High yield bonds. US senior loans: Value in the current environment

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1 US senior loans: Value in the current environment CIO WM Research 19 October 216 Barry McAlinden, CFA, strategist, Leslie Falconio, Strategist, Philipp Schöttler, strategist; Carolina Corvalan, strategist Senior loans offer an attractive alternative to more "traditional" fixed income investments in the current low interest rate environment. They also protect against potentially higher rates in the future through their floatingrate nature. Most US loans have a LIBOR floor of 98bps, on average, and 3m LIBOR has now risen to 88bps. Loan coupon cash flows should soon reset higher based on our outlook for higher LIBOR rates. Senior loans offer a yield of 5.9% (to 3yr) and we think defaults will only increase very gradually. This translates into our 12-month outlook for total returns of 3-5% for US loans, which compares favorably vs. most fixed income alternatives. What are senior loans and why are they compelling? Senior loans (also referred to as "leveraged loans") are incomegenerating assets with a fixed maturity. They pay a regular interest rate to investors and return the principal investment amount at the end of their life. As such, loans share some similarities with regular corporate bonds but have important differentiating features as well, which we discuss in this report. Their features include the following: They protect against potentially higher rates in the future through their floating-rate nature. Due to their senior status within a company's capital structure and the fact that most loans are secured by company assets, their credit risk is considerably lower than for HY bonds. Loan borrowers are usually medium or large firms with a subinvestment grade credit rating. Thus, the asset class is often compared to high yield (HY) bonds. Senior loans are originated by banks and then sold to institutional investors. Individual investors can get access to the asset class via funds. Including senior loans in a portfolio tends to improve portfolio yield while lowering duration (see Fig. 2). In addition, loans tend to have a low correlation to other asset classes, which improves diversification (see Fig. 3). As a consequence of their seniority and secured position in the capital structure and partly due to their limited secondary market liquidity, loans tend to have a lower return volatility compared to high yield bonds or equities; US loans have had an annualized volatility of 6. over the last 15 years, compared to 9. for US HY bonds and 14.7% for US equities. Fig. 1: 3m LIBOR should soon exceed floor values Sep-13 Sep-14 Sep-15 Sep-16 Sep-17 Source: UBS Average LIBOR floor 3m LIBOR (CIO forecast) 3mo LIBOR (actual) Fig. 2: High yields and low duration Yield, in %, and duration, in years Yield Loans IG 1-5yr MBS HY Corps Agencies Preferreds CMBS IG Corps Treasuries TIPS (1) Duration Source: Bloomberg, BAML, UBS, as of 3 Sept Fig. 3: Correlations to US senior loans (26 to 216) From -1 to Treasuries US Bond Aggregate S&P 5 HY bonds Source: Bloomberg, BAML, UBS, as of 3 Sept This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

2 Loan features in detail The most important features to consider when investing into senior loans are their: 1) very low interest rate duration due to their floating-rate character; 2) lower credit risk; 3) higher liquidity risk and 4) call risk. 1. Duration: The coupon rate on senior loans is floating, which means that it is reset regularly based on the development of a shortterm benchmark rate plus a stated credit spread. In the case of US loans, the benchmark is usually the 3-month USD LIBOR and the reset is done every 45 to 6 days on average. As a consequence, rate duration of senior loans is close to zero and the interest rate risk is thus very low, which is especially beneficial in times of rising rates. A recent development since the financial crisis has been the introduction of LIBOR floors, or minimum reset rates. In these cases, the coupon is fixed until the market LIBOR rate exceeds the floor level, which moderately increases the loan's duration. Approximately 9 of the US leveraged loan index currently contains a LIBOR floor of 98bps, on average. Due to their floating-rate nature, loans tend to perform best in periods when interest rates rise (or remain flat, as loans usually still provide a good yield pick-up). Loans provided returns of historically when interest rates were rising, outperforming most fixed income classes (see Fig. 4). However, when rates fell, loans tended to lag in performance. 2. Credit risk: Senior loans are typically secured by the borrower's assets. As such, they have a higher ranking within a company's capital structure than senior unsecured bonds (see Fig. 5). Thus, in case of a default, this part of the debt will usually be first in priority to obtain recovery values. Furthermore, loans usually involve protective covenants providing the lender with forceful control over the borrower, although covenant protection has eroded over the past years. These features lead to lower default rates as well as higher recovery values for loans relative to HY bonds (see Fig. 6). The average annual credit loss over the last 2 years was 1.3% on US loans and 2. on US high yield bonds. In summary, the credit risk of senior loans is considerably lower than for HY bonds. However, the leveraged nature of issuers does make the loan asset class highly sensitive to credit cycle fluctuations. 3. Liquidity: Senior loans are originated by banks and then traded "over the counter" (OTC) between different banks and mostly collateralized loan obligations (CLOs) and loan fund managers. Senior loans provide less liquidity than even HY bonds. While this feature is actually a useful protection for long-term investors, it has to be considered carefully before making an investment into loans. For investors who have a longer investment time horizon, the illiquidity premium that is typically offered by loans for compensation is an attractive return component. Fig. 4: Last 1 years average annualized returns Returns (LHS) and standard deviation of returns (RHS) 2 15% 5% -5% 35% 3 25% 2 15% Treasuries IG Corps HY Corps Sr. loans IG Corps ABS FRN FRN Fall Rise Rise modestly Return volatility (rise modestly) (RHS) Source: BAML, Bloomberg, UBS, as of 3 September 216. Note: The interest rate regime refers to changes in the 1-yr UST yield Fig. 5: Loans rank senior within a company's capital structure Priority of claims of different securities Source: UBS Senior loans Senior unsecured bonds Subordinated bonds Tier 1 / hybrid bonds Equity Fig. 6: US loan vs. US HY default rate Trailing 12-month default rates, in % Loan default rate Loan average HY bond defalut rate HY bond average Source:Moody's, UBS, as of 3 September 216 5% 4. Call risk: The majority of loans are immediately callable, although some have a USD 11 soft call where the issuer has to pay a USD 1 penalty to refinance at a lower rate for the first six months or one year following issuance. Many issuers have taken advantage of strong market conditions and have repriced their loans to lower credit spreads by using this continuous call feature. Similar to the CIO WM Research 19 October 216 2

