PORTFOLIO COLUMBUS FIXED DISCUSSION INCOME Bank loans: Remedy for rising rates? March 13 OUTLOOK & OPPORTUNITIES PLEASE VISIT jpmorganfunds.com for access to all of our Insights publications. AUTHORS IN BRIEF Bank loans are justifiably drawing an increased amount of attention and investment among the traditional institutional investor base: They are typically senior instruments, secured by a debtor s assets, and rank first in priority of payment in the capital structure. This generally makes them less sensitive to changes in credit fundamentals than high yield bonds. They tend to provide tighter covenant packages than high yield bonds. They are floating rate instruments. Their yield rises and falls with changes in LIBOR, so they are relatively insensitive to interest rate movements compared to high yield bonds and other fixed income investments. Their stability tends to offset interest rate risk and mitigate the price volatility inherent in a fixed income allocation. The market for bank loans has become large and reasonably liquid, similar to the high yield market. William J. Morgan Portfolio Manager Columbus High Yield James P. Shanahan Portfolio Manager Columbus High Yield Jon J. Salstrom, CFA Client Portfolio Manager Columbus High Yield From tactical offshoot to strategic mainstream With a secondary trade volume averaging $1 billion per quarter, activity in the $634 billion bank loan market is comparable to the high yield bond market (Exhibit 1). Paralleling the maturation of high yield, bank loans (also known as leveraged loans) evolved from a sector characterized by club deals, i.e., illiquid loans, predominantly by small-cap issuers, to one dominated by large-cap issuers with large liquid credit facilities. Loans of more than $3 million constitute roughly 8% of the value of the market today, a proportion that has grown from a little less than half in the past Coming back strong: Less leveraged than its earlier incarnation, the bank loan market has turned around. EXHIBIT 1: BANK LOAN MARKET SIZE 9 USD (billions) 8 7 6 5 4 3 1 16 145 141 141 188 5 16 3 34 53 88 55 5 5 8 14 5 45 3 64 118 1993 1994 Market size 1995 1996 1997 1998 1999 Source: Credit Suisse. Data as of January 1, 13. 1 New issues 3 617 46 48 366 37 3 41 4 5 6 841 856 779 7 8 9 64 61 634 74 154 99 56 1 11 1 NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
The market grows up: Large-cap issuers and large credit facilities now dominate. EXHIBIT : BANK LOAN ISSUE SIZE 1 9 >$31 million 8 $1 $3 million 7 $11 $ million 6 <$1 million 5 4 3 1 1 3 4 5 6 7 8 9 1 11 1 Percent Source: Credit Suisse. Data as of December 31, 1. decade (Exhibit ). These large-cap issuers generally have more varied product lines, customer bases and geographical diversification than small-cap issuers, all of which can make for a more stable credit profile. The nature of bank loan demand has evolved along with the nature of supply. Traditional institutional investors, generally with no explicit leverage, have accounted for a larger share of the market as awareness has grown of the attributes of bank loans attractive relative yields, enhanced fixed income diversification, and reduced volatility and exposure to interestrate duration. The other important group of loan buyers consists of collateralized loan obligations (CLOs), which generally assume a buy-and-hold approach, contributing to price stability. Despite the high leverage inherent in CLO structures, the lower default rate and higher recoveries have allowed most CLOs to navigate the financial crisis and ensuing recession with little credit impairment across the various tranches. Explicit leverage in the form of the credit default swaps used by hedge funds has shrunk and the instruments today rely less on leverage than before. Top of the heap: Bank loans position in the corporate capital stack provides extra cushion. EXHIBIT 3: REPRESENTATIVE CAPITAL STRUCTURE* Capital structure Senior Secured Loan High yield bonds and/or subordinated mezzanine debt 3 5% 3% Preferred equity 4% First Common equity Loss Source: Credit Suisse. *The chart is hypothetical and shown for illustrative purposes only. Bank loan basics Bank loans are loans made to businesses, often with belowinvestment-grade credit ratings. They are typically senior instruments, secured by the debtor s assets, and rank first in priority of payment in the capital structure, ahead of unsecured debt (Exhibit 3). Because of their senior secured status, bank loans have historically had lower default rates, higher recovery rates and lower credit volatility relative to corporate high yield bonds. Beginning in 1995, about the time banks started syndicating their loans to non-bank institutional investors, to the end of last year, bank loan recovery rates ran half again as high as those for high yield: 66.1% for loans against 43.8% for high yield bonds. Exhibit 4 compares the attributes of bank loans to other corporate asset classes. Bank loans generally supplement their creditworthiness with more comprehensive and restrictive covenant packages than those for high yield bonds. The covenant packages usually consist of incurrence covenants and often include financial maintenance covenants as well. Lineup card compares key attributes of corporate asset classes. EXHIBIT 4: BANK LOANS VERSUS OTHER ASSET CLASSES Leveraged loans 1st lien Leveraged loans nd lien High yield bonds Equities Security Yes 1st ranking Yes nd ranking Generally none None Ranking Senior Senior Lower than secured loans Junior Covenants Generally comprehensive Similar to 1st lien; occasionally Less restrictive; incurrence None less restrictive limitations Term 5 8 years 5 8 years 7 1 years Open ended Income Cash pay floating (LIBOR-based) quarterly Cash pay floating (LIBOR-based) quarterly Cash pay fixed semi-annual Dividends uncertain, usually cash pay Call protection* Limited 1 years 4 5 years N/A Relative credit risk Low High Moderate N/A Relative interest rate risk Low Low Moderate N/A Source: J.P. Morgan Investment Management, Inc. *Refers to protection against the borrower repaying the debt prior to when it is due. When a borrower has discretion to repay debt before it is due, it causes reinvestment risk for the lender. In addition, if the debt is repaid before it is due it may diminish/enhance the return, depending on whether the investment was purchased at a premium/discount. Columbus Fixed Income Bank loans: Remedy for rising rates?
