Floating Rate Loans: An Attractive Yield Opportunity

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1 Floating Rate Loans: An Attractive Yield Opportunity Joseph Lynch portfolio manager Bank Loan Management Bond yields remain at record lows and the Fed continues to espouse policy to keep interest rates low in an effort to boost the economy. While this environment of sustained low rates has, on the one hand, frustrated those seeking yield from their fixed income investments, it has also engendered complacency regarding the potential impact of rising rates on many investors portfolios. One less well-known investment type floating rate loans (also known as bank loans) potentially offer a solution to the compound problem of low yields and interest rate risk. Floating rate loans offer potentially attractive current yields as well as a hedge against rising rates. Generally, floating rate loans are short-term loans arranged by banks to non-investment grade companies. Offering the potential for stable income, downside mitigation and, importantly, a hedge against inflation, these instruments can be a valuable addition to a diversified portfolio at any time. Stephen Casey portfolio manager Bank Loan Management June 2012 These loans are originated by a bank (also known as an arranger) and then are typically syndicated, meaning a pool of lenders comes together to finance them. Once the loan is issued, lenders 30 have 67the 100 option 48to 100 hold their 100 portion 55 55for 100 the life 100 of the 83loan, 31or to 72sell 90 it to other investors on a secondary market. C 60 M 30 Y 0 K 30 Floating rate loans: a primer Banks and other financial entities generally arrange floating rate loans for large corporations that typically have below investment grade credit ratings. The loans finance mergers and acquisitions, leveraged buyouts (LBOs), recapitalizations, capital expenditures and other general corporate purposes. The loans earn an adjustable rate of interest, primarily made up of an adjusting base rate and a credit spread reflecting issuer risk. The adjusting base rate is typically LIBOR (the London Interbank Offer Rate, which is the rate at which banks lend each other money in the wholesale market). Similar to an adjustable-rate mortgage, the base rate resets on a regular basis (in this case, usually every 30 to 90 days), giving rise to the floating rate moniker. In low rate environments and/or under difficult market conditions, the arranging bank may offer LIBOR floors as an incentive for lenders. For example, if a loan has a 1.5% LIBOR floor and three-month LIBOR falls below this level, the base rate resets to 1.5%. The credit spread component of interest payments and the discount to par, if there is one, reflects credit quality and certain market-based factors, such as liquidity. Because investors are compensated for taking on risk, lower credit quality or liquidity typically results in higher yields. 1

2 Floating rate loans are generally considered senior secured debt in the capital structure of a company. This means that, in the event of default or bankruptcy, the holders of the loans may be in a better position to maximize recovery than other creditors because they often have a first priority claim, or lien, on the assets of the borrower and could be repaid before other securities issued by the company, such as high yield debt, preferred or common stock. Floating rate loans are generally secured by assets such as equipment, receivables, inventory, real estate, stock, trademarks and patents. Figure 1: sample capital structure senior secured debt (floating rate loans) Higher high yield debt (unsecured or subordinated) priority of payment preferred stock common stock lower Benefits of floating rate loans Floating rate loans can be a valuable part of a diversified portfolio, offering several advantages, described briefly below and, later, in more detail (see page 5 for risks of investing in floating rate loans). Current Income: Meaningful yield opportunities, particularly in the current low interest rate environment. Protection against rising interest rates: With their floating rates, these loans are designed to benefit from rising interest rates and thus can potentially generate increased income and price stability in a rising rate environment. Capital preservation: Typically structured as senior, secured instruments, floating rate loans generally hold a first-priority lien on the assets of the borrower and, in the event of a default or bankruptcy, typically result in higher recoveries. Effective way to enhance diversification: Floating rate loans have historically offered low correlation to high quality and long duration asset classes. Favorable risk/return profile: Floating rate loans have historically demonstrated an attractive risk/return profile relative to other asset classes. 2

