A leveraged. The Case for Leveraged Loans. Introduction - What is a Leveraged Loan?

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1 PENN Capital Management The Navy Yard Corporate Center 3 Crescent Drive, Suite 400 Philadelphia, PA Phone: For more information: Christian Noyes, Senior Managing Partner [email protected] Introduction - What is a Leveraged Loan? A leveraged loan is a private, floating rate loan agreement between an arranger (bank or group of banks) and an issuer (a company with a subinvestment grade credit rating of BB+ or below). The issuer often uses the loan to refinance existing debt, finance a merger or acquisition, recapitalize its balance sheet, or fund ongoing operations. Due to the issuer s credit rating, these loans are more expensive to the borrower and have stricter covenants than traditional bank loans. To issue a leveraged loan, the arranger and issuer typically work together to set the overall structure of the loan and seek input from market participants on pricing. These loans are senior secured credit on the issuer s balance sheet, giving lenders priority over bondholders and stockholders in the event of bankruptcy. Most institutional leveraged loans are classified as Term Loan B, have limited amortization, and repay only the principal at maturity. Leveraged loans comprise approximately 55% ($2.0 trillion) of the $3.6 trillion high yield corporate credit market, with institutional leveraged loans representing $949 billion of that $2.0 trillion. Comparatively, the high yield bond market represents $1.5 trillion (approximately 41%) of the corporate credit market below investment grade. (Source: Credit Suisse) Five Reasons to Invest In the Leveraged Loan Market A leveraged loan is a private, floating rate loan agreement between a bank and a company that has a subinvestment grade credit rating (BB+ or below). Institutional investors should consider leveraged loans as part of a welldiversified fixed income portfolio for: Protection against rising interest rates Portfolio diversification Downside protection in case of default Strong technicals Attractive risk-adjusted returns Leveraged loans have many of the same benefits as traditional high yield debt without incurring the same risks. Institutional leveraged loans differ from traditional high yield debt because they are also owned by banks and insurance companies, as well as non-bank entities such as institutional investors and hedge funds, and are actively traded among investors.

2 The institutional leveraged loan market is appealing to investors because it is a large, liquid market with basic fundamentals that complement slowgrowth market conditions. Besides market conditions, there are other advantages the leveraged loan market offers institutional investors: Protection Against Rising Interest Rates Leveraged loans historically perform strongly during Fed and Treasury rate increases, due largely in part to floating rate coupons and shorter durations. For example, if a loan is set at 225 basis points above the 3- month LIBOR (set at 0.5% at the time of issue), the loan coupon will be 2.75%. If LIBOR rises to 0.65%, the loan will reset and investors will receive 2.90%. The floating rate component is thus a hedge against rising interest rates. As referenced in Exhibit 1, the Credit Suisse Institutional Leveraged Loan Index has on average outperformed a wide range of fixed income indices during periods of rising interest rates. Since leveraged loans have a shorter duration (and are less sensitive to changes in interest rates), they add another layer of protection in the event Treasury yields reverse their decades-long fall. Exhibit 1 Relative performance of leveraged loans during periods of interest rate change Period of Fed Hike Movements Duration Months CS Instl Leveraged Loan Index ML 10 Year Treasury Index ML US High Yield Index Barclays US Agg Index T he fundamentals of the institutional leveraged loan market are wellsuited for our expectations of a slow growth U.S. economy. 6/30/99-5/31/ /30/04-6/30/ Source: Credit Suisse; Bloomberg Portfolio Diversification A diverse fixed income portfolio usually includes bonds of varying quality, yield, duration, and sector. Including leveraged loans simply makes an institutional investor s portfolio more robust. 1/31/94-2/28/

3 The first table in Exhibit 2 below illustrates how the inclusion of leveraged loans enhances a fixed income portfolio: a senior secured debt instrument with a floating rate and short duration provides noninvestment grade bond portfolio diversification. Exhibit 2 Portfolio Diversification Levered Loans High Yield Bonds Investment Grade Total Portfolio Secured Debt X X Unsecured Debt X X X Floating Rate X X Fixed Rate X X X Short Duration X X X Long Duration/ Rate Sensitive X X Call Protection X X X No Call Protection X X Low Volatility X X X High Coupon/ Total Return X X Source: Credit Suisse The second table of Exhibit 2 below shows that leveraged loans have a low correlation with investment grade corporate bonds and a negative correlation with Treasuries. Correlation of Returns January December 2014 CS Instl Leveraged Loan Index Credit Suisse Institutional Leveraged Loan Index 1.00 L everaged loans provide diversification in the typical fixed income portfolio by virtue of their structure: senior secured debt instrument with a floating rate and short duration. Merrill Lynch ABS 0.37 Merrill Lynch US Corporate Master 0.31 Barclays Capital Aggregate Standard & Poor's Russell Source: Credit Suisse Downside Protection in Case of Default While all loan agreements have the potential to default, the risk profile for leveraged loans is much lower than non-investment grade bonds and other credit agreements. Leveraged loans usually have shorter durations and maturities than bonds, so arrangers have better insight into an issuer s financial health during the underwriting process and throughout the life of the loan. Merrill Lynch Mortgage -0.11

