Rising Rates and the Case for Leveraged Loans PERSPECTIVE FROM FRANKLIN FLOATING RATE DEBT GROUP

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1 January 11, 2013 Topic Paper September 2015 Rising Rates and the Case for Leveraged Loans PERSPECTIVE FROM FRANKLIN FLOATING RATE DEBT GROUP Mark Boyadjian and Reema Agarwal of Franklin Templeton Fixed Income Group take a look at the implications of a changing-rate environment for investors in bank loans, at the current market composition and how to position portfolios in this environment. Mark Boyadjian, CFA Senior Vice President, Director of Floating Rate Debt Group Franklin Templeton Fixed Income Group Reema Agarwal, CFA Vice President, Director of Research Franklin Templeton Fixed Income Group For certain investors in particular pension funds and insurance companies that tend to follow a more cautious investment strategy the extended period of record or near-record low US interest rates has been a thorn in the side. Many such institutions rely on investment returns to meet commitments or drive profitability and have been beleaguered by the low yields inherent in the current environment. As a result of a search for yield among such constituents, some of these institutions have been looking at asset classes outside conservative low-yielding government and corporate bonds. One of these has been leveraged loans or bank loans, which offer the potential to provide a fairly attractive level of income with minimal interest-rate risk because the interest rate has the ability to adjust. For example, at the end of 2014, the Credit Suisse Leveraged Loan Index had an average coupon greater than 4.75%, duration 1 positioning of less than 0.25 years, and an average dollar price below par 2. We believe concern regarding anticipated increases in US interest rates is going to continue to have implications for fixedrate and floating-rate assets. In that context, our view is that fixed-rate assets particularly those with a duration of five years or shorter may be experiencing material principal declines as a result of the interest-rate risk they possess. While our outlook for the corporate credit market generally is positive for the balance of this year, we re growing increasingly concerned about the potential credit risks that could develop in 2016 and Our concerns stem from the sense that floating-rate debt, like many asset classes, is sensitive to the laws of supply and demand. Our belief is the US Federal Reserve (Fed) will finally act in 2015, and cause investors to rethink their exposures to fixed income. In the context of rising rates, we believe many investors will seek to shed their duration and flock to assets they perceive as having yield with low duration, which may include leveraged loans. For example, in 2013, the asset class expanded tremendously as cash flow came in amid expectations of rising rates (the so-called taper tantrum ). In our view, some of the recent market volatility has been caused by uncertainty over the timing and movement of interest rates. Investors have been down this path before. Fed policymakers have talked about or hinted at increasing interest rates in the past two years, but haven t done so. This volatility has given us the opportunity to obtain assets for our portfolio that have high credit quality but are offered at a discount to par. CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. 1. Duration is a measurement of a bond s or a portfolio s sensitivity to interest-rate movements. Par value represents the face value of a bond. 2. Source: Credit Suisse, 2015 Leveraged Finance Outlook and 2014 Annual Review, 19/2/15. Leverage Finance Strategy Update, 2/4/15. Indexes are unmanaged, and one cannot directly invest in an index. Past performance does not guarantee future results.

