%, outpacing both U.S. Treasuries and investment-grade bonds. With the exception of a few years, income has been the main driver of performance over time; the debt has produced 5.3% average annual returns from January 1997 through June 2014 (see Exhibit 1, below). Exhibit 1: Income has been the key driver of loan performance over time 15.0% 10.0% 5.0% 0.0% LEVERAGED LOAN RETURNS KEY TAKEAWAYS With their short durations, attractive yields relative to other fixed-income securities, and positive fundamentals, leveraged loans have garnered significant attention and delivered attractive returns during the past few years. Leveraged loan issuers have taken advantage of the low-interest-rate environment to strengthen their balance sheets by refinancing and extending maturities. One result of these credit improvements has been low default rates, a condition that FMR Co thinks may continue for the next 12 to 24 months. An increase in more issuer-friendly terms underscores the importance of skilled credit analysis to ensure risks are understood and lenders are compensated accordingly. Leveraged loans can play a variety of roles in a well-balanced portfolio, and still offer value for long-term investors. Authors 5.0% 10.0% 15.0% Market Value * Interest Total Return Lisa Kasparian Institutional Portfolio Manager, FMR Co Eric Mollenhauer, CFA Portfolio Manager, FMR Co Kevin Nielsen, CFA Portfolio Manager, FMR Co *Returns for 2008 and 2009 have been truncated for scale. In 2008, the market value return, interest, and total return for leveraged loans were -33.8%, 4.7%, and -29.1%, respectively. In 2009, the returns were 44.3%, 7.5%, and 51.6%, respectively. Returns represented by the S&P/LSTA Leveraged Loan Index data is year to date as of 30 June Past performance is no guarantee of future results. Source: S&P Capital IQ LCD. This document has been written by Pyramis Global Advisors and FMR Co. Fidelity Worldwide Investment is retained as the sole distributor of their range of products to the institutional market outside of North America. 1

2 Not surprisingly, leveraged loans have benefited as investors have sought ways to generate more income without taking on too much interest-rate risk. One of the key differences between traditional fixed-income instruments and leveraged loans is that traditional bonds typically have fixed-rate coupons, whereas leveraged loans are structured to adjust, or float, over a benchmark rate often the London Interbank Offered Rate (LIBOR). 2 The spread on the loan is fixed for the life of the loan, but the LIBOR component is adjusted periodically, usually every 90 days. As a result, the duration 3 of loans is very low relative to other fixed-income instruments. With LIBOR hovering around historic lows for so long, many companies have been willing to pay investors a minimum base rate, or floor, until LIBOR climbs above that level. At the end of June, approximately 88% of the S&P/LSTA Leveraged Loan Index had a LIBOR floor, averaging 105 basis points (bps). Although LIBOR floors have provided incremental income to loan investors over the past few years, once the global economic recovery gains steam and LIBOR begins to rise, the presence of floors will delay the floating-rate coupon until LIBOR rises above these thresholds. Another key benefit of leveraged loans is the downside protection they may offer relative to other debt issued by noninvestment-grade companies. While the credit profile of the companies may be similar, the structure of the debt is quite different. Loans are senior, secured debt of the borrower, which helps reduce some of the credit risk for lenders. In the event that a borrower defaults, the senior status of leveraged loans means that lenders are the first to be paid; the fact that the debt is secured by the borrower s assets provides lenders with a claim to that collateral. These important characteristics have historically led to higher recovery rates when compared with subordinated debt (see Exhibit 2, below). Exhibit 2: Seniority and collateral protection have led to a higher recovery rate on loans than on bonds Average Recovery Rates on Non-Investment-Grade Corporate Debt Leveraged Loans 80.3% Senior Secured Bonds 63.5% Senior Unsecured Bonds 48.1% Subordinated Bonds* 28.2% *Includes senior subordinated, subordinated, and junior subordinated bonds. Data based on ultimate recoveries or the value creditors realise at the resolution of a default event. Source: Moody s Investors Service, Annual Default Study: Corporate Default and Recovery Rates, , 28 Febuary One reason companies issue leveraged loans is to gain more flexibility in managing their debt. High-yield corporate bonds typically have a significant non-call period a time period during which they cannot be prepaid, or called away from the Exhibit 3: Limited maturities support a benign default outlook for the next two years. 