Bank Loan Market Overview: Opportunities for Diversification, Risk Reduction, and Return Enhancement August 2013 Niklas Nordenfelt, CFA Managing Director and Senior Portfolio Manager Sutter Credit Strategies Nikki Freeman Loan Trader Sutter Credit Strategies Leveraged loans (also known as bank loans ) represent an asset class that may provide plan sponsors with new investment opportunities. Typically diversification within the fixed income market is limited to a plan s outlook on duration, sector, yield curve positioning, or issue selection. Leveraged loans, however, provide further diversification as a nontraditional fixed income product. They can improve not only portfolio diversification, but also other investment goals such as return enhancement and risk mitigation. Historically, leveraged loans have performed well throughout both volatile and rising interest rate environments. What is a leveraged loan? The name of the asset class can be misleading. In this case the term leverage actually only refers to the borrower s credit rating. Loans are categorized as either investment grade loans or leveraged loans. Investment grade loans loans issued to higher-rated companies are a very small part of the bank loan market as investment grade companies tend to have more funding options available to them. In contrast, leveraged loans are akin to high yield bonds and defined as syndicated loans made to less-than-investment-grade companies, generally rated below BBB-/Baa3. The term loan refers to a syndicated loan, which is an extension of credit provided by a group of lenders with a single set of terms. Syndicated loans are structured, arranged, syndicated, and administered by one or several commercial or investment banks known as arrangers. Syndicated loans are senior to bonds within a firm s capital structure, and the type of syndicated loan is further defined by the credit rating of the borrower. Leveraged loans are common sources of financing for below-investment-grade companies, and often constitute important pieces of their overall capital structure. The vast majority of loans trading in the secondary market are leveraged, senior secured, fully-funded term loans, and thus, to institutional investors, bank loan strategies are generally synonymous with leveraged loan strategies. Therefore, a proper definition of the term leveraged loans is important to understanding the asset class. Use of leveraged loans within the capital structure Leveraged loans are senior to both senior subordinate bonds and equity, and generally feature more restrictive covenants. Belowinvestment-grade companies use leveraged loans primarily to finance acquisitions, leveraged buyouts (LBOs), capital expenditures, and general corporate purposes. A typical leveraged structure is capitalized with between 50% to 55% loans, 30% to 35% bonds, and 20% to 25% equity. Exhibit 1: Sample Capital Structure of Below-Investment-Grade Company 100% Senior 90% 80% 50% 70% 60% 50% 40% 25% 30% 20% 10% 25% Subordinate 0% Sample Capital Structure n Equity n Sr. Subordinate Bonds n Leveraged Loans Primary market for leveraged loans Investors in leveraged loans are primarily institutions that can be specifically categorized as collateralized loan obligations (CLOs); banks; hedge, distressed and high yield funds; prime rate funds; finance; and insurance companies. The leveraged loan market has grown steadily from $73 billion in par amount outstanding in 1998 to almost $600 billion in par amount outstanding as of June 2013 (Exhibit 2). CFA and Chartered Financial Analyst are trademarks owned by the CFA Institute.