2 Bank loans offer a few key characteristics that may look attractive to many investors within the context of a rising-rate environment. The duration on a leveraged loan is typically very low. If interest rates rise, price sensitivity is generally much less relative to a high-yield bond alternative. Leveraged loans are considered below-investment-grade in credit quality, but their senior and secured status can provide investors/lenders a degree of potential credit risk protection. Historically, leveraged loans have had a relatively low or even negative correlation 3 to traditional fixed income vehicles such as government bonds. The floating-rate feature in leveraged loans means that as shortterm interest rates go up, the corresponding income on loans typically should go up as well. Supply and Demand Interest rate dynamics can have important implications in terms of supply and demand for the asset class. Traditionally, leveraged loans have derived the majority of total return from income. The majority of that income is derived from the underlying benchmark for US-dollar denominated term loans, the London Interbank Offered Rate (LIBOR). LIBOR would be expected to rise as US interest rates rise. In a rising LIBOR environment, we expect the demand for leveraged loans as an asset class could likely exceed the supply. When you put that in the context of three other crucial issues rising leverage levels, increasing covenant-lite issuance 4, 5 and record collateralized loan obligations formation what we see occurring is a ballooning of the level of credit risk as a result of the increase in demand. Rising Leverage Levels In general, at this time, interest coverage levels the notional ability to service debt appear to be very comfortable. Current leverage levels are approaching the historical peaks seen in 2007, but with historically lower interest rates, according to our analysis, companies in general appear well able to cover their interest costs at this time. It s also our view that adjustments to EBITDA are likely to increase over time, so it is likely this leverage may be understated versus companies that are coming to the loan market at this point. When it comes to the supply/demand situation, our concern is there will be an increase in the total amount of debt outstanding either senior or total and in our opinion, that could cause a situation where credit quality may deteriorate and investors may in turn receive less compensation for it. This is where credit quality comes in. Companies that are at the higher end of the company credit-quality spectrum should have a better ability to handle the eventual rise in interest rates. Conversely, we think companies in the middle and lower tiers of credit quality are likely to suffer more of the pain when interest rates rise. Continuously Callable The fact that floating rate loans are continuously callable also influences the supply/demand concept and the deterioration of credit quality, because as demand exceeds supply and loans begin to trade above par, many borrowers will exercise their option and refinance their loans at a lower spread. This has two primary effects for investors: It caps principal appreciation potential, and it reduces the income they are receiving for the same level of credit risk. When one sees higher demand levels, one would expect to see higher issuance levels. Our view is that in this case issuances would be more rated toward the middle credit quality and the lower credit quality subspace of the loan market. As a result, we think the market composition would likely change to increase middle tier and lower tier. Covenant-Lite Generally as issuance and demand increases, companies would typically try to remove covenants or try to come to market without covenants. Chart 1: Increasing Covenant-Lite Issuance Covenant-Lite Share of Institutional Volume Q Q % 60% 50% 40% 30% 20% 10% 0% 4Q11 2Q12 4Q12 2Q13 4Q13 2Q14 4Q14 New Issues issues Source: S&P LCD Quarterly Report, December Past performance does not guarantee future results. 3. Correlation measures the degree to which investments move in tandem. Correlation will range between 1 (perfect positive correlation, moving in the same direction) to -1 (perfect negative correlation, moving in opposite directions). 4. Source: S&P LCD Quarterly Report, December A covenant-lite loan is a type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. Rising Rates and the Case for Leveraged Loans 2

3 While so-called covenant-lite loans are generally thought to be riskier since they include fewer potential opportunities to actively mitigate credit risk deterioration, it is helpful to view their proliferation in the context of our current investment climate. During periods of excess demand, it has not been historically uncommon to experience various forms of asset price inflation. With respect to leveraged loans, this can take the form of increased issuance of loans characterized by either higher leverage ratios or fewer, if any, covenants. Covenant-lite loans formed 7% of the leveraged loan market in 2006 by dollar amount. 6 They comprised 20% of the market by At the end of May 2015, they represented 59%. 8 Of the new issues that came to the market in 2014, 63% were covenant-lite loans. 