4 Additionally, leveraged loans are governed by strict covenants that require the issuer s management to maintain the requisite balance sheet and financial ratios. In the event a leveraged loan defaults, it s senior secured status provides investors with the first claim against the issuer s assets. Exhibit 3 shows leveraged loans as an asset class have lower default rates and higher recovery rates than high yield bonds. Corporate earnings rebounded since the 2008 crash, creating greater cash flow, and an extended maturity profile for the high yield market, which indicates that high yield bond default rates (a proxy for leveraged loan default rate) are expected to remain below long- term averages. Exhibit 3 Default & Recover Rates: Leveraged Loans vs. High Yield Bonds: Loans generally have lower default rates and superior recovery rates versus bonds L everaged loans tend to have stricter covenants that require the issuer s management to maintain strong balance sheets and financial ratios. Source: Credit Suisse High Yield Bonds vs. Leveraged Loans: Loss, Recovery and Default Rates Default Rate Avg. Principal Loss Rate Avg. Recovery Rate Year Bonds Loans Bonds Loans Bonds Loans Average Strong Technicals Banks have invested in leveraged loans for decades, beginning with the securitization of non-investment grade debt in the 1980s. This market was valued at $580 billion prior to the 2008 credit crisis, and then sharply contracted along with the larger credit markets.

5 While the leveraged loan market s prolonged growth was temporarily stunted, the subsequent economic recovery created the right conditions for a leveraged loan market revival. Prospective investors may want to know what factors are driving leveraged loan market growth currently and in the future. The quality of issuers and their demand for these loans is robust. As of 2014, 93% of new leveraged loans belong to higher rated issuers (BB or B), and 28% of proceeds have been used to refinance existing debt. We can also look to recent history for some guidance about the future: in the later stages of the most recent loan market rally ( ), collateralized loan obligation (CLO) activity skyrocketed, as leveraged loans were the preferred vehicle in financing that period s mergers and acquisitions boom. At the height of the market in 2008, CLOs commanded more than 70% of the leveraged loan market share. Since then, the use of CLOs to fund mergers and acquisitions declined sharply to below 30% by the end of 2014 (see Exhibit 4). We believe the regulations under Dodd-Frank and the Volcker Rule will likely limit the investment banking industry from issuing CLOs with the same excessive levels of leverage experienced in the last two credit cycles. If properly enforced, the new regulations limiting the use of leverage should improve the price stability of the levered loan market over a full credit cycle. G iven the current low interest rate environment and the growing demand by institutional money managers, there is little to suggest that current growth rates in the leveraged loan market will subside any time soon. Exhibit 4 Deals by Use of Proceeds (as a percentage of total volume)

6 Conclusion The leveraged loan market is attractive to the institutional investor that is interested in: an investment secured by tangible assets, strong covenants, protection against rising interest rates and a market diversified by both industry and credit quality. T here is opportunity for most high-yield fixed income institutional investors to significantly reduce volatility in their portfolio at an acceptable level of cost. In the spirit of full disclosure, not all aspects of leveraged loans are advantageous. In absolute terms, leveraged loans generally offer a lower coupon and do not have call protection, which may potentially diminish total return. The liquidity of the investment may be compromised by the loans longer settlement period with fewer underwriters, and consequently larger trade lot sizes. Investors can compensate for these shortcomings by scrutinizing credit quality and issue selection. Investing in the leveraged loan market requires significant ongoing due diligence of an issuer s fundamental business position and capital structure. Institutional leveraged loans can provide the needed counterweight in a well-balanced portfolio only for the right investor with the correlative objectives. This commentary may not be disclosed or used for any other purpose without the prior written consent of PENN. The information in this commentary is based upon publicly available information and reflects market conditions, and our views, as of the date of this commentary. PENN s opinions and estimates constitute PENN s judgment and should be regarded as such. From time to time, PENN may provide information in this commentary that was supplied by third parties. Any opinions, advice, statements, services, offers, or other information expressed or made available by a third party, are those of such third party and not PENN. PENN does not independently verify the information provided by third parties, does not guarantee the accuracy, completeness, timeliness or correct sequencing of such information, and assumes no responsibility for errors made by the cited parties. PENN makes no representations as to the actual value which may be received in connection with a transaction or the legal or accounting effects of transactions. The information in this commentary does not take into account the effects of any possible transactions. This commentary is not a solicitation, and it does not constitute an offer to buy or sell any securities or indexes mentioned.