2 Exhibit 2: Par Amount of Outstanding Leveraged Loans ($ in Billions) $700 $600 $500 $400 $300 $200 $100 $0 $14 $35 $73 $101 $117 $130 $132 $148 $193 $248 $400 $557 $596 $531 $504 $517 $553 $596 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 7/1/2013 Source: Standard & Poor s LCD Prior to 2000, the primary investors of loans were banks, insurance companies, and prime rate funds. However, with the growth of the collateralized debt obligation (CDO) market, the dominant participants became CLOs. More recently, hedge, distressed and high yield funds have become much larger participants at the expense of banks and prime rate funds (Exhibit 3). Exhibit 3: Leveraged Loan Investors 1998 vs. 2013 1998 1998 Non Bank Breakout: 36.8% Source: Standard and Poor s LCD Since 2007 and the onset of the credit crunch, the asset class has opened to new investors including hedged, distressed, and high yield funds. While CLOs still represent the largest investors in leveraged loans, hedge, distressed, and high yield funds have significantly increased their investments comprising almost 10% of the non-bank market. Prime funds firmly remain the second-largest concentration of investors in loans, with a 28.9% share (Exhibit 4). The evolution of the investor base has had profound effects in the trading style of leveraged loans. Indeed, we believe the increased volatility that the asset class experienced during the credit crisis was directly tied to the relatively lax lending standards that a thriving securitization market helped to encourage. The credit analysis typically applied to the asset class was lacking with the proliferation of CLOs. Private equity firms gladly took advantage of the abundant liquidity by structuring buyouts with significantly more aggressive capital structures. The return of traditional, conservative credit analysis has benefited the market going forward. Leveraged loan issuers now have an average interest coverage ratio of 3.7x, up from the recent lows of third quarter 2009 and leverage is down to an average of 4.1x from 5.2x in third quarter 2009. The diversification of the investor base has also greatly increased the liquidity of the asset class making it attractive to more investors. Loan-mutual funds grew to record levels at the end of May 2013 with total assets of $121.9 billion. These inflows have contributed to the growth of jumbo loan tranches (larger than $2 billion); there are a total of 18 jumbo loan tranches in the market, up from 12 last year. 45% 42% Exhibit 4: Growth of Prime Funds 2003-13 Banks Non Banks 13% CLO Insurance Co. Prime Rate Fund 2013 2013 Non Bank Breakout: 85.2% 59% 9% 4% Banks Non Banks 29% 1% CLO Finance Co. Hedge, Distressed & High-Yield Funds Insurance Co. Prime Rate Fund Source: Standard & Poor s LCD Loans vs. bonds While leveraged loans and high yield bonds are often issued by the same companies, the characteristics of the instruments are quite different. A brief comparison summary is provided in Exhibit 5.