9 So, clearly there has been a trend to strip away covenants when companies come to the market. The key point to note here is the percentage of covenant-lite loans differs by credit quality. At the higher end of the creditquality spectrum, the percentage of convenant-lite loans has tended to be lower than in the lower and middle tiers. Middletier companies have 68% covenant-lite issuance; in the upper tier it s 46%. 10 This is critical in our view. We think covenants should be seen in the context of the overall credit quality. As an investor, we would be less concerned about the lack of covenants for a higher credit-quality issuer than for a company that we felt needed closer monitoring of its performance. It is also worth noting that historically covenant-lite loans have had a lower payment default rate than covenanted loans. 11 Of the loans that did default, the recovery levels of covenant-lite loans were lower than those of covenanted deals. So we think that has implications for when the next credit cycle turns, and we are trying to position the portfolio accordingly. In particular, given what we see in the loan market, we re attempting to position our portfolios to move up in credit quality. Eventually, we think the market will morph into one where you will see a greater percentage of lower- and middle-tier credit constituents and overall credit quality of the market will be lower than it is currently. Collateralized Loan Obligations (CLOs) CLOs are the largest investor group in the institutional loan market, representing 62% of the investor base in the loan market by dollar amount. 12 In 2014, we saw record deal formation of $124 billion 13, and we believe CLO formation will continue to be strong through the remainder of However, new US regulations due to come into effect in 2016 would require managers of CLOs to support transactions in a more material way; therefore, we think CLO formation is likely to decline starting in The rules are designed to help mitigate the risk of a new credit bubble in the leveraged loan market, with a specific focus on rising leverage levels and the proliferation of covenant-lite loans. As a result, we expect the fall in issuance to be more pronounced in the upper-tier, higher-credit quality space, because that s where CLOs are a bigger player and LIBOR is a bigger component of income for upper-tier loans. Positioning for Potential LIBOR Rise Going into what we think will be a peak default cycle sometime in 2016 or 2017, we would expect investors to be looking to own the shortest default risk as possible, particularly for lenders with lower-tier or middle-tier credit risk. We would therefore tend to be biased toward investing in loans that have higher credit quality. By the time we are in the environment we expect in 2016 and 2017, we anticipate seeking to position our portfolios to attempt to mitigate the increasing risk of the peak default cycle, while also potentially benefiting from a rising LIBOR. Table 1: Default and Recovery Rates Default Rates Recovery Rates With Maintenance Covenants Covenant-Lite With Maintenance Covenants Covenant-Lite % 0.61% % 34.80% % 5.48% % 38.16% % 1.70% % 23.35% Source: Credit Suisse Group. Data based on Credit Suisse Leveraged Loan Index. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Recovery rate is the amount that a creditor received in the event of a default, expressed as a percentage of par value. 6. Source: Credit Suisse Group, July Ibid. 8. Ibid. 9. Source: S&P LCD Quarterly Report, December Credit Suisse Group, July Source: Credit Suisse Group. Data based on Credit Suisse Leveraged Loan Index. Indexes are unmanaged and one cannot directly invest in an index. Past performance does not guarantee future results. 12. Source: S&P LCD Quarterly Report, December Ibid. Rising Rates and the Case for Leveraged Loans 3

4 Floating Rate Coupon Chart 2: Managing Expectations in a Rising-Rate LIBOR Environment Floating-Rate Income for Some Investors May Initially Decline as LIBOR Rises Loan Market Average All-In Coupon Projected 3-Month LIBOR (Example) Loan Market Average LIBOR FLOOR Loan Market Average CREDIT SPREAD over 3-Month LIBOR Time For illustrative purposes only. There is no assurance that any projection or forecast will be realized. We would also note that while we expect performance of the asset class to be good initially because of increased demand, the income levels could actually decline before rising due to LIBOR floors. The relationship between how rapidly LIBOR rises, relative to how rapidly refinancing activity occurs, could find some investors in a position to experience declines, before income starts to rise again. The concept of a LIBOR floor may be confusing investors in terms of the compensation they are receiving. The LIBOR floor helps ensure investors receive some minimum base level of compensation, in addition to the credit spread the bank loan may pay. The primary risk an investor accepts when investing in bank loans is credit risk, and the compensation they receive is the spread over LIBOR. Given that LIBOR is currently so low (0.33%) 14, many borrowers have agreed to pay a LIBOR level that s above the current rate. So in a rising LIBOR environment, we would expect investors to be looking for loans with low or no LIBOR floors. Portfolio Positioning Franklin Floating Rate Debt Group