BBH Strategy Insight August 2016 Floating-Rate Loan Investing: The Loan Market Today The size of the global institutional loan market reached the $1 trillion mark earlier this year from practically zero 20 years ago. Secured floatingrate loans now comprise 2% of the total U.S. Fixed Income market, and 11% of the Corporate credit market. In comparison, the Corporate market share of High Yield bonds and Investment Grade bonds corresponds to 17% and 72%, respectively (sources: LSTA and BBH Analysis). The growth of the loan market (see Exhibit I below) is the result of institutional investors becoming interested in diversified portfolios of loans as investable assets and a change in the traditional banking model. Historically, large commercial banks would make loans to corporate borrowers and hold them on their books through maturity. As institutional investors became more interested in purchasing loans as investments, the commercial banks moved toward the current model of arranging large loans and then selling them through a syndication process to investors. When corporate borrowers are rated sub-investment grade, the decision to borrow via a loan format rather than bonds is typically driven by lower interest costs for the secured debt, faster time to market versus Securities Exchange Commission (SEC) registration, and the ability to repay the loan with few restrictions. $ Billion 1200 1000 800 600 400 200 Exhibit I: Growth of the U.S. Institutional Loan Market 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD* Data reported for full-year from 1998 to 2015. * YTD as of June 30, 2016. Data as of June 30, 2016. Sources: JP Morgan and BBH Analysis. Loans continue to have a few different monikers in the marketplace; e.g., Floating-Rate Loans, Term Loans, Leveraged Loans, Senior Loans, Syndicated Loans, and Bank Loans. They all refer to the same financial instrument loans made to corporate borrowers, typically rated below investment grade, that are syndicated and then sold to institutional investors. The loan market remains an institutional investor market, purchased primarily by managers of Collateralized Loan Obligations (CLOs), Pension Funds, Finance Companies, Insurance Companies, Mutual Funds, and Credit Hedge Funds (as shown in Exhibit II on the right). These types of Insurance & Finance Companies 8% High Yield Funds & Credit Funds 16% Loan Mutual Funds 18% Exhibit II: The U.S. Loan Market Ownership Composition Collateralized Loan Obligations (CLOs) 58% Data as of June 9, 2016. Sources: LSTA, S&P Capital IQ LCD, and BBH Analysis.
BBH Strategy Insight Page 2 large institutional investors bring with them a favorable long-term investment horizon that lends considerable fund-flow stability to the asset class. For example, CLOs, with their locked-up capital, purchased approximately 58% of the newly issued loans in 2015 versus retail Loan Mutual Funds that comprise 18% of loan buyers. Insurance companies comprise about 8% of loan investors, with High Yield Bond Mutual Funds and Credit Hedge Funds purchasing about 16% of the market. Open-End Mutual Funds remain the main entry point for retail investors to access the loan market. This commentary describes some general characteristics of loans and our experience finding opportunities in this expanding market that has quickly became an important source of value for our portfolios. The Case for Floating-Rate Loans Loans are generally issued for the same corporate purposes as bonds; i.e., acquisitions, refinancings, recapitalizations, and general corporate purposes. However, in contrast to other fixed income asset classes, floating-rate loans possess some very favorable characteristics that make them uniquely attractive to fixed income investors. Consider the following: Exhibit III: Asset Class Yield (%) 8 7 6 US LOANS US HY Corp 5 4 EM Corp 3 US IG Corp 2 US IG MBS 1 Muni 0 0 1 2 3 4 Duration (Years) 5 6 7 8 US Loans = Credit Suisse Leveraged Loan Index, US HY Corp = Barclays Capital US Corporate High Yield Index, EM Corp = Barclays Capital Emerging Markets USD Corporate and Quasi Sovereign Index, US IG MBS = Barclays Capital US Investment Grade Mortgage-Backed Securities Index, Muni = Barclays Capital Municipal Bond Index, US IG Corp = Barclays Capital US Aggregate Corporates Bond Index Data as of August 4, 2016. Sources: Barlcays Capital, Credit Suisse, and BBH Analysis. Protection from interest rate risk The floating nature of loan interest payments means that they reset periodically, incorporating changes in the London Interbank Offered Rate (LIBOR) Exhibit IV: Priority Waterfall and reducing the sensitivity to interest rate driven price volatility, or duration, to practically zero. Furthermore, most loans today include a floor on the reference LIBOR Floating Rate Loans rate. This LIBOR floor introduces a minimum threshold Leveraged Loans, Bank Loans, Senior Loans Secured to the interest earned on loan investments, and provides Collateral protection against declines in global interest rates. (see Senior Unsecured Bonds Exhibit III above) Downside protection Loans are typically secured obligations and the most senior instruments in the capital Subordinated Bonds structure, entitled to repayment before all other debt obligations, as illustrated in Exhibit IV on the right. The first Preferred Stock liens on a borrower s collateral plus the capital cushion provided by junior capital provide recovery rates for loans that far exceed those of bonds. For instance, secured loans Equity For illustrative purposes only
BBH Strategy Insight Page 3 that go into default ultimately recover on average 80% of principal versus 49% for Senior Bonds and 28% for Subordinated Bonds with loans and bonds having similar default rates. 1 Loans also tend to have stronger covenant protections as part the debt structure than bonds. Low return volatility compared to High Yield bonds Loans exhibit a more stable return profile, as shown in Exhibit V below. Indeed, the historical volatility is in line with Investment Grade bonds and considerably lower than High Yield bonds. As a result of their lower volatility, loans have produced more periods of positive annual returns than High Yield bonds. Loans are generally viewed as a defensive way to gain exposure to the leveraged credit markets. Attractive Current