3 Exhibit 5: Comparison of Leveraged Loans and High Yield Bonds Leveraged Loans High Yield Bonds Interest Rate/Coupon Floating Rate Fixed rate Rating Below investment grade Below investment grade Security Typically senior secured Generally unsecured Priority Senior Subordinate Covenants Generally comprehensive Less restrictive, mostly financial Callability Generally no, pre-payable at par without penalty Usually call protected Term 5-9 years 7-10 years Amortization Required quarterly principal Bullet payment at maturity payments Source: Wells Capital Management Exhibit 6: Comparison of ML HY Master II Constrained Index and CS Institutional Loan Index Sector Loans (%) HY Bonds (%) Aerospace 3.16 1.44 Air Transportation 0.00 0.23 Automotive & Auto Parts 2.81 2.63 Banks & Thrifts 1.60 4.65 Broadcasting 3.15 2.09 Building Materials 0.77 2.57 Cable/Satellite TV 3.68 4.03 Capital Goods 3.64 1.72 Chemicals 3.84 2.55 Consumer Products 0.50 1.21 Containers 0.97 2.86 Div. Financial Services 1.60 5.55 Diversified Media 4.55 1.40 Energy 3.88 13.94 Entertainment/Film 1.18 0.51 Environmental 1.18 0.37 Food & Drug Retail 1.30 0.72 Food/Beverage/Tobacco 6.74 2.24 Gaming 1.72 3.27 Healthcare 12.92 7.98 Homebuilders/Real Estate 0.77 2.53 Hotels 0.86 0.20 Insurance 0.80 0.82 Leisure 1.72 0.59 Metals/Mining 1.45 3.48 Paper 0.97 0.99 Publishing/Printing 0.51 1.04 Railroad 0.00 0.09 Restaurants 1.85 0.55 Services 9.43 3.70 Steel 0.97 2.12 Super Retail 4.41 3.01 Technology 8.08 4.99 Telecommunications 4.29 9.15 Textiles/Apparel 0.46 0.58 Transportation Ex Air/Rail 0.99 0.59 Utilities 3.24 3.63 Data as of June 30, 2013. Source: Credit Suisse, BofA/Merrill Lynch, Bloomberg The Loan market is well diversified across sectors (exhibit 6). However, relative to the high yield bond market, loans are slightly higher quality with less Triple-C rated issues (exhibit 7). The average maturity profile is shorter as well. Exhibit 7: Loans (%) Bonds (%) Double-B and Higher 40.3 42.0 Single-B 47.6 40.8 Triple-C and Lower 5.6 17.2 Non-Rated 6.5 0.0 Avg. Price 99.4 101.5 Avg. Coupon 5.0 7.6 Avg. Maturity 5.1 6.8 Source: Credit Suisse, BofA/Merrill Lynch, Bloomberg Due to the differences in the characteristics and terms between loans and bonds, the resultant default rates and recovery rates are correspondingly different. Historically, default rates for leveraged loans have been lower than that of bonds. Exhibit 8 shows that, through June 2013, high yield bond default rates are up to 2.75% compared with loan default rates at 2.25%. Exhibit 8: 12-Month Trailing Default Rate (%) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Loan Defaults Bond Defaults Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Source: Moody s It is notable that recovery rates for loans continue to be greater than that of bonds. Loans have historically provided, and should continue to provide, higher recovery rates due to their priority (senior) status in the capital structure. They typically receive protection through covenants, and the fact that most loans are secured by assets such as accounts receivables, inventory, plant machinery, and equipment (Exhibit 9). Even with the growing amount of cov-lite loans in the market, loans still exhibit strong recovery rates for investors.