analysts divide our investable universe into upper, middle, and lower credit risk tiers based upon our independent forward-looking analyses of credit risk for each loan. By contrast, indexes use the backwardlooking analysis of credit rating agencies to assign credit risk tiers. Our portfolios are constructed seeking to exploit these differences between forward- and backward-looking risk assessments. We assess long-term creditworthiness (including probability of default), then assign near- to intermediate-term forward-looking credit risk to our investible universe. The tables on the next page summarize our view of potential market implications of a rising LIBOR environment, and potential portfolio positioning based on our analysis. Many investors look at the LIBOR floor with the floating-rate spread as their compensation for the credit risk. That s a mistake in our opinion. As LIBOR begins to rise, investors would want to participate in the income stream that will flow. But the floor becomes worth less as LIBOR rises. 14. As at 21/8/15. Rising Rates and the Case for Leveraged Loans 4

5 Table 2: Potential Market Implications in a Rising LIBOR Environment Potential Impact on the Market Immediate Effect Intermediate Loan Impact Sector Subsequent Effect on Loans Subsequent Loan Sector Impact Increased demand for floatingrate loans and short-duration assets likely Shorter-maturity US Treasury yields increase expected Uncertain impact on longerduration assets Market Technicals Increased flows into loan mutual funds and separate account loan mandates from US and non-us investors likely Potential Market Composition Upper Tier: Decreases Middle Tier: Increases Lower Tier: Increases LIBOR Floor Market Composition When LIBOR rises, loans with embedded LIBOR floors should be impacted more adversely than loans with no or low LIBOR floors Expected Impact on Total Returns (Initial) Upper Tier: + Middle Tier: + Lower Tier: + Loan Pricing: Higher Credit Spreads: Tighter Refinancing Increases likely Issuance: (potentially) Activity: Increases Covenants: Increased pressure to remove or amend Maturities: Seek to shorten average portfolio maturities Leverage: Increases likely Upper Tier Strong demand for higher-quality assets likely Stronger demand for assets with no or low LIBOR floors likely Middle/Lower Tier Expect more refinancing activity due to higher LIBOR floors Expect short maturities to extend out Future Credit Quality Upper Tier: Dependent on LIBOR Middle Tier: - Lower Tier: - For illustrative purposes only. There is no assurance that any projection or forecast will be realized. Potential market composition is market value percentage distribution by credit risk. Riskier middle/lower tier names expected to experience higher defaults due to higher interest costs; less capital availability. Table 3: Potential Portfolio Positioning Potential Positioning by Tier Table 3: Potential Portfolio Positioning Potential Portfolio Construction Implications Duration Positioning Actively acquire loans with shorter maturities Upper Tier Seek shorter maturity, low or no LIBOR floor, discount dollar price assets and avoid high spread, high LIBOR floor, premium-priced assets Middle Tier Seek higher quality, shorter maturity, discount dollar price assets with low leverage and smaller facility size and avoid high spread, high LIBOR floor, premium-priced assets without call protection LIBOR Floor Positioning Actively acquire loans with low or no LIBOR floors Credit Quality Positioning Upper Tier: Increase MV% exposure Middle Tier: Decrease MV% exposure Lower Tier: Decrease MV% exposure Lower Tier Seek higher quality, shorter maturity, discount dollar price assets with low leverage and smaller facility size and avoid high spread, high LIBOR floor, premium-priced assets without call protection Riskier middle/lower tier names expected to experience higher defaults due to higher interest costs; less capital availability. Employ refinancing wave of middle tier and lower tier loans as a par exit. For illustrative purposes only. There is no assurance that any projection or forecast will be realized. Rising Rates and the Case for Leveraged Loans 5

6 Copyright Franklin Templeton Investments. All rights reserved. Franklin Templeton Investments (Asia) Limited is the issuer of this document. The document, which is for informational purposes only, sets forth our views as of the date published. The stock provided is for illustration purpose only. It is not a recommendation to purchase, sell or hold any particular security. The stock identified is not necessary indicative of a portfolio's holding at any one time. The underlying assumptions and these views are subject to change. There is no guarantee that any forecasts expressed will be realized. Franklin Templeton Investments accepts no liability whatsoever for any direct or indirect consequential loss arising from use of this report or any information, opinion or estimate herein. This document has not been reviewed by the Securities and Futures Commission of Hong Kong. Franklin Templeton Investments (Asia) Ltd 富 蘭 克 林 鄧 普 頓 投 資 ( 亞 洲 ) 有 限 公 司 17/F Chater House, 8 Connaught Road Central, Hong Kong Tel: (852) Fax: (852) franklintempletoninstitutonal.com Copyright 2015 Franklin Templeton Investments. All rights reserved. 9/15