Leveraged Loan Funds: Debunking the Myths SM
Leveraged Loan Funds: Debunking the Myths Contents 2 Myth #1: Managing liquidity in actively managed leveraged loan mutual funds is difficult. 3 Myth #2: In the leveraged loan market, demand currently lags supply 4 Myth #3: Valuations of leveraged loans are becoming overheated In recent years, leveraged loans have been embraced by investors looking for income in an environment marked by credit market volatility and historically low yields. But worries from retail investors about a range of issues in the leveraged loan, or floating rate, market have led to a steep spike in outflows by their investors. These concerns typically revolve around three particular areas: managing liquidity, supply and demand trends, and valuations. But are these concerns warranted? In many cases, the answer is no. The misconceptions about the leveraged loan market tend to ignore facts that help suggest that current market conditions can potentially be quite favorable for investors. As a result, some investors are missing out on an asset class that could supply income and a dose of portfolio protection when interest rates rise. Leveraged Loan funds: Debunking the Myths 1
Myth #1: Managing liquidity in actively managed Leveraged loan mutual funds is difficult. Investors may assume that mutual funds focusing on leveraged loans face liquidity challenges, which could lead to difficulties for fund shareholders who want to redeem their shares. However, the facts don t support this concern: In 2014, for example, many retail investors headed for the exits, redeeming a total of $21 billion from leveraged loan mutual funds. Despite the relatively large outflow, the redemption process was orderly and proceeded without incident. Exhibit 1: FUnd Flows (2003-2015) Fund Flows ($ billions) $70 $60 $50 $40 $30 $20 $10 $0 -$10 -$20 -$30 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1Q15 Source: Lipper FMI via JP Morgan One reason for the ease of those redemptions is that fund managers have several strategies to manage liquidity. A fund manager may maintain a cash allocation that can be used for shareholder redemptions. Another strategy is to employ fixed rate high yield bonds that a manager can sell to fund redemptions, as high yield bonds typically benefit from shorter settlement periods. What s more, some fund managers invest primarily in larger issuers, where liquidity is generally greater than in middlemarket deals. And to meet large, unexpected redemptions, some fund managers maintain a dedicated line of credit that gives them the financial flexibility to handle a spike in share sales without negatively impacting the portfolio s structure. None of this implies that in a scenario like the 2008 credit crisis, liquidity would be available on a normal basis. If many investors panicked and sold shares at the same time, liquidity for leveraged loans funds would potentially be impaired as it would be for every other asset class, explains George Goudelias, Portfolio Manager of RidgeWorth Seix Floating Rate High Income Fund. If there s a stampede to the gate, all asset classes will come under pressure, he remarked. Leveraged Loan funds: Debunking the Myths 2
But in more normal periods, including the second half of 2014, Goudelias says liquidity shouldn t be a worry for the average investor. The leveraged loan market has grown in size and depth, he says. This asset class is maturing and proving it can be as functional as others, including high yield. Myth #2: In the leveraged loan market, demand currently lags supply. The leveraged loan asset class has exploded in recent years, with new issuance records set. And, in fact, this surge in supply has been closely matched to growing demand. So what gives rise to the myth about lagging demand? One answer is that it may reflect the perspective of observers looking solely at the retail market, where demand did, indeed, dip in 2014. But understanding the relationship between supply and demand in the leveraged loan market means also understanding that retail investors account for a minority of the total market. Exhibit 2: Demand for leveraged loans by Investor Category (2013 vs. 2014) 2013 Investors 2014 Investors Other 6.5% Hedge, Distressed & HY Funds 8.8% Other 6.2% Hedge, Distressed & HY Funds 9.8% CLOs 53.2% Leveraged Loan Mutual Funds 31.5% CLOs 62.2% Leveraged Loan Mutual Funds 21.8% Source: Lipper FMI via JP Morgan Overall, loans have more of an institutional mindset corporations, endowments, hedge funds, asset managers, pension funds, and insurance companies, notes Vincent Flanagan, Portfolio Manager of RidgeWorth Seix Floating Rate High Income Fund. In 2013, inflows to retail leveraged loan mutual funds reached a record $63 billion. This trend reversed in 2014, but institutional investors more than picked up the slack. Collateralized loan obligations, or CLOs asset-backed securities collateralized with floating rate debt are a large and rapidly growing institutional asset class. Issuance in the CLO market hit a record of nearly $132 billion in 2014, far above the $87.1 billion issued in 2013. Leveraged Loan funds: Debunking the Myths 3
Exhibit 3: Leveraged Loan Supply & Demand 2013-2014 ($ Billions) Year Quarterly Year 2013 1Q14 2Q14 3Q14 4Q14 2014 Gross New Issuance 669.9 176.5 128.3 104.2 57.6 466.9 Paydowns* -258.8-54.3-53.6-46.2-31.7-194.0 Repricing -241.7-70.2-8.5-10.9-0.9-90.5 Net New Issuance 169.4 52.0 66.2 47.6 25.0 182.4 Retail Inflows 62.8 7.7-6.7-10.2-12.6-23.1 CLO Issuance 87.1 23.9 39.7 39.7 31.1 131.9 Total Demand 149.9 31.5 33.0 26.9 18.5 108.8 Supply Surplus/(Shortfall) 19.6 20.5 33.2 20.7 6.4 73.6 Sources: JP Morgan; S&P; LCD; Lipper FMI *Notes: Paydowns include amortizations, unscheduled paydowns, and bond-for-loan issuance; CLO issuance includes only USD deals. When a CLO is launched, you are effectively creating demand for loans because CLOs don t sit in cash, says Goudelias. They have to be fully invested, so it creates a very strong technical when you have such strong CLO demand. What s more, Flanagan adds, much like other markets, underwriters aren t likely to create deals if there s no demand from investors. Will there be short periods of time when underwriters may push the market too much? he asks. Perhaps, but those types of issues often get corrected quickly. Myth #3: Valuations of leveraged loans are becoming overheated. When leveraged loans are trading at or near par, investors have limited upside other than a stable income stream. In June 2014, nearly 60% of the leveraged loan market was trading at or above par (Source: JPMorgan), which led some investors to conclude that the market was frothy, or overheated. Bargains were few and far between. However, by December 2014, the number of loans trading at or above par had dropped to just 3% (Source: JPMorgan), as the same external factors affecting other investment markets such as geopolitical tensions and falling oil prices had an impact here, too. With money leaving mutual funds for an extended period, credit spreads widened relative to U.S. Treasuries, which created attractive opportunities for investors to benefit from lower valuations. Spreads are wider, so the starting point on yield and price is better than where it was a year ago, says Flanagan. At current prices, the asset class is undervalued. Leveraged Loan funds: Debunking the Myths 4