3 HY bond market, call features will constrain the price appreciation potential of loans during strong market conditions. Loan market characteristics The US institutional loan market has been growing steadily, with the amount outstanding of the S&P US Leveraged Loan Index rising from USD 9 billion in 1999 to USD 89 billion to date. Institutional investors and CLOs comprise the majority of the US senior loan ownership structure. However, retail investors constitute a significant source of US loan demand, accounting for roughly 2 of primary allocations (see Fig. 7). Fig. 7: Loan investors by type Insurance Co. Loan Mutual Funds 2 In terms of rating, US loans are rated below investment grade but of the market is BBB rated (see Fig. 8). Sector-wise, the loan market has a large exposure to the technology, healthcare, services and media sectors (see Fig. 9). It's also worth noting that commodity-sensitive sectors have a relatively small weight in the US. Hedge, Distressed & HY Funds Finance Co. 1% CLO 61% Since short-term interest rates have moved to record low (or even negative) levels in recent years, loan issuers have started to include interest rate floors in their loan contracts. Theses floors make sure that coupon payments will not fall below a certain threshold often set at 1bps plus the quoted spread protecting investors from a certain degree of falling rates. On the other hand, this feature introduces some rates duration to the asset class, as coupon payments will only start to "float" once the interest rate floor is reached. By now roughly 9 of outstanding US loans have a LIBOR floor of 98bps, on average. Outlook & recommendations The US credit market has broadly benefited from a continued search for yield in the past months, as global monetary policy remains accommodative and US macro data points to resilient economic growth despite late-stage cycle trends, including tightening lending standards. Against this backdrop, US CLO demand has firmed from levels seen earlier in the year. Average CLO issuance volume was USD 6bn in the April to August period and rose to USD 8bn in Sept. While the CLO market has picked up from low levels, market expectations for CLO issuance this year have declined to about USD 45bn from USD 7bn, compared to USD 99bn of CLO issuance last year. We believe CLO issuance should remain steady enough to maintain supply/demand balance, even as managers consolidate along with new risk retention rules that go into effect next year. Retail flows, the other main source of US loan demand, have also shown modest inflows recently. Most US loans have a LIBOR floor of 98bps on average, so they will have a fixed duration exposure until short-term rates reach.9. LIBOR has slowly crept up towards.8 following the Fed's first rate hike in December 215 and the influence of money market reform rules. CIO expects the Fed to raise rates this December and for two more rate hikes next year. This should support loan demand as coupon levels would then be in a position to reset higher. Source: S&P LCD, UBS, as of 3 September 216 Fig. 8: S&P US loan index ratings breakdown BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- Source: S&P LCD, UBS, as of 13 October 216 Fig. 9: S&P US loan index sector breakdown 1 Source: S&P LCD as of 13 October 216 CIO WM Research 19 October 216 3

4 In the US, new large loans had an average gross debt/ebitda level of 5.x in the first half of 216, slightly up from 4.7x in 215. US regulators have highlighted that leverage above 6x would be a problem, capping the amount of deals with excessive leverage. Interest coverage decreased from 4.4x in 215 to 3.6x so far this year. The percentage of covenant-lite loans continues to remain elevated. We expect the US loan default rate to increase towards its longterm average of 3% in the next 12 months from 2. currently as the credit cycle advances, with an expected recovery rate that falls short of the long-term average recovery rate of 7 for loans. This stems from the concentration of energy and metals firms among the defaulted issuers that offered low recovery values in the recent past. Over the next 12 months, we expect senior loans to deliver total returns of 3-5%, driven mostly by carry. Even if interest rates were to remain at their current low levels for longer, we believe that loan valuations are attractive at current levels, offering a yield pick-up of over investment grade corporate bonds with maturities of 1-5 years. Due to the speculative-grade nature of the issuers which borrow in the loan market, we recommend that senior loans be considered by investors with an adequate risk profile, who would otherwise be comfortable investing in HY bonds. Additionally, the secondary market for loans can be illiquid at times. Investors should thus be comfortable with some illiquidity risk. We think that senior loans are an attractive addition to a well-diversified taxable fixed income portfolio, providing for strong risk-adjusted returns, an appealing yield as well as diversification benefits. Fig. 1: US HY bond less senior loan yields All loans B rated loans Source: S&P LCD, UBS, as of 7 October 216 Fig. 11: US senior loan credit spreads LIBOR + 3, 2,5 2, 1,5 1, Loan spread to maturity Loan spread to 3yr average life Source: S&P LCD, UBS, as of 7 October 216 CIO WM Research 19 October 216 4

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