35% 30% 25% 20% 15% 10% 5% 0% LEVERAGED LOAN INDEX MATURITY BREAKDOWN Maturity schedule of the S&P/LSTA Leveraged Loan Index. Data excludes defaulted facilities and is based on par amount outstanding. Source: S&P Capital IQ LCD, as of 3 July bond holder. In contrast, leveraged loans can generally be called at any time or after a short period, such as six months. This characteristic limits their price appreciation and increases their reinvestment risk, since the debt could be prepaid when conditions favour issuers, leaving holders to reinvest the proceeds at lower rates. However, it s a benefit that has allowed corporate borrowers to reduce their cost of financing as interest rates have declined during the past several years. Favourable conditions, improved balance sheets Favourable conditions have helped support loan performance, which is driven largely by the improving economy and underlying health of non-investment-grade borrowers, as well as by investors willingness to take on additional credit risk. During the past few years, corporate borrowers have taken advantage of the low-interest-rate environment to reduce the cost of their outstanding debt and to extend maturities, which has strengthened balance sheets. In fact, less than 1% of the S&P/LSTA Leveraged Loan Index is scheduled to mature before the end of 2015 (see Exhibit 3, above). This improved corporate liquidity, coupled with slow but steady economic growth, has resulted in low default rates, a trend that FMR Co expects to continue for the next 12 to 24 months. Excluding Energy Future Holdings Corp. the long-anticipated bankruptcy filing from the large legacy leveraged buyout 4 from 2007 the trailing 12-month default rate stood at 1.08% at the end of June. 5 Market technicals + strong demand = issuer-friendly deals Demand for leveraged loans has been strong across the board, as investors have been willing to take on incremental credit risk in order to achieve higher yields. Companies have satisfied this demand by accessing the loan market to finance their businesses. 2

3 Exhibit 4: Strong demand has compressed yields 5.10% 4.90% 4.70% 4.50% 4.30% Dec-2012 Jan-2013 Feb-2013 Mar-2013 Apr-2013 EFFECTIVE YIELD May-2013 Jun-2013 Jul-2013 Source: S&P Capital IQ LCD, as of 30 June In fact, since the end of 2012 through June of 2014, the number of issuers in the loan index has grown by 175 new borrowers, to approximately 870 companies today (+25%). 6 Over that same period, the face value of institutional loans outstanding grew by 37%, ending the first half of the year at $757 billion. 7 Collateralized loan obligations (CLOs), captive vehicles that invest in loans, remain far and away the largest investor in this debt, representing 53% of the market in 2013 and 61% of the market in the first half of Loan mutual funds and exchange-traded funds (ETFs) were the second-largest buyers, with 31% of market share in 2013 and 24% in Corporate borrowers too have become more comfortable with modestly increased leverage on balance sheets as the economy continues to grow. Looking at the market as a whole, average leverage ratios have inched up, but it s important to note that borrowers debt-servicing costs are extremely low, because they ve benefited from low interest rates over the past several years. Like most other income-oriented investments, strong demand also has pushed yields downward for loans over the past few years. In the case of loans, typical valuation metrics, such as yield-to-call or yield-to-worst, 10 are less relevant given the loans ongoing ability to be called. One way of looking at current value in the market is to simply use the effective yield, which estimates potential one-year forward returns, assuming prices and LIBOR stay constant. As indicated in Exhibit 4 (above), effective yields have declined from 5.04% on 31 December 2012 to 4.59% on 30 June 2014, driven by increased price levels, declining spreads (as borrowers have refinanced at lower rates), and reduced LIBOR floors all of which are to be expected at this point in the economic cycle. Aug-2013 Understanding covenant-lite loans Another outcome of strong demand has been investor acceptance of more lenient borrowing terms. This is evidenced Sep-2013 Oct-2013 Nov-2013 Dec-2013 Jan-2014 Feb-2014 Mar-2014 Apr-2014 May-2014 Jun-2014 by the increasing number of covenant-lite (cov-lite) loans that have come to market, which, at 62% of new issues year to date, exceeds prior peak levels. 11 Covenants are part of the legal contract between the borrower and the lender, defining both parties obligations and limitations. There are several different kinds of covenants, including maintenance covenants, which stipulate certain financial ratios (such as maximum leverage and minimum interest coverage) that must be maintained by the borrower. The ratios are monitored quarterly, and if they fall below the required levels, the borrower is obligated to either repay the loan or renegotiate the terms of the loan with lenders. In contrast, high-yield bonds traditionally have debt incurrence covenants that restrict the ability of an issuer to borrow more debt but don t require ongoing compliance. Cov-lite deals eliminate maintenance covenants but still include typical debt incurrence and other limitations. Cov-lite deals provide more financial flexibility for borrowers, giving them more time to right the ship and hopefully avoid a distressed event. While cov-lite deals limit the protective actions lenders can take if the issuer s financial health starts to deteriorate, cov-lite loans remain senior, secured debt of the borrower features that have historically kept recoveries of cov-lite loans in line with those on full covenant loans. 