Revised August 2013 Senior Secured Loans Questions and Answers About Senior Secured Loans Joe Lemanowicz Managing Director and Head of U.S. Senior Secured Loan Team Pramerica Fixed Income U.S. senior secured loans ( senior loans ) continue to receive a lot of attention from investors seeking higher yields and protection against rising interest rates. The following Q&A is designed to answer some of the common questions we have been receiving from investors regarding U.S. senior loans. Q: What are senior secured loans? Senior loans, also known as bank loans or leveraged loans, are unregistered, noninvestment grade debt obligations issued by public and private corporations. Financial institutions have been making senior loans to companies for decades, with an active secondary market established for institutional investors in the mid-1990s. As of June 30, 2013, there were $1.3 trillion in senior loans outstanding from U.S. issuers, and 362 billion outstanding from European issuers. 1 Q: What key benefits do senior loans provide? Floating Coupons: Among the most attractive attributes of senior loans is their floating coupon, which typically resets on a quarterly basis. The floating coupon enables investors to earn higher current income if the loan s base rate (London Interbank Offer Rate or LIBOR), rises above any stated LIBOR floor in the loan. The floating coupon serves to minimize the interest rate risk of senior loans relative to fixed rate securities. Given the very low level of LIBOR today, with 3-month LIBOR about 26 basis points ( bps ), most new issue secured loans have a minimum base rate, or floor, that averages about 100 bps. The floor provides investors with higher current income at the present time. The trade-off, however, is that the senior loan coupon will remain fixed until LIBOR rises above the floor. Structural Protection: Senior loans are normally secured by the assets of the borrower which gives investors seniority in a company s capital structure. Consequently, senior loans have a high recovery rate vs. high yield bonds in the event of a default. Attractive Current Spreads and Coupons: Senior loans offer an attractive entry point in today s environment. Credit spreads are above their long-term averages with most new issue coupons in a range of 3.75% to 5.0%. 1 Diversification: Senior loans have low correlation to other asset classes and can help improve the risk/return profile of an overall fixed income portfolio. 1 Source: Credit Suisse for both market size and coupon range. Coupon range as of July 31, 2013.
Q: How have senior loans performed during periods of rising interest rates? Senior loans have been among the best performing asset classes in a variety of rising interest rate environments. Below we look at two different scenarios: 1) Short-Term Rates Rise: The first scenario illustrates the Federal Reserve s three major tightening periods since 1991. Since loan coupons adjust periodically to a short-term base rate, investors benefit from rising short-term rates. During each period, senior loans performed well relative to most other U.S. debt obligations, including U.S. Treasury bonds, U.S. high yield bonds, and U.S. broad market fixed income securities, as measured by the Barclays U.S. Aggregate Bond Index. SENIOR LOANS HAVE PERFORMED WELL WHEN SHORT-TERM RATES RISE JANUARY 1, 1991 TO JULY 31, 2013 2 20% 15% 10% 5% 0% -5% Senior Secured Loans Aggregate Bond Index 17.9 US Treasuries High Yield Bonds 12.6 10.4 6.5 5.7 3.9 3.4 1.6 2.1 0.0-0.9-3.2 Feb. 1994 - Feb. 1995 June 1999 - May 2000 June 2004 - June 2006 Change in Federal Funds Rate: 3.0% to 6.0% 4.75% to 6.5% 1.0% to 5.25% 2) Intermediate-Term Rates Rise: The scenario below illustrates three time periods when 10-year U.S. Treasury rates rose by a significant degree since 1991, including the most recent interest rate increase from May to July 2013 when interest rates rose by more than 50%. 3 In all time periods, senior loans outperformed U.S. Treasury bonds, U.S. high yield bonds, and U.S. broad market fixed income securities. SENIOR LOANS HAVE ALSO PERFORMED WELL WHEN 10- YEAR TREASURY YIELD RISES JANUARY 1, 1991 TO JULY 31, 2013² 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% 13.4% Senior Secured Loans US Treasuries Aggregate Bond Index High Yield Bonds 6.6% 4.1% 2.0% 1.5% 0.4% -0.8% -3.5% -4.3% -2.4% -2.2% -2.0% Oct. 1993 to Nov. 1994 Oct. 1998 to Jan. 2000 May 2013 to July 2013 Change in 10-Year U.S. Treasury Yields: 5.42% to 7.90% 4.60% to 6.66% 1.67% to 2.57% Q: How can senior loans complement my existing portfolio? Senior loans can provide important diversification benefits and improve the risk/reward profile of broader fixed income and multi-sector portfolios. Given their unique characteristics, senior loans have historically demonstrated a low to negative correlation to most major asset classes. Not surprisingly, loans have historically had a negative correlation to U.S. Treasuries. Their correlation to U.S. broad market fixed income securities and to gold is close to zero, and their correlation to U.S. equities is relatively low. High 2 Sources: Illustrations, Pramerica Fixed Income. Underlying data, Credit Suisse and Barclays Capital. Data represents the Credit Suisse Leveraged Loan Index and Barclays Capital US Aggregate Bond Index, US Treasury Index, and US Corporate High Yield Index. Past performance is not a guarantee or reliable indicator of future results. See Notes section for index descriptions. 