All in All it was not much of a Maturity Wall BY JASON M. THOMAS AND LINDA PACE

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1 Market Commentary August 27, 2012 All in All it was not much of a Maturity Wall BY JASON M. THOMAS AND LINDA PACE By virtually any measure, the speculative grade corporate credit market in the United States is performing exceptionally well: the default rate is half of its historic average; a larger share of loans is rated above B- than ever before; and fund flows into the asset class continue to set records. 1 Financing terms for corporate borrowers are extremely accommodative, with all-in borrowing costs at record lows. These conditions are a far cry from those forecast by analysts who warned of a financial doomsday due to the record volume of speculative grade credit set to mature between 2012 and Of the 4,118 tranches in the The predicted collision with the maturity wall never materialized. 719 U.S. CLOs Moody s has Pessimists based their forecast on several key assumptions that rated since 2001, only 32 were not borne out empirically. Through August 2012, over 80% of tranches (0.78%) suffered the leveraged loans set to mature between 2012 and 2014 have July 2011 principal losses at maturity already been refinanced. 3 Rather than sorting through record default volumes or worrying about a new credit crunch, market observers today are more likely to be concerned about high prices and excessive liquidity. This experience suggests that common assumptions about refinancing risk may be misplaced. In the absence of extreme macroeconomic stress or illiquidity, the volume of maturing obligations should not generate default risk independent of the credit quality of the borrower. Declines in the relative price of senior claims on cash-generative businesses arising solely from maturity dates create arbitrage opportunities likely to be quickly bid away. Corporate Lending Trends and the Origin of the Maturity Wall Large corporate loans are typically syndicated, where the bank originator retains a portion of the loan and sells the rest to other financial institutions. Between 2005 and 2007, more than $800 billion of institutional loans the portion of these syndications designed specifically for non-bank institutional investors and securitization pools were originated and sold in the United States, which was approximately three-times the loan volume of the prior three years. 4 The increased loan issuance was facilitated by the growth of 1 S&P Capital IQ Leveraged Commentary and Data (LCD), S&P/LSTA Leveraged Loan Index. 2 New York Times, Corporate Debt Coming Due May Squeeze Credit, March 16, S&P Capital IQ Leveraged Commentary and Data (LCD), Leveraged Loan Index Maturity Breakdown. 4 S&P Capital IQ Leveraged Commentary and Data (LCD), Institutional Loan Volume.

2 collateralized loan obligations (CLOs). 5 CLOs issued approximately $240 billion of notes to fund loan purchases during the period. 6 Syndicated loans sold to institutional investors are generally made to borrowers with speculative grade credit ratings (below BBB/Baa). Almost by definition, speculative grade borrowers are unable to repay principal payments out of free cash flow and must refinance all or part of existing debt at or before maturity. 7 With average institutional loan tenors of approximately seven years, the bulk of the loans originated in were expected to mature between 2012 and In addition, nearly $350 billion of high-yield bonds were issued in the U.S. between 2005 and 2007, the bulk of which were also set to mature during the same window. 8 Figure 1: Gross Debt Issuance, Speculative Grade Credit Market $600,000 $500,000 USD, Millions $400,000 $300,000 $200,000 $100,000 $0 High Yield Bonds Institutional Term Loans The liquidity risk created by the record issuance volume of was real but thought to be manageable. That appeared to change with the onset of the global financial crisis and concomitant recession. The average bid price on leveraged loans fell to $0.62 per $1 of par value after the Lehman Brothers bankruptcy filing and the double whammy of recession and illiquid financial markets caused the default rate to peak at 11% in CLOs were particularly hard hit: between the fourth quarter of 2008 and the first quarter of 2010 just $2.4 billion of CLOs were issued, a 97% decline from the annual rate prior to the crisis. The collapse in CLO issuance and restrictions on the reinvestment of previously-issued CLOs removed the most significant buyer from the institutional loan market and generated concerns of insufficient capacity to refinance loans set to mature between 2012 and In addition to these capacity concerns, some analysts were particularly worried about the underlying credit quality of the loans issued between 2005 and First, the dreadful experience with securitized residential mortgage loans led some observers to analogize leveraged loans purchased by CLOs to subprime mortgages. 10 Second, about one-third of the institutional loans originated during the period were used to 5 CLOs are bankruptcy-remote corporations that issue tranched notes supported by the cash flows of a pool of assets purchased and managed by the CLO sponsor. 6 S&P Capital IQ LCD. 7 Moody s Investors Service (2009), Ratings Symbols and Definitions. 8 Melentyev, O. (2012), High Yield Chartbook: Q2-2012, Bank of America Merrill Lynch. 9 S&P Capital IQ LDC. 10 Mah-Hui Lim, M. (2009), Old Wine in a New Bottle: Subprime Mortgage Crisis Causes and Consequences, Levy Institute Working Paper No