12 While some investors may regard cov-lite as indicating a degradation of credit quality, it is more a sign of strong demand in the market. Lenders are willing to accept fewer restrictions and borrowers are taking advantage of this opportunity. The cov-lite structure does, however, underscore the importance of in-depth credit analysis to ensure that risks are understood and that lenders are being compensated for those risks. Second-lien loans: a high-yield alternative? Another sign of strong demand that is often cited as a concern about underwriting standards is the increased issuance of second-lien loans, which remain a small component (4.6%) of the outstanding loans in the S&P/LSTA Leveraged Loan Index. 13 Second-lien loans also rank as senior debt of the issuing company and are secured by the issuer s assets, but as the name implies, lenders don t have the first claim on those assets. In the first half of 2014, according to S&P Capital IQ LCD, investors picked up an additional 348 bps, on average, when investing in a company s second-lien loans, compared with its first-lien loans. Additionally, the current profile of second-lien issuers indicates that very few, if any, have subordinated bonds, suggesting that companies are issuing second-lien loans in lieu of subordinated debt. This may imply that second-lien loans are viewed as an alternative to high-yield bonds for borrowers. In fact, the investor base for second-lien loans is dominated by traditional buyers of high-yield debt: hedge, distressed, and high-yield bond funds (45%), followed by CLOs (37%), with loan mutual funds, exchange-traded funds, and insurance and financial companies representing the marginal buyers. 14 3

4 Multifaceted roles for investor portfolios While some investors may have utilized leveraged loans as a tactical allocation to protect against the prospect of rising interest rates, loans can provide important benefits for longterm investors (see Exhibit 5, below). Consider: Income generation Virtually all the total return that investors generate in loans over time has come from income. With most income-oriented options at record low yields, loans may help investors fill some income gaps. Diversification and lower volatility Leveraged loans have the potential to serve as portfolio diversifiers because of their low historical performance correlations with other asset classes. The performance relationships stem from leveraged loans unique characteristics, including the seniority in the issuer s capital structure, collateral protection, and floating-rate coupons all of which have contributed to lower volatility over time. Hedge against rising interest rates and inflation By definition, fixed-income securities carry interest-rate risk (as interest rates increase, the prices of fixed-rate securities fall, and vice versa). Leveraged loans have shorter durations due to the interest-rate resets as well as their shorter average maturities so they can both reduce the risk and take advantage of rising interest rates. And because loan coupons adjust based on changes in LIBOR, they can serve as a hedge against rising inflation in a growing global economy. Looking forward: despite moderately increased risks, leveraged loan outlook still favourable Historical perspective may be helpful to assess the market s future course. Before the financial crisis, leveraged loans were considered to have fairly stable principal values, and now, with most of the loan market trading close to par, we believe the market is back to the basics. Risk is always present, however, and investors need to be mindful that the ongoing callability of leveraged loans both limits their upside potential and increases their reinvestment risk. Other potential risks are shifting investor demand and the transition to a market environment in which investors become more risk averse. When demand is strong or investors are more accepting of risk, credit spreads can tighten as coupons fall. However, if demand decreases perhaps moving to another asset considered to have better relative value or investors begin to prefer higher-quality credits, spreads will likely widen and the principal value of the loan will decline. On the positive side of the ledger, there is a favourable economic outlook, given signs that the global recovery is taking hold, and we expect the loan market will continue to provide value to investors. Stronger fundamentals can benefit individual companies and, in the aggregate, the larger market over both the short and the long term. Less than 5% of total outstanding leveraged loans are scheduled to mature during the next three calendar years 15 and a lower interest burden for companies should help to keep default rates low. The U.S. economy s ongoing expansion also bodes well for this asset category. In addition to economic shifts having a