3 We excluded a period in the first half of 2009 when 10-year US Treasury rates also rose sharply, by almost 125 bps. This period was uncharacteristically volatile as US Treasury yields had fallen sharply in 2008 during the financial crisis, then rose again in 2009. The period was also marked by record high spread levels in the credit markets. Page 2
yield bonds have the highest correlation to loans given that both sectors are comprised of the debt of below investment grade companies. LOW CORRELATION TO MOST OTHER ASSET CLASSES JANUARY 1, 1992 TO JUNE 30, 2013 4 US Treasuries Aggregate Bond Gold TIPS* CPI S&P 500 High Yield Bonds Senior Loans (0.30) (0.03) 0.03 0.15 0.31 0.42 0.74 Over the past two decades, senior loans delivered annualized returns comparable to the Barclays U.S Aggregate Bond Index (5.9% for senior loans vs..6.1% for the Aggregate Bond Index from Jan. 1, 1992 to June 30, 2013). 4. However, when looking at excess returns, which remove the component of the return derived from changes in interest rates, senior loans delivered +244 bps in annualized excess return vs. just +25 bps for the Aggregate Bond Index 5. This shows that a large component of the absolute return of the Aggregate Bond Index over the past 21 years can be attributed to price appreciation as interest rates fell to historic lows. With interest rates unlikely to trend much lower from today s levels, we do not expect the price appreciation component of a fixed rate bond s return to be as significant as it has been in the past. Q: How do senior loans compare to high yield bonds? Aside from both being issued by non-investment grade corporations, secured loans and high yield bonds have meaningful structural differences and risk/return profiles, as shown below. Two notable differences are that senior loans are less sensitive to interest rate changes due to their floating coupons, and senior loans have experienced higher recovery rates given their seniority in an issuer s capital structure. Characteristics Senior Loans High Yield Bonds HOW SENIOR LOANS DIFFER FROM HIGH YIELD BONDS COMPARISON OF CHARACTERISTICS Coupon Floating (fixed spread over LIBOR) Fixed Typical Maturity 5-8 years 7-10 years Callability Anytime (with some limited protection) Usually callable after 3-4 years Effective Duration Short Intermediate Capital Structure Security Ratings Maintenance Covenants The most senior in an issuer s capital structure Typically secured by lien on assets or stock in subsidiary companies Usually one or more notches above high yield bonds of same issuer Yes. Currently, 65% of market has covenants, typically tested quarterly. Below senior loans Typically unsecured BB+ or lower Minimal Long-Term Default Rate 6,7 3.5% 4.0% Long-Term Recovery Rate 6,8 68.0% 40.2% 4 Sources: Calculations, Pramerica Fixed Income. Underlying data from Credit Suisse and Barclays Capital based on the Credit Suisse Leveraged Loan Index and the Barclays US Treasury, US Aggregate Bond, TIPs, and US Corporate High Yield Bond indices. Source for Gold and CPI data is Bloomberg. Data for TIPs index is from Jan.1, 1997, the inception of the index. See the Notes section for index descriptions. 5 Source: Annualized excess returns were calculated by Pramerica Fixed Income. Excess returns for senior loans were calculated by subtracting 3-month LIBOR from the total return of the Credit Suisse Leveraged Loan Index. Excess returns for the Barclays US Aggregate Bond Index were calculated by Barclays Capital. Past performance is not a guarantee or a reliable indicator of future results. See the Notes section for index descriptions. 6 Source: JPMorgan. Loan data is from Jan. 1, 1990 to June 30, 2013. High yield bond data from Jan. 1, 1982 to June 20, 2013. 7 Represents weighted average US dollar default rates for senior loans and high yield bonds. 8 Based on recovery rates for senior loans and high yield bonds 30-days after default. Page 3