3 finance leveraged buyouts. The large buyouts of generally had less favorable credit statistics than in the previous four years: the average purchase price was 25% higher, relative to earnings; debt was 25% higher, on average, relative to operating cash flow (Ebitda); and interest coverage ratios were one-third lower. 11 The economic contraction of caused these credit profiles to deteriorate further and reduced the likelihood that many of these businesses could refinance existing obligations at maturity. Figure 2: TTM Default Rates, Speculative Grade Debt 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1/1/2007 5/1/2007 9/1/2007 1/1/2008 5/1/2008 9/1/2008 1/1/2009 5/1/2009 9/1/2009 1/1/2010 5/1/2010 9/1/2010 1/1/2011 5/1/2011 9/1/2011 1/1/2012 5/1/2012 High-yield Bond Default Rate Leveraged Loan Default Rate Bearish Assumptions Did Not Hold While default rates in 2010 backed off from the peaks reached in late-2009, many analysts suspected this would prove to be a temporary respite before the huge volume of maturing obligations pushed default rates to new records in Instead, default rates continued to decline for the next two years (Figure 2) and the maturity wall was managed through repayment, refinancing, and amendments (Figure 3). 13 This occurred despite a more sluggish recovery than was contemplated at the end of Figure 3: Institutional Loans Set to Mature Between 2012 and 2014 $500,000,000,000 $450,000,000,000 $400,000,000,000 $350,000,000,000 $300,000,000,000 $250,000,000,000 $200,000,000,000 $150,000,000,000 $100,000,000,000 $50,000,000,000 $0 Loans to Mature in: /31/ /31/2010 8/10/ S&P Capital IQ LDC, Credit Stats. 12 Moody s Investors Service (2010), Refunding Risk and Needs for U.S. Speculative-Grade Corporate Issuers, , February S&P Capital IQ LDC. 3

4 The high default or bearish forecast depended on three assumptions about the speculative grade credit market that did not hold. First, pessimists assigned undue significance to the market s capacity. In theory, the lack of CLO issuance should not exert any lasting influence on default rates or the market price of corporate loans. The basic intuition of arbitrage-free asset pricing is that the payoffs from assets like corporate loans can be replicated by constructing a portfolio of other assets like corporate equities and government bonds. 14 If a decline in the capacity of traditional buyers caused loan prices to fall below the market value of the replicating portfolio, there would be an arbitrage opportunity that would draw capital to loans from other asset classes. The impact of capacity constraints should therefore be transitory and last only as long as it takes investors to recognize and capitalize on the investment opportunity. At the end of March 2012, the total market value of financial claims in the U.S. stood at $161.5 trillion. 15 The estimated $700 billion of speculative grade debt that was set to mature between 2012 and 2014 is less than 0.5% of this total, or just 10% of the $7 trillion households have deposited in zero-yielding savings accounts. It also represents just 2.8% of the $25.2 trillion in corporate equities junior to institutional loans in the corporate capital structure, or 70% of the $1 trillion in outstanding commercial paper that needs to be rolled over every 46 days. 16 The magnitude of the cross-asset fund flows necessary to fill any capacity shortfall was always small in the context of the overall U.S. financial market. Figure 4: Net Monthly Fund Flows, U.S. Bond and Stock Mutual Funds $50,000 $40,000 $30,000 $20,000 $10,000 $0 -$10,000 -$20,000 -$30,000 -$40,000 -$50,000 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Taxable Bond Mutual Funds Domestic Equity Mutual Funds Since refinancing rather than full amortization is the contemplated means of repayment, high-yield bonds and leveraged loans have features that allow them to be called by the borrower. This means that these instruments can generally be refinanced prior to maturity, often in exchange for a fee. In the 30 months since January 2010, more than $526 billion of high-yield bonds have been issued domestically, about 50% more than was issued over the entire period. More than 55% of these bonds have been used to refinance existing debt, 17 with $227 billion issued as part of a transaction to retire existing loans. 18 Since nearly all high-yield bonds have fixed coupons, borrowers attraction to high-yield bonds is easy to 14 C.f. Ross, S. (2005), Neoclassical Finance, Princeton University Press. 15 Federal Reserve Flow of Funds, L. 5. Total Liabilities and its Relation to Total Financial Assets. 16 Federal Reserve, Maturity Distribution of Commercial Paper Outstanding. 17 Melentyev, O. (2012) 18 S&P Capital IQ LDC. 4