direct impact on credit-sensitive sectors of the market, such as leveraged loans, investors will likely prepare for the onset of higher rates, supporting demand for floating-rate debt and short durations. Against this backdrop, we anticipate that loan returns are likely to be in the mid-single digits over the next 12 months. Although we are watchful of the trend toward reduced credit protection, this trend underscores the need to utilize in-depth credit analysis to fully understand the risks involved with both the issuing companies and the individual loans, and be sure that compensation is commensurate with credit risk. For long-term investors, who are cognizant of their attendant risks, leveraged loans can offer attractive value and can play an important role in a balanced portfolio. Exhibit 5: With low return correlations to other asset classes, leveraged loans may provide important portfolio diversification Risk/Reward Profile, July 1994 June 2014 Annualised Total Return Annualised Standard Deviation Sharpe Ratio Correlation to Loans Correlation to Inflation U.S. Government 10+ Year Bonds 6.13% 7.37% Large-Cap U.S. Stocks 9.79% 15.18% Leveraged Loans 5.68% 5.91% 0.46 N/A 0.32 High-Yield Bonds 8.25% 8.74% U.S. government 10+ Year Bonds represented by the BofA Merrill Lynch 10+ Year U.S. Treasury Index. Large-cap U.S. stocks represented by the S&P 500 Index. Leveraged loans represented by the S&P/LSTA Performing Loan Index. High-yield bonds represented by the BofA Merrill Lynch U.S. High Yield Constrained Index. Inflation data is based on the 20-year period from June 1994 through May Source: FMR Co, as of 30 June

5 Authors Lisa Kasparian Institutional Portfolio Manager Eric Mollenhauer, CFA Portfolio Manager Kevin Nielsen, CFA Portfolio Manager Lisa Kasparian is an institutional portfolio manager for FMR Co. As a member of the investment team, she is the principal liaison for portfolio management on FMR Co s leveraged loan, structured credit, and highyield-bond strategies. Eric Mollenhauer is a portfolio manager for FMR Co. Eric manages or co-manages several leveraged loan portfolios and is a co-portfolio manager on FMR Co s collateralized loan obligations. Eric is also a Chartered Financial Analyst charterholder. Kevin Nielsen is a portfolio manager for FMR Co. Kevin co-manages several leveraged loan portfolios. Kevin is also a Chartered Financial Analyst charterholder. FMR Co Thought Leadership Vice President and Senior Investment Writer Maggie Stenman provided editorial direction. Endnotes 1 Leveraged loans may also be referred to as bank debt, bank loans, term loans, floating-rate loans, syndicated loans, senior secured loans, or senior loans, to name a few. 2 The London Interbank Offered Rate (LIBOR) is a widely used benchmark interest rate at which banks borrow funds from one another for short-term loans. 3 Duration measures the sensitivity to changes in interest rates. 4 A leveraged buyout is the takeover of a company or asset using a significant amount of borrowed funds to pay for the acquisition. 5 S&P Capital IQ LCD, as of 30 June S&P/LSTA Leveraged Loan Index, as of 30 June S&P Capital IQ LCD, as of 30 June S&P Capital IQ LCD, as of 30 June S&P Capital IQ LCD, as of 30 June Yield-to-worst is the lowest possible yield a lender can receive on a bond without the issuer defaulting. 11 S&P Capital IQ LCD, as of 30 June Moody s Investors Services, Covenant-Lite Defaults and Recoveries: Time is Catching Up with Covenant-Lite, 24 June Index definitions The BofA Merrill Lynch 10+ Year Treasury Index is a subset of the BofA Merrill Lynch Treasury Master Index. The index measures the total return performance of U.S. Treasury bonds with an outstanding par that is greater than or equal to $25 million. The maturity range of these securities is greater than 10 years. The BofA Merrill Lynch U.S. High Yield Constrained Index is a modified marketcapitalization-weighted index of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating and an investment-graderated country of risk (based on an average of Moody s, S&P, and Fitch). In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of The BofA Merrill Lynch U.S. High Yield Index but caps issuer exposure at 2%. The S&P 500 Index is a market-capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. The S&P/LSTA Leveraged Loan Index is a market-capitalization-weighted index designed to represent the performance of U.S. dollar-denominated institutional leveraged loan portfolios using current market weightings, spreads, and interest payments. The S&P/LSTA Leveraged Performing Loan Index is a market-valueweighted index designed to represent the performance of U.S. dollardenominated institutional leveraged performing-loan portfolios (excluding loans in payment default) using current market weightings, spreads, and interest payments. 13 S&P/LSTA Leveraged Loan Index, as of 30 June S&P Capital IQ LCD, as of 30 June S&P/LSTA Leveraged Loan Index, as of 3 July Important Information This document is issued by FIL Responsible Entity (Australia) Limited ABN , AFSL No ( Fidelity Australia ). 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