Q: What are covenant-lite loans and do they have more credit risk? Covenant-lite ( cov-lite ) loans are loans that do not require an issuer to remain in compliance with maintenance covenants. Such covenants monitor a borrower s ongoing adherence with financial tests such as interest coverage and leverage ratios relative to cash flow. It is important to note that cov-lite loans still contain incurrence based covenants. Among other things, incurrence covenants limit adverse actions management may take with regard to incremental debt issuance and other shareholder-friendly activities. Covenant protection is one of the many factors that we consider when investing in senior loans. We do not believe that maintenance covenants, or the lack thereof, have a material impact on the creditworthiness of an issuer. Rather, we place greater weight on the fundamental prospects of an issuer as measured by a company s balance sheet strength, cash flow generation, competitive positioning, and quality of management. Q: Is this the right time to invest in senior loans? Yes. We believe senior loan spreads offer good value in today s market relative to historic spread levels (487 bps vs. a long-term average of 358 bps). At this time, we find the new issue market especially attractive given the original issue discounts offered, which can range from 25 to 100 bps of par vs. the offer side price quotes in the secondary market. CURRENT SENIOR LOAN SPREADS ARE ATTRACTIVE RELATIVE TO LONG- TERM MEDIAN bps 2,000 1,500 1,000 500 JANUARY 1, 1992 JULY 31, 2013 9 0 All Loans B BB Current 487 510 335 Median 358 427 268 510 bps 487 bps 335 bps In addition, senior loans are well supported from both a fundamental and a technical perspective. Fundamentally, the financial health of most U.S. loan issuers has improved steadily since the financial crisis and should remain on solid ground as the U.S. economic recovery moves forward. Although credit statistics appear to have plateaued, defaults are expected to remain at low levels currently about 1.8% vs. a historical average of 3.5%. 10 On a technical level, demand from institutional investors, retail investors, and collateralized loan obligations has been exceptionally strong so far in 2013. New loan issuance has been easily absorbed by the marketplace. Q: How do I invest in senior loans? Institutional investors can gain exposure to senior loans through a wide range of investment vehicles across the risk spectrum. Investors interested in traditional, unleveraged loan portfolios may consider a mutual fund, institutional commingled account, or institutional separate account, depending on the size of their investment. Mutual funds and commingled accounts generally have fixed investment guidelines while separate accounts allow for a more tailored approach with exposure limits and risk budgets based on the investor s objectives, guidelines, and risk appetite. Investors seeking higher potential returns may choose to invest in leveraged loan vehicles and instruments. These range from closed-end mutual funds (up to 2X to 3X leverage), to low-to-medium leveraged institutional accounts (with 1X to 5X leverage), to collateralized loan obligation (CLO) equity notes (with 7X to 10X leverage.) 9 Source:.Credit Suisse for data. Spread levels were calculated by Pramerica Fixed Income and represent the senior loan discount margin, a rate of interest paid on current below-par market prices rather than the coupon at par; based on loans with a four-year average life, the historical average life of senior loans. Past performance is not a guarantee or a reliable indicator of future results. See Notes section for index descriptions. 10 Source: JP Morgan. Represents weighted average USD default rates for 12-months ending June 30, 2013 and from Jan. 1, 1990 to June 30, 2013. Page 4
Q: What are the major risks involved in investing in senior loans? As with any type of investment, senior loans bear certain risks. Three of the key risks are: Credit Risk: Although senior loans have strong structural credit protections and seniority over other creditors, they are still non-investment grade instruments that are subject to the financial stability of the issuing company. Each senior loan requires ongoing credit research and monitoring. Call Risk: If market spreads decline or credit quality improves, a senior loan will likely be refinanced/repriced at a lower spread, which limits the return of the loan. Today, most loans being issued provide a 1% call premium if the loan is prepaid within six months of issuance. Market Volatility: Similar to other fixed income credit products, senior loans may be subject to periodic technicallydriven sell-offs resulting from supply and demand imbalances. For example, from mid-2008 to early 2009, senior loan prices were vulnerable to excessive new issuance and forced selling from levered vehicles with market value triggers. We believe such factors in large part do not exist today. Q. Are there opportunities outside of the U.S. to invest in secured loans? Yes. We believe there are attractive relative value opportunities in the European senior loan market. We hold this view notwithstanding the fact that the European loan market is smaller and less liquid than the U.S. market, and, in recent years, has contracted as more issuers turned to the European high yield bond market to meet their financing needs. The current spread on European senior loans is 549 bps, which is 61 bps above its historical average and 62 bps wider than the U.S. senior loan market. 