Incurrence covenants specify the criteria a borrower must meet in order to engage in conduct such as taking on additional debt or paying dividends. Financial maintenance covenants specify the financial ratios, such as total debt/ebitda 1 and interest expense/ebitda, that the borrower must comply with on an ongoing basis. Loans lacking certain financial maintenance covenants are referred to as covenant lite loans. While financial maintenance covenants are useful to creditors, they are only one factor among many, including overall lending terms, additional covenants and the potential recovery value of the collateral package, in assessing the quality of any loans. As a general rule, the most creditworthy borrowers are able to negotiate the least restrictive covenant packages. lower volatility compared to high yield bonds. Subject to how close to par they are trading, loan prices neither fall when rates rise, nor rise when rates fall and spreads compress. If and when credit spreads move lower, the borrower holds an option to call back the loan and repay it early, forcing the loan investor to reinvest cash proceeds in a lower yield environment that reflects improved economic and business sentiment. By contrast, high yield bonds, issued with eight- to 1-year maturities, generally have provisions that prevent them from being called in the first half of their term. This call protection gives high yield bonds relatively more total return potential as prices climb above par. A loan for all seasons Bank loans usually pay a cash coupon that resets in accordance with changes in an underlying short-term interest rate, primarily LIBOR. 3 The floating rate coupon can serve to neutralize the risk of rising interest rates on the price of the loan. A standard bank loan coupon is LIBOR ( L ) plus a spread expressed in basis points, for example, L+35, or LIBOR plus 3.5%. This feature may shield bank loans from duration risk and makes for an investment that is defensive in a range of economic environments. If rates rise on the strength of economic recovery, the floating rate component should provide duration protection, compared to conventional bonds exposed to price depreciation through interest rate risk. Additionally, loans are also more defensive than high yield bonds in terms of credit risk. If credit spreads widen when bond prices fall in a deteriorating credit environment, the loans relative position in the capital structure, reinforced with collateral, should provide stronger credit protection than that afforded by unsecured bonds. Unlike high yield bonds, bank loans generally enjoy little or no call protection. They exchange higher return potential for 1 Earnings before interest, taxes, depreciation and amortization, a common measure of operating profitability. The popularity of covenant lite loans has had the paradoxical effect of reducing sharp spikes in default rates. Cov lite loans typically maintain incurrence and other covenants, even though they eliminate the ongoing financial maintenance covenants which strategic investors have used as a tool to force companies into a restructuring that may or may not have been necessary. Under the provisions of a cov lite loan, companies which miss earnings but otherwise maintain sufficient operating liquidity, would not have to undertake expensive facility amendments or unnecessary restructurings. Thus cov lite has actually tended to decrease the credit risk profile of the below-investment-grade market and preserve enterprise value for below-investment-grade investors. 3 The London Interbank Offered Rate, the average rate banks charge for lending to one another and the most widely used short-term loan benchmark. A brief history of bank loans The bank loan market traces its origins to the high yield market of the 198s. Most below-investment-grade issuers carry both bonds and loans on their balance sheets. Initially, through much of the 198s and 199s, large banks tended to retain a significant piece of the loans on their balance sheets and syndicated the balance to other banks. There was no active secondary trading market at the time. While high yield investors had no direct access to bank loans at this stage, prudent high yield managers carefully scrutinized the terms and structure of the bond issuer s bank loans as part of their credit analysis, due to the impact this senior secured debt could have on the issuer s unsecured bonds. Beginning in the late 199s, banks began syndicating the loans more broadly to institutional investors attracted by the loans floating rate income and lower credit volatility. Leveraged loans came of age in the following decade. The market grew deeper and more liquid and began to function more like its high yield counterpart. Major banks made