Conclusion The leveraged loan market has changed significantly from the depths of the financial crisis in 2008. And while investors have embraced leveraged loans, they also may be wary of shifting trends in the economy and in the financial markets. As a result, it s important to educate investors about what is real versus perceived in this complex market. After all, leveraged loans offer a compelling potential opportunity for investors to add diversification to a portfolio, as well as the ability to generate income and offer protection from rising interest rates. SM About the RidgeWorth Investments Research Series This report is part of the RidgeWorth Investments Research Series, an ongoing educational program that explores various investment topics. For more information about this and other informative programs offered by RidgeWorth Investments, please visit www.ridgeworth.com or call 866-595-2470. The RidgeWorth ipad app gives users instant access to detailed information about the RidgeWorth Funds, award-winning marketing content for wealth and retirement plan advisors and more. The RidgeWorth ipad app is available for free from the App Store. Leveraged Loan funds: Debunking the Myths 5
Investment Risks: Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer term bonds and a lower rate of return. Generally, a fund s fixed income securities will decrease in value if interest rates rise and vice versa. Although a fund s yield may be higher than that of fixed income funds that purchase higher rated securities, the potentially higher yield is a function of the greater risk of that fund s underlying securities. Floating rate loans are typically senior and secured, in contrast to other below-investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. Participation in certain types of loans may limit the ability of a fund to enforce its rights and may involve assuming additional credit risks. Equity securities (stocks) may be more volatile and carry more risk than other forms of investments, including investments in high grade fixed income securities. The assertions contained herein are based on RidgeWorth s opinion. This information is general and educational in nature and is not intended to be authoritative. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. This information is based on information available at the time, and is subject to change. It is not intended to be, and should not be construed as, investment advice. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions. Credit Ratings noted herein are calculated based on S&P, Moody s and Fitch ratings. Generally, ratings range from AAA, the highest quality rating, to D, the lowest, with BBB and above being called investment grade securities. BB and below are considered below investment grade securities. If the ratings from all three agencies are available, securities will be assigned the median rating based on the numerical equivalents. If the ratings are available from only two of the agencies, the more conservative of the ratings will be assigned to the security. If the rating is available from only one agency, then that rating will be used. Ratings do not apply to a fund or to a fund s shares. Ratings are subject to change. Barclays U.S. Aggregate Bond Index is a widely recognized index of securities that are SEC registered, taxable, and dollar denominated. The Index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities. Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, noninvestment grade, fixed rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. S&P 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. It is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Investors cannot invest directly in an index. Collateralized Debt Obligation (CDO) is a structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. Collateralized Loan Obligation (CLO) is a special purpose vehicle that issues debt and equity for its capital, and purchases bank loans as assets using that capital to provide a steady stream of income and possible capital appreciation. Coupon is the interest rate stated on a bond when it s issued. Leveraged buyout is a valuation ratio of a company s current share price to its per-share earnings. The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Price-to-Earnings Ratio (P/E) is a valuation ratio of a company s current share price to its per-share earnings. Spread is the difference between the bid and the ask price of a security or asset. Yield Curve is a curve that shows the relationship between yields and maturity dates for a set of similar bonds, usually Treasuries, at any given point in time. An investor should consider a fund s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the RidgeWorth Funds can be found in a fund s prospectus. To obtain a prospectus, please call 1-888-784-3863 or visit www.ridgeworth.com. Please read the prospectus carefully before investing. 2015 RidgeWorth Investments. RidgeWorth Investments is the trade name for RidgeWorth Capital Management LLC, an investment adviser registered with the SEC and the adviser to the RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC, which is not affiliated with the adviser. Collective Strength. Individual Insight. is a federally registered service mark of RidgeWorth Investments. Credit Suisse Institutional Leveraged Loan Index is a subindex of the Credit Suisse Leveraged Loan Index which contains only institutional loan facilities priced above 90, excluding TL and TLa facilities and loans rated CC, C or in default. It is designed to more closely reflect the investment criteria of institutional investors. Leveraged Loan funds: Debunking the Myths 6
RFWP-LF-0415 SM