3 Current income Historically, annual returns of floating rate loans have benefited from their underlying all-in coupon, which includes a floating base rate, with the current yield of the S&P LSTA Index, which tracks the asset class, averaging 5.95% over the past 11 years. 1 Figure 2: interest Return (%) Source: S&P LCD. Protection against rising interest rates Floating rate loans can be employed as a potential stabilizing component in a fixed income portfolio during periods of rising interest rates. Unlike fixed rate bonds, yields on floating rate loans actually rise when rates go up (see Figure 3). Figure 3: Bank loans performance in rising rate environments Fixed Income Performance in Years When Fed Has Raised Rates Three or More Times ( ) 15% 10% 5% 8 Rate Rises 6 Rate Rises 5 Rate Rises 4 Rate Rises 3 Rate Rises Floating Rate Loans High Yield Bonds Corporate Bonds Government Bonds 3 Rate Rises 0% -5% -10% Source: Morningstar, 1/1/92 12/31/11. For illustrative purposes only. Floating rate loans are represented by the Credit Suisse Leveraged Loan Index, a representative index of tradable, senior secured, U.S. dollar denominated non-investment grade loans. High yield bonds are represented by the Barclays Capital U.S. High Yield 2% Issuer Cap Index, which covers the universe of fixed rate, non-investment grade debt. Corporate bonds are represented by the Barclays Capital U.S. Credit Index, which includes all publicly issued, fixed rate, non-convertible investment-grade dollar denominated, SEC registered corporate debt. Government bonds are represented by the Barclays Capital U.S. Government Bond Index, which is composed of the Barclays Capital U.S. Treasury Bond Index (all public obligations of the U.S. Treasury, excluding flower bonds and foreign-targeted issues), and the Barclays Capital Agency Index (all publicly issued debt of U.S. Government agencies and quasi-federal corporations, and corporate debt guaranteed by the U.S. Government). Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see important disclosures at the end of this article. 1 Source: S&P LCD. 3

4 During periods of declining rates, prices of floating rate loans have demonstrated more stability than fixed-rate bonds. Floating rate loans have the potential to generate increased income in a rising rate environment due to their market-linked base rate (e.g., LIBOR). In addition, the short time between rate resets (usually 30 to 90 days) also mitigates portfolio duration risk. Capital preservation Despite their non-investment grade credit quality, floating rate loans have typically retained more of their value than other junior securities through prior investment and economic cycles (see Figure 4). 2 Since these loans are usually senior, secured instruments that hold a first-priority lien on the assets of the borrower, in the event of a default or bankruptcy, the asset class has historically enjoyed a lower default rate and higher recovery rate than high yield bonds. Figure 4: Over the last 12 years, the bank loan market has preserved an average of 98.6% of capital Capital Preservation in Bank Loan Market % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Source: Moody s Investor Service. For illustrative purposes only. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see important disclosures at the end of this article. 2 Source: Moody s Investor Service. 4

5 Effective way to enhance diversification Adding floating rate loans to a portfolio can effectively enhance diversification. As seen in the correlation matrix in Figure 5, the price movement of the S&P/LSTA Leveraged Loan Index has shown a fairly limited relationship to the price movements of equity and higher quality and longer duration fixed income securities potentially avoiding the lock-step movement that can hurt investors during times of rising rates. Figure 5: 10-Year Correlation Matrix U.S. ML High Grade Bank Loans High Yield Treasuries Equity Corp Index Bank Loans High Yield U.S. Treasuries Equity ML High Grade Corp Index 1.00 Source: S&P/LSTA Leveraged Loan Index March 2012 Review. Favorable risk/return profile Floating rate loans have historically demonstrated an attractive risk/return profile relative to other asset classes. Outside of the market dislocation of 2008 and 2009, their returns have been fairly consistent over the past 12-plus years, generally exhibiting a lower risk or volatility profile compared with some other asset classes, as measured by the standard deviation of monthly returns. (Standard deviation is a statistical measurement that sheds light on historical volatility. It measures the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation and, therefore, the greater the expected volatility of returns.) Figure 6: Risk/Return of Select Indices January 1997 December 2011 Standard Deviation of Monthly Returns Average Annualized Returns 1.9% S&P/LSTA Index 5.4% 2.9% ML High Yield Index 7.6% 1.6% ML High Grade Corp Index 6.8% 2.2% 10 Year Treasury Index 6.6% 4.8% S&P 500 Index 7.5% Source: S&P/LSTA Leveraged Loan Index March 2012 Review. As Figure 6 illustrates, floating rate loans have a monthly standard deviation of only 1.9% with an average annualized return of 5.4%. This is a fairly impressive 5