active two-way secondary markets in loans and trading became more standardized. Two relatively new and growing participants influenced its subsequent course. CLOs emerged as the largest buyers of leveraged loans, and hedge funds used total return swaps to gain exposure to the asset class. Both exploited the loans inherently low volatility to leverage up and magnify returns. The CLOs took their cue from the popularity of collateralized mortgage obligations home mortgages bundled together and sold in tranches of varying yield (and risk) according to investor preference. Total return swaps are essentially a leveraged derivative position in one or more loans with a bank or broker counterparty, somewhat similar to a margin account. J.P. Morgan Asset Management 3
Between 5 and 8, demand for loans took off, driven by a huge increase in CLO issuance. Private equity firms took advantage of the seemingly insatiable demand for loans to finance leveraged buyouts (LBOs) of public firms. The robust demand pushed LBO multiples to peak levels on cyclically high earnings. In the liquidity crisis that swept across the markets in 8, highly leveraged structures that were sensitive to falling market values, including total return swaps and a particular type of CLO, the market value CLO, collapsed in a vicious cycle of margin calls and forced selling. The sell-off squeezed leverage out of the leveraged loan market. By the time prices hit bottom, they implied a default rate of 1%, and bank loans suffered their only year of negative returns. The extreme volatility of 8 9 had two lasting effects. It prompted changes in financial regulation seeking to restrain leverage on the sell side and buy side alike. These changes should substantially reduce the risk of a market collapse arising from waves of margin selling like the market experienced in late 8. In addition, the volatility increased awareness of the attributes of bank loans by institutional and retail investors, whose presence in the market enhanced its stability. Bank loans.: putting floors under the structure Post-crisis loans, underwritten in a time of near-zero shortterm policy rates, have introduced a significant innovation: LIBOR floors. With three-month LIBOR rates hovering around 3 basis points and loans trading at discounts in the secondary market in 9, new-issue bank loans at spreads that made sense to their issuers did not offer enough yield to attract investors. As a result, issuers began offering LIBOR floors that provided a minimum yield, no matter how low the benchmark fell. In effect, they gave income-seeking investors something akin to a win/win proposition. If the economy lagged and the Fed kept interest rates low, negating the value of the variable rate feature, the loans would still pay out above-market yields. Conversely, if rates rose above the LIBOR floor, the floor might become worthless, but the variable rate feature would kick in. In a weak economy, the LIBOR floor introduced the idea of duration in an asset class that otherwise would have none. Virtually all of the loans issued since 9 have LIBOR floors and currently three-quarters of the total market has LIBOR floors of some sort. As the economy and the loan market have improved, and the prospect of rising rates has increased, the floors have come down and the duration distortion has diminished. Some newly issued loans have floors as low as 75 basis points, though most floors run between 15 and 15 basis points, down from 5 to 3 basis points for the early loans in the cycle. While historical precedents are lacking, we expect investor demand will rise in tandem with rising rates and support loan prices. Loans diversify bonds Unlike most fixed income bonds with low coupons and extended maturities, bank loans should perform well in the majority of rising rate scenarios. They can have very low or even negative correlation to fixed income securities in general and correlate moderately well with equities and economic growth (Exhibit 5). The floating rate feature of bank loans acts to buoy them against falling bond prices caused by rising rates. In a period of stagflation, the relatively rare but not unprecedented scenario in which inflation pushes up interest rates despite meager economic growth, the senior secured Loan yin, bond yang: Bank loans have correlated negatively to traditional fixed income assets over the past decade. EXHIBIT 5: CREDIT SUISSE LEVERAGE LOAN CORRELATIONS Correlation 1..8.6.4.. -. -.4 High Yield REITs Russell Source: Credit Suisse. Data as of December 31, 1. S&P 5 JPM Emerging Markets Bank loans = 1. Gold U.S. 3-day T-bill Barclays U.S. Agg Bd USD ML Mortgage Barclays U.S. Corp Aaa U.S. Gov t 1+ Yrs U.S. Gov t 5 7 Yrs 4 Columbus Fixed Income Bank loans: Remedy for rising rates?