11 Another interesting trend in the European high yield market is the increased issuance of bonds with senior secured status. These pari parssu bond issues are accorded the same asset protection as secured loans, and, as result, may be considered attractive alternatives for some senior secured loan portfolios. While secured high yield bonds have structural features similar to loans and currently offer higher fixed rates, they are also more sensitive to interest rate changes than senior loans. 11 Source: Credit Suisse as of July 31, 2013. Underlying data is for the Credit Suisse Western European Leveraged Loan Index. Spread levels were calculated by Pramerica Fixed Income and represent the senior loan discount margin, a rate of interest paid on current below-par market prices rather than the coupon at par; based on loans with a fouryear average life, the historical average life of senior loans. Historical average spread based on data from Jan. 1, 2000 to July 31, 2013. Past performance is not a guarantee or a reliable indicator of future results. See Notes section for index description. Page 5
Notes Credit Suisse Leveraged Loan Index The CS Leveraged Loan Index is a representative, unmanaged index of tradable, US dollar denominated floating rate senior secured loans and is designed to mirror the investable universe of the US dollar denominated leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month. Average values are computed over the index for coupon, current yield, initial spread and price. The average coupon, current yield and initial spread are weighted by market value (amount outstanding x price) at the end of the measurement period for each loan currently paying interest in the index. Barclays Capital US Aggregate Bond Index The Barclays U.S. Aggregate Index covers the USD-denominated, investment-grade, fixed-rate or step up, taxable bond market of SEC-registered securities and includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM pass throughs), ABS, and CMBS sectors. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB-) or better using the middle rating of Moody s, S&P, and Fitch. Barclays Capital U.S. Corporate High Yield Bond Index The Barclays U.S. Corporate High-Yield Index covers the USD-denominated, noninvestment-grade, fixed-rate or step up, taxable corporate bond market. The index excludes Emerging Markets debt. Securities must be rated below investment-grade (Ba1/BB+/BB+ or below) using the middle rating of Moody s, S&P, and Fitch, and have at least 1 year until maturity. Barclays Capital U.S. Treasury Index. The Barclays U.S. Treasury Index is an index that includes all Treasuries in the Barclays U.S. Aggregate Index that mature in 10 years or more. Barclays Capital Global Inflation-Linked: U.S. TIPS Index The U.S. Government Inflation-Linked Bond Index measures the performance of the U.S. Treasury Inflation Protected Securities ("TIPS") market. The index includes TIPS with one or more years remaining to maturity. S&P 500 Index The S&P 500 Index a commonly recognized, market capitalization weighted index of 500 widely held equity securities, designed to measure broad U.S. equity performance. A benchmark index is not professionally managed, does not have a defined investment objective, and does not incur fees or expenses. Index performance includes the reinvestment of all dividends. You cannot invest directly in this index. S&P 500 is a registered trademark and service mark of the McGraw-Hill Companies. Credit Suisse Western European Leveraged Loan Index: All Denominations Unhedged. The Index is a representative, unmanaged index of tradable, floating rate senior secured loans designed to mirror the investable universe of the European leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month. Notice Copyright 2013 Pramerica Investment Management. Unless otherwise indicated, Pramerica Fixed Income holds the copyright to the content of the article. Pramerica Investment Management is a trading name of Prudential Investment Management, Inc., the principal asset management business of Prudential Financial, Inc. ( Pramerica Financial ). Pramerica Investment Management is an indirect subsidiary of Pramerica Financial, a company incorporated and with its principal place of business in the United States. Pramerica Investment Management is an investment adviser registered with the U.S. Securities and Exchange Commission. 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