4 Exhibit 9: Historical Recovery Rates (%) 80 70 60 50 While credit ratings help to categorize the type of loan outstanding, a company s credit rating is not the sole criterion by which an attractive loan should be evaluated. External credit ratings provide a starting point for evaluating issues, but to successfully invest in the loan market, investors must focus on a credit-intensive process that requires a solid understanding of a company s business fundamentals, corporate manage- 40 ment, stability of financing, covenants, etc. We believe that analyzing 30 leveraged loans is a natural extension of high yield bond analysis due 20 10 0 6/1/2008 10/1/2008 Bond 2/1/2009 6/1/2009 10/1/2009 Loan 2/1/2010 6/1/2010 10/1/2010 2/1/2011 6/1/2011 10/1/2011 2/1/2012 6/1/2012 10/1/2012 2/1/2013 to the similarities of the underlying credits. Indeed, we believe that, in order to be a good loan investor, it is important to understand the subordinate part of the capital structure (the bonds). Similarly, a thorough understanding of high yield bonds requires an understanding of the senior debt (the bank loans) ahead of the bonds in the capital structure. Source: Bloomberg, BofA/Merrill Lynch As an example, current recovery pricing levels are assuming a recovery rate of $74.08, for loans and $43.63 of par for bonds. The current default rate levels are well below the long term average of 3.8% for loans and 4.2% in high yield. Since the credit crisis companies have improved their balance sheets which will contribute to continued low default rates. Consequently, we believe that a great opportunity exists to invest in both asset classes. Importance of credit analysis For most institutional investors it would not be feasible to purchase individual leveraged loans, so identifying a strong leveraged loan manager is vital. Although increased volume in the leveraged loan market can be attributed to the rise of CLOs, institutional investors can seek managers that approach credit analysis more carefully with a thorough understanding of the underlying issuers. During the rapid expansion of the leveraged loan market prior to 2008, credit analysis was less emphasized by investors who sought issues that met certain tests established by rating agencies for inclusion in CLOs. Their primary goal was to build portfolios as quickly as possible, and as a result, many CLOs invested in poorly structured loans that have performed poorly during the credit crisis. Although CLOs post credit crises now have tighter collateral controls they still lack the individual credit focus that prime funds can provide. Risk diversification characteristics of the leveraged loan asset class Exposure to leveraged loans on a tactical basis or as a strategic allocation can be beneficial to risk reduction and diversification efforts for fixed income allocations. The leveraged loan market has exhibited consistent performance over time (Exhibit 8). Volatility in leveraged loan returns has been far less than the other traditional asset classes over the same trailing periods ending June 2013. Exhibits 10 and 11 show that the leveraged loan index produces consistently positive long-term returns coupled with the lowest standard deviation of six different equity and fixed income indices. Exhibit 12 highlights the consistency of the rolling five-year risk-return characteristics of the asset class compared to other broad asset classes. Exhibit 10: Returns Ended May 2013 3 Years (%) 5 Years (%) 7 Years (%) 10 Years (%) Credit Suisse Leveraged Loan Index 6.95 5.91 4.79 5.36 Dow Jones Industrial Average 17.35 6.63 7.27 8.23 Russell 3000 16.82 5.69 6.06 8.09 Russell 2000 15.72 7.15 5.99 9.78 BoA ML US High Yield Master II 11.90 10.62 9.22 9.34 S&P 500 16.87 5.43 5.88 7.58
5 Exhibit 11: Standard Deviation Ended May 2013 3 Years (%) 5 Years (%) 7 Years (%) 10 Years (%) Credit Suisse Leveraged Loan Index 3.65 10.15 8.96 7.50 Dow Jones Industrial Average 12.50 17.19 15.32 13.62 Russell 3000 14.72 19.58 17.31 15.16 Russell 2000 19.34 24.37 21.58 19.74 BoA ML US High Yield Master II 6.54 13.84 12.04 10.34 S&P 500 14.02 18.85 16.69 14.57 Exhibit 12: Rolling Five-Year Returns vs. Standard Deviation Return/Standard Deviation 60-Month Moving Windows, Computed Quarterly; June 2003 - May 2013 Credit Suisse Leveraged Loan Index Dow Jones Industrial Average Russell 3000 Russell 2000 S&P 500 BoA ML US High Yield Master II Market Benchmark: S&P 500 In addition to lower volatility, the leveraged loan asset class is also characterized by a low correlation to common equity and fixed income styles. Of particular note is the very low correlation to the Barclays Aggregate Index and Merrill Lynch High Yield Master II Index as seen in Exhibit 13. This low correlation indicates a further opportunity to diversify fixed income exposure within an asset allocation. Exhibit 13: Correlation of Returns to CS Leveraged Loans Index 10 Years Ended May 2013 1) Dow Jones Industrial Average 0.35 2) Russell 3000 0.44 3) Russell 2000 0.43 4) BoA ML US High Yield Master II 0.74 5) S&P 500 0.42 6) Barclays U.S. Aggregate -0.03 As a whole, historical volatility for leveraged loans has been lower than other asset classes and we believe the volatility is expected to remain lower relative to the other designated asset classes due to its senior secured status within the capital structure. Thus, the risk-reduction characteristics are expected to hold in the future. Interest rate hedge As a floating rate product leverage loans have performed well and outperformed most alternatives during past periods of Fed rate hikes and during periods of rising Treasury yields (Exhibit 14). The recent rise in Treasury yields following a prolonged period of almost only declining rates raises the question of how asset classes typically perform during periods of rising rates. Exhibit 14 shows performance of various asset classes during two different types of rising rate environments. The first part of the chart shows returns during periods of Fed fund rate hikes while the second chart shows how asset classes performed while the yield on the 10-year Treasury rises. Currently, the market is experiencing the latter (rising Treasury yields) and has not yet entered a period of Fed fund rate hikes. Loans have performed very well in past periods of rising rates. Indeed, during periods of rising Fed funds rates, loans outperformed in almost every period averaging an annualized total return of 6.73% compared to 4.97% for equities, -0.40% for 10-year Treasuries, and just 2.12% for the Barclays Aggregate Index. High yield also performed better than most fixed income alternatives though they lagged the equity market.