An income story: Over the last years, income has accounted for most of bank loan returns three-quarters of the time. EXHIBIT 6: CREDIT SUISSE LEVERAGE LOAN INDEX: CALENDAR YEAR RETURNS 5 4 3 Income return Price return Return (%) 1-1 - -3-4 -5 9 93 94 95 96 97 98 99 1 3 4 5 6 7 8 9 1 11 1 Source: Credit Suisse. Data as of December 31, 1. and floating rate characteristics of loans can mitigate the risk of rising rates and/or deteriorating credit relative to their investment grade and high yield counterparts. Outside extreme periods on the order of the financial crisis of 8 and its aftermath in 9, bank loans realize the preponderance of their return from the coupon they earn, not capital appreciation (Exhibit 6). The fact that loans have little or no call protection constrains their appreciation potential to a slight premium above par. In a fixed income bull market, as interest rates fall and bond prices rise, borrowers can repay loans at par or a slight premium without penalty. So when the loan market is trading at or close to par, the call feature limits further price appreciation, in a fashion symmetrical to the way the floating rate feature hedges loan price declines when rates are rising. This is not to say that bank loans entirely lack capital appreciation potential. Bank loans have sold at a discount in the wake of bear markets and have risen toward par in past cycles as the economy improved (Exhibit 7). Prices have sat at par for an extended period through this recovery, making it primarily a coupon/carry market. In today s environment with increasing demand for floating rate investments and improving economic data, the price of loans trading at par should remain anchored at par or re-price to reflect lower credit spreads. Loans priced at a discount should rise toward par value, providing moderate price appreciation potential on some of the risky loans in the current market. Counterintuitive: Bank loan discounts have risen above historical norm even as bank loan defaults have fallen below. EXHIBIT 7: CREDIT SUISSE LEVERAGED LOAN INDEX DISCOUNT MARGIN TO MATURITY VS. LEVERAGED LOAN DEFAULT RATES 16 Discount margin to maturity 1 14 Leveraged loan issuer default rate 1 Average discount margin to maturity 3 1 Average default rate 3 Percent 8 6 4 3.% 4.95% 5.8%.6% 1998 1999 1 3 4 Note: The above chart is for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results. 1 Source: J.P. Morgan North American Credit Research Default Monitor. Source: Credit Suisse Leveraged Loan Index. Data as of December 31, 1. 3 Average is for period represented. 5 6 7 8 9 1 11 1 J.P. Morgan Asset Management 5
The cycle turns While the aftermath of the financial crisis may have rid the market of many of its excesses, it did not change its cyclical nature. Demand pressures have inevitably loosened lending standards in the past and seem likely to do so again in the future, especially if equity gains bring M&A back to life, as now seems to be the case. Ultimately this will water down issue underwriting standards, an indication that profitable investing in bank loans calls for careful loan-by-loan fundamental analysis. For the time being, relaxing credit standards may not be an entirely negative phenomenon. Corporations are fiscally fit right now; their balance sheets are reaping the benefit of several years of post-crisis discipline. As Exhibit 7 demonstrates, default rates (measured by issuer count) on bank loans are running at.6%, well below the historical norm of 3.%. It generally takes several years for more relaxed standards to show up in the default rate. In the meantime, and especially early on, more lenient standards could help ease the current supply bottleneck. Conclusion: building a better buffer In steady and uncertain markets, bank loans tend to offset interest rate risk and mute the interest-rate-driven price volatility inherent in a fixed income allocation. In a scenario of low rates and increases on the horizon, this property becomes increasingly more valuable. In the three major episodes of rising rates since bank loans started being widely syndicated, they have solidly outperformed investment grade credit (Exhibit 8). With fixed income portfolios today concentrated in instruments with low yields and growing interest rates, the case for diversification seems hard to avoid. Probably to an even greater extent than thoroughly researched high yield bonds, thoroughly researched bank loans have historically buffered fixed income portfolios against rising interest rates. Research is the key, because the two instruments, while they reduce rate risk, add to credit risk. Not all issues are created equal. Across most asset classes this idiom rings true, but it applies with special relevance to issues from highly levered firms, including bank loans. Once again, fundamental analysis offers the surest means not only of minimizing credit risk but optimizing the benefit of overall asset diversification. While bank loans do not provide a perfect interest rate hedge to a fixed income allocation and can give up total return potential versus high yield, their attributes in a diversified asset allocation model are compelling. Diversification in action: In rising rate episodes bank loans have solidly outperformed corporate credit. EXHIBIT 8: FIXED INCOME RETURNS IN RISING FED FUNDS RATE EPISODES Fed Funds target rate (%) 8 7 6 5 4 3 1 /94 /95 Loans: 1.38% Bonds: -.99% Source: Credit Suisse, Barclays. Data as of December 31, 1. 6/99 5/ Loans: 3.93% Bonds: -.4% 6/4 6/6 Loans: 1.64% Bonds: 6.% 9 93 94 95 96 97 98 99 1 3 4 5 6 7 8 9 1 11 1 6 Columbus Fixed Income Bank loans: Remedy for rising rates?
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