5 understand given today s low interest rate environment. However, the low-interest rate, low-growth environment has also made speculative grade credit attractive to investors as well. Net inflows to taxable bond mutual funds have been $490 billion since 2010, which compares to a net $281 billion outflow from domestic stock mutual funds over the same period (Figure 4). 19 All Securitization is Not Created Equal Second, the experience of subprime mortgages and structured finance collateralized debt obligations (CDOs) led many to assume that loans purchased by CLOs would perform poorly simply because they were securitized. In reality, residential mortgage securitization performed poorly because of adverse selection and moral hazard problems not present with CLOs. 20 Unlike with home mortgages, syndicated corporate loans are large and have their own credit rating, which allow investors to estimate the likely performance of the CLO s loan collateral at relatively low cost. Second, the lead arranging bank generally keeps a portion of the loan on-balance sheet as a condition of the loan syndication deal. This means the originator typically had real skin in the game often absent from mortgage deals. Thirdly, CLO structures are relatively transparent and generally include performance fees that create added financial incentives to ensure low-quality loans are not included in the securitization pool. The data bear out the substantial differences in CLO performance relative to other securitization vehicles. CLO collateral defaults peaked at 6.5% percent in June 2009 compared to cumulative default rates of 50% on securitized subprime mortgages as of November Of the 4,118 tranches in the 719 U.S. CLOs Moody s has rated since 2001, only 32 tranches (0.78%) suffered principal losses at maturity. 22 Similarly, 85% of CLO liabilities originally rated AAA remained rated AA or better, compared to just 11% of residual mortgage (structured finance) CDO liabilities. 23 Perhaps most importantly, the corporate loan securitization market has also come back to life: new CLO issuance was greater in the second quarter of 2012 than in any quarter since By contrast, residential mortgage securitization remains dominated by government agencies, with the private sector s market share actually falling to 1% in 2012 from 4% in Loans purchased by CLOs were of high quality, on average, and no more likely to default than loans held on-balance sheet. 26 Leveraged Lending Promotes Contract Flexibility Third, predictions of large default volumes depended implicitly on the existence of frictions that would prevent borrowers and lenders from renegotiating agreements in the light of new economic circumstances. In reality, the coordination costs involved in loan renegotiations are relatively low, particularly when the case for maturity extensions is based on macroeconomic rather than company-specific factors. If a borrower can continue to meet coupon payments without difficulty, a lender may rationally choose to extend the maturity on the existing loan, often in exchange for some financial consideration. Since January 2010, lenders have agreed to extend the maturity dates on more than $120 billion in institutional loans, usually in exchange for a 19 Investment Company Institute, "Trends in Mutual Fund Investing, August Keys et al. (2010), "Did Securitization Lead to Lax Screening, Quarterly Journal of Economics. 21 Federal Reserve Board of Governors and Federal Reserve Bank of New York. The subprime loan default figure Includes loans 90+ days past due and loans in foreclosure. 22 Moody s Investors Service (2012), CLOInterest, July Coffee, M. (2011), CLOs: Where Do We Go from Here, LSTA. 24 S&P Capital IQ LDC. 25 Federal Housing Finance Administration (2012), Conservator s Report, Q Benmelech, E., Dlugosz, J. and Ivashina, V. (2011), Securitization without Adverse Selection: The Case of CLOs. NBER Working Paper

6 fee ranging between 0.24% and 0.34% of the loan balance, an increase in the effective interest rate, and some repayment of the original principal amount. 27 Creditors willingness to engage in these amend-to-extend transactions is undoubtedly linked to today s depressed interest rate environment. In a world of ultra-low interest rates, alternative reinvestment opportunities may often be no better than the loan extension, even for marginal credits. But the countercyclical nature of interest rates provides a natural hedge against refinancing risk. Since leveraged businesses solvency is especially sensitive to changes in operating cash flow and macroeconomic conditions, better alternative reinvestment opportunities (i.e. higher interest rates) are more likely to occur in states of the world where operating earnings are higher and default less likely. Conclusion and Outlook Predictions of a wave of defaults when the speculative grade debt market hit the maturity wall of were far off the mark. The bulk of speculative grade debt set to mature during this period has already been refinanced without incident thanks to fund inflows from other asset classes and the alignment of interest between lenders and borrowers. The future is uncertain, as many credits will need to be refinanced in the timeframe, but an uncertain future and refinancing risk is precisely what makes these credits speculative grade. Recent experience provides reasons to be optimistic that the volume of maturing claims should not inhibit the refinancing of cash-generative, otherwise solvent businesses, at least in the U.S. The asset class remains attractive to investors dismissive of the upside of equity but in need of yields that at least keep pace with inflation. Ironically, the biggest risk in the U.S. leveraged finance market today may be high prices and too much liquidity chasing the very credits that were not supposed to be able to get refinanced. Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated, based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts. Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information. This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Contact Information: Jason Thomas Director of Research Jason.Thomas@carlyle.com (202) S&P Capital IQ LDC. 6