Trends 09 10.11 Seeking Alternatives Senior loans an innovative asset class Dirk Wieringa, Alternative Investments Advisory Senior loans are an innovative asset class that provide a hedge against rising interest rates and inflation as well as combine the beneficial features of and equities. Thanks to regular interest payments, they have a similar payment structure to. The risk-adjusted income, however, is comparable to equity returns. Thanks to these characteristics, these investment instruments offer an attractive opportunity to diversify a fixed income portfolio in the current interest rate environment, which is delivering low returns for traditional fixed-income investments. Investor protection Senior loans are secured loans with a floating rate of interest that are classified as senior debt. Within the capital structure of the borrower, they thus enjoy priority over all other liabilities. Senior loans are granted to non-investment grade companies, i.e. companies with a credit quality comparable to a BB+ rating or lower. Investor protection is also increased in most cases using so-called covenants, which provide the investor with the option to demand a higher risk premium or accelerate repayment upon the deterioration of the company s credit rating. Viewed historically, thanks to their seniority in the capital structure, senior loans 10/28 Dossier Chart 1: Historical ultimate recovery rate (following year of default) Recovery rate (%) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 80.3% Loans 63.5% Senior secured 49.2% Senior unsecured 29.3% Subordinated 18.4% Subordinated junior Source: Moody s. Data from 1987-2010. The details relate to the average discounted recovery rate from the cash and/or securities that the creditors receive upon establishment of the default, i.e. generally upon the opening of bankruptcy proceedings pursuant to Chapter 11. Historical performance indications and financial market scenarios are no guarantee for current or future performance. Performance indications do not consider commissions levied at subscription and/or redemption. DossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossier
DossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossier have had a higher recovery rate in the recent past upon payment defaults: for senior loans, the recovery rate following a bankruptcy is around 80% while bond holders recover between 18% and 64% on average (Source: Moody s. Data: 1987-2010). Portfolio context / relative benefits over high-yield investments For long-term minded investors, given the extremely low interest rates, the question arises as to how a fixed income portfolio can be optimally positioned. In the current market environment, senior loans offer attractive benefits and in a portfolio context can be easily integrated into the investment structure of institutional clients. Thanks to their return structure based on floating interest rates they typically pay a spread above a base rate such as LIBOR senior loans provide a hedge against interest rate fluctuations. In addition, they allow for a potential outperformance of other fixed-income asset classes if interest rates rise. Although in the case of high-yield investors Chart 2: Rolling three-year correlation to core fixed-income investments Correlation 0.6 0.5 0.4 0.3 0.2 0.1 0.0-0.1-0.2-0.3-0.4-0.5 Jan. 01 Jan. 02 Jan. 03 Jan. 04 Credit Suisse Leveraged Loan Index S&P 500 (TRI) Jan. 05 Jan. 06 Barclays High Yield Index DJ UBS Commodity Index Jan. 07 Jan. 08 Jan. 09 Trends 09 10.11 Jan. 10 Source: Credit Suisse, Bloomberg. Data from January 2001 to December 2010 Dossier 11/28
Trends 09 10.11 Chart 3: Annualized volatility Standard deviation (%) 20% 15% 10% 5% Source: Credit Suisse; Bloomberg. Data from January 2001 to December 2010. Historical performance indications and financial market scenarios are no guarantee for current or future performance. Performance indications do not consider commissions levied at subscription and/or redemption. 12/28 Dossier 7.84 12.48 4.02 0% Credit Suisse Leveraged Loan Index Barclays Capital U.S. Aggregate Bond Index DJ UBS Commodity Index 16.9 19.03 Barclays High Yield Index S&P 500 (TRI) are confronted with both interest rate and credit risk, this is limited solely to credit risk for senior loans as a result of their structure. Upon closer examination, it also becomes apparent that senior loans pay their investors a higher credit risk premium on average than high-yield. Furthermore, senior loans enjoy increased investor protection compared to traditional high-yield investments and thanks to their low to negative correlation with most other asset classes, senior loans also provide income-relevant diversification benefits. As a result of their low correlation to core fixed-income investments, they allow for an improvement of the risk/return profile of the fixed-income portion of a portfolio. Senior loans are also appealing due to their natural inflation protection: they exhibit a higher correlation to the expected and unexpected inflation trend (0.6 in comparison to -0.25 for or -0.02 for equities) 1. A further advantage is the constantly low level of volatility, as the following performance figures demonstrate: Between 1997 and 2007, senior loans posted steady total returns of between 2% and 10%. During the crisis year of 2008, the market recorded a loss of approximately 30%, which was, however, compensated for in 2009 by a return of +50% and in 2010 by a performance of +10% (S&P/ LSTA Leverage Loan Index). Opportunities offered by the senior loan market The market for senior loans is most mature in the US. Although in Europe this 1 Source: Credit Suisse. Bonds: Barclays Capital U.S. Aggregate Bond Index. Equities: S&P 500 (TRI). For the analysis, the quarterly figures between December 1980 and June 2009 were used. DossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossier
DossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossierDossier Chart 4: The market for senior loans 1 800 1 600 1 400 1 200 1 000 800 600 400 200 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Market size Issue volume development is somewhat more recent, it began in the US in the early 1990s. During the last 20 years, the market for senior loans has experienced enormous growth and has today reached a value of almost USD 1.6 trillion. Because of the worsening situation as regards traditional refinancing options, the senior loan market offers a number of opportunities. This is due to more restrictive lending by the banking sector, which is faced with more stringent guidelines in connection with capital adequacy requirements such as Basel III, as well as the strained financial situation of financial intermediaries in many cases, which no longer permits investments in noninvestment-grade companies. This situation is reflected in the volume of new issues for senior loans, which has increased again since the financial crisis. In the non-us markets, in particular, the supply of senior loans has risen significantly during the last two years. This allows for diversification within a fund not only according to sector, but also according to region. Source: Credit Suisse In summary, it can be said that senior loans represent an attractive investment alternative for investors with a long-term focus. The asset class is also especially interesting for institutional investors who are looking for an alternative to their fixed-income investments. Trends 09 10.11 Dossier 13/28
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