6 combination when compared to the other fixed income asset classes that have benefited from a nearly 20 year bull run in fixed income, which has seen the yield on the 10-Year U.S. Treasury steadily decline from levels near 8% in 1992 to current levels near 2%. Risks of investing in floating rate loans The main risk faced by investors in the leveraged loan asset class is credit risk. Floating-rate loans are issued to companies with below investment grade ratings and, by their very nature, have a higher likelihood of default than investment grade companies. In the event of a default, investors in a loan may potentially lose some of their principal. To help mitigate this risk, portfolio managers conduct thorough research on issuers, screening for those that offer less risk while delivering attractive returns. In our Neuberger Berman floating rate portfolio, our investment process follows a clearly defined set of credit best practices that we have developed over our many years of experience in the leveraged finance market. We focus on investing in loans of issuers that generate strong and stable free cash flow; operate in non-cyclical industries; have a variable cost structure; and maintain a strong tangible asset base (which often equates to higher recovery rates in the event of a default). Additionally, we manage risk by constructing a well diversified portfolio across issuer and industry to minimize the impact of any single credit event. Floating rate loan 2012 outlook 3 Based on the solid operating performance of the underlying issuers and current technical conditions in the floating rate loan market, we believe the market could generate a total return of 6% 8% for 2012 with the majority of the return coming from interest income and the balance from price appreciation, based on a high B/low BB rated portfolio and a continued low growth economic environment. From a fundamental perspective, slow to steady growth, combined with low defaults, has historically been attractive for loan performance. In our portfolio, we seek loans from borrowers who have adequate liquidity and cash flow to justify their valuations today, as opposed to choosing securities that can only have positive returns if the issuer is able to grow its profitability or improve its balance sheet. In addition, our outlook is for default rates to act as a positive catalyst for the leveraged loan market. We believe the default rate will be 2% for 2012 and 2013, as the 2011 default rate ended below 1%, down from a peak of 11% in From a technical standpoint, we expect steady new issue during the upcoming year to keep supply and demand in balance. The forward calendar is being driven by i) existing issuers terming out or refinancing upcoming maturities with longer-dated issues; ii) private equity sponsors putting cash to work in new deals; and iii) recapitalizations of 3 Forecasts may not materialize. The use of models has inherent limitations and actual results may differ materially from forecasted results. Projections or other forward-looking statements regarding future events, targets or expectations are only current as of the date indicated. There is no assurance that such events or projections will occur and they may be significantly different than shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and they may be superseded by subsequent market events or for other reasons. 6

7 legacy transactions. By historical standards, current yields on new issues are attractive, ranging from 4% 7%, which can be broken into a LIBOR floor of 1.0% 1.5%, a credit spread of basis points and a discount of basis points based credit quality and ratings (see Figure 7). Figure 7: Estimated 2011 bank loan return breakdown Total 5.0% 8.5% LIBOR Floor 1.0% 1.5% Credit Spread 3.0% 5.5% Discount 1.0% 1.5% Current 4.0% 7.0% 1.0% 1.5% For illustrative purposes only. Illustration only of the drivers behind the yield in current markets. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see important disclosures at the end of this article. Accessing the floating rate loan market Individuals tend to invest in floating rate loans via mutual funds due to the high investment minimums associated with separate accounts. Mutual funds offer the benefit of low minimums, daily liquidity and diversification. Neuberger Berman Floating Rate Income Fund adheres to a strong risk management framework which seeks to maximize yield while minimizing the impact of any single credit event. We utilize proprietary analytical tools to closely monitor risk and investments and conduct regular and ongoing monitoring of market activity, current events, and investment positions and opportunities. We view the loan asset class as an attractive and important portfolio allocation in any market environment, though the benefits in a low yield and rising rate environment are certainly clear. While the asset class provides an attractive current yield and total return opportunity, it also provides downside protection due to the senior, secured nature of underlying assets. 7