6 During periods of rising Treasury yields, loans and high yield stand out compared to their peers in fixed income. Both provide good diversification from interest rate sensitivity and outperformed the other fixed income asset classes in every period. Equities were the best performers in these periods. Leveraged loans are able to benefit from the floating rate and a short duration profile. Perhaps in anticipation of rising rates, the first half of 2013 had a record breaking $26.8 billion inflow into the asset class compared to the second largest inflow of $17.9 billion during the entire year of 2010. Investors seeking exposure to floating rates ahead of the eventual end of Fed s quantitative easing represented a large portion of the inflow we believe. Sutter Credit Strategies Leveraged loan investors since 1998 $1.9 billion currently invested in leveraged loans across the following vehicles Separate accounts 1 CLO NAIC-rated institutional commingled fund Within high yield bond fund mandates Consistent performance since inception with strong downside protection Deep credit team, established infrastructure and strong access to loan market issuance Why leveraged loans? As an asset class, leveraged loan exposure helps diversify fixed income allocations, reducing risk via reduced portfolio standard deviation. Loans also provide superior credit protection given their senior secured status, and as floating rate instruments, they are effective hedges against rising rates. Credit analysis, however, is vital to properly navigating the market, and in periods of volatility, successful portfolios will be those that best identify strong credits that can withstand market downturns and provide the appropriate risk/reward for current pricing levels, covenant structure, and asset coverage. There are few actively managed portfolios dedicated to leveraged loans, and a distinct tactical advantage exists for those investment portfolios managed by experienced analysts with a long-term track record in the analysis of leveraged credits. Exhibit 14 Period of Fed Hikes CS Loans Index BoA ML Cash Pay High Yield Barclays Aggregate Index BoA ML 10-yr Index BoA ML Corporate Index S&P 500 Index Change in Fed Funds Rate To From Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized (bps) Jan 1994 Feb 1995 12.22% 10.38% 3.36% 2.87% 1.36% 1.16% -3.66% -3.14% 0.86% 0.74% 3.97% 3.39% 300 Jun 1999 May 2000 3.93% 3.93% -3.21% -3.21% 2.11% 2.11% 0.07% 0.07% -0.38% -0.38% 5.97% 5.97% 175 Jun 2004 Jun 2006 12.64% 5.88% 17.47% 8.04% 6.54% 3.09% 3.92% 1.86% 6.57% 3.10% 11.91% 5.55% 400 Average 6.73% 2.57% 2.12% -0.40% 1.15% 4.97% Period of Rising Rates CS Loans Index BoA ML Cash Pay High Yield Barclays Aggregate Index BoA ML 10-yr Index BoA ML Corporate Index S&P 500 Index Change in10-yr TSY Yield To From Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized Total Return Annualized (bps) Oct 1993 Nov 1994 13.87% 11.78% -0.73% -0.63% -3.88% -3.34% -10.98% -9.49% -4.84% -4.16% -0.55% -0.47% 248 Sep 1998 Jan 2000 6.61% 4.62% 3.97% 2.79% -0.81% -0.57% -10.06% -7.21% -1.27% -0.90% 24.37% 16.64% 225 May 2003 Jun 2006 21.99% 6.48% 30.79% 8.85% 6.07% 1.88% -1.67% -0.53% 6.40% 1.98% 31.01% 8.90% 178 Average 7.63% 3.67% -0.68% -5.74% -1.03% 8.36% Exhibit 14: Wells Capital Management, Bloomberg, Credit Suisse, BofA/Merrill Lynch, Barclays Capital, Standard & Poor s
7 Authors Niklas Nordenfelt, CFA Managing Director, Senior Portfolio Manager Sutter High Yield Fixed Income Niklas Nordenfelt is currently managing director, senior portfolio manager with the Sutter High Yield Fixed Income team at Wells Capital Management. Niklas joined the Sutter High Yield Fixed Income team of Wells Capital Management in February 2003 as investment strategist. Niklas began his investment career in 1991 and has managed portfolios ranging from quantitative-based and tactical asset allocation strategies to credit driven portfolios. Previous to joining Sutter, Niklas was at Barclays Global Investors (BGI) from 1996-2002 where he was a principal. At BGI, he worked on their international and emerging markets equity strategies after having managed their asset allocation products. Prior to this, Niklas was a quantitative analyst at Fidelity and a portfolio manager and group leader at Mellon Capital Management. He earned a bachelor s degree in economics from the University of California, Berkeley, and has earned the right to use the CFA designation. Nikki Freeman Loan Trader/Portfolio Analyst Sutter High Yield Fixed Income Nikki Freeman joined the Sutter High Yield Fixed Income team at Wells Capital Management in 2012 as a bank loan trader and portfolio analyst. Prior to joining Wells Capital Management, Nikki was an analyst at Barclays Capital with a focus on convertible bond arbitrage. Nikki earned a bachelor s degree in economics from Stanford University. Wells Capital Management 525 Market Street, 10th Floor, San Francisco, California 94105 www.wellscap.com Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.