8 Neuberger Berman LLC 605 Third Avenue New York, NY This material is intended as a broad overview of the portfolio manager s current style, philosophy and process. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were, or will be, profitable. Third-party economic or market estimates discussed herein may or may not be realized and no representation is being given regarding such estimates. Any views or opinions expressed may not reflect those of the firm as a whole. All information is current as of the date of this material and is subject to change without notice. Unless otherwise indicated, returns shown reflect reinvestment of dividends and distributions. Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. The Strategy may invest in senior loans and other debt securities which may be rated below investment grade. The risks of investing in such securities, such as risk of default, could result in loss of principal. Economic and other market events may reduce demand for certain senior loans held by the Strategy, which may impact their value. Loans and other debt securities are also subject to the risk of increases in prevailing interest rates. Generally, bond values will decline as interest rates rise. However, because floating rates on senior loans only reset periodically, changes in prevailing interest rates can be expected to cause some fluctuation in the value of these securities. Similarly, a sudden and significant increase in market interest rates, a default in a loan in which the Strategy owns an interest, or a material deterioration of a borrower s creditworthiness may cause a decline in the value of these securities. Floating rate loans may be more susceptible to adverse economic and business conditions and other developments affecting the issuers of such loans. Although senior floating rate loans are generally collateralized, there is no guarantee that the value of collateral will not decline, causing a loan to be substantially unsecured. No active trading market may exist for many loans, and some loans may be subject to restrictions on resale, which may also prevent the Strategy from obtaining the full value of a loan when sold. This document is issued for use in Europe and the Middle East by Neuberger Berman Europe Limited, which is authorised and regulated by the UK Financial Services Authority ( FSA ) and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER. Neuberger Berman is a registered trademark. This document is being made available in Asia by Neuberger Berman Asia Limited ( NBAL ), a Hong Kong-incorporated investment firm licensed and regulated by the Hong Kong Securities and Futures Commission ( SFC ) to carry on Types 1, 4 and 9 regulated activities, as defined under the Securities and Futures Ordinance of Hong Kong (Cap.571) (the SFO ). This document, and the information contained in it, is being made available in Australia by Neuberger Berman Australia Pty Ltd (CAN ), holder of Australian Financial Services Licence No ( NB Australia ), to a person defined as a wholesale client under section 761G of the Corporations Act 2001 (Cth) and applicable regulations, and other such persons to whom disclosure would not be required under chapter 6D and Part 7.9 of the Corporations Act 2001 (Cth) ( Wholesale Investor ), for informational and discussion purposes only. This document is intended only for the Wholesale Investor to which it has been provided, is strictly confidential and may not be reproduced or redistributed in whole or in part nor may its contents be disclosed to any other person (other than such Wholesale Investor s agents or advisers) under any circumstances without the prior written consent of NB Australia. This document, and the information contained herein, is not, and does not constitute, directly or indirectly, a public or retail offer to buy or sell, or a public or retail solicitation of an offer to buy or sell, any fund, units or shares of any fund, security or other instrument ( Securities ), or to participate in any investment strategy. The Wholesale Investor who receives this document should not consider it as a recommendation to purchase any Securities mentioned in it. To the extent that information in this document constitutes financial product advice, it is general financial product advice only, and provided only by NB Australia to Wholesale Investors. This document does not take into account the Wholesale Investor s investment objectives, financial situation and particular needs (including financial and tax issues) as an investor. Any Securities mentioned in this document will only be available to a Wholesale Investor to whom the provision of a disclosure document prepared in accordance with Australian law is not required. The Wholesale Investor to which this document is provided should not rely on the information contained in this document in making any future investment decision. This document has been issued for use in Japan and Korea by Neuberger Berman East Asia Limited, which is authorized and regulated by the Financial Services Agency of Japan and the Financial Services Commission of Republic of Korea, respectively. Please visit for additional disclosure items required under the Financial Instruments and Exchange Act of Japan. The Neuberger Berman name and logo are registered service marks of Neuberger Berman Group LLC. Neuberger Berman Management LLC and the individual fund names in this piece are either service marks or registered service marks of Neuberger Berman Management LLC. Neuberger Berman LLC is a Registered Investment Advisor and Broker-Dealer. Member FINRA/SIPC. L / Neuberger Berman Fixed Income LLC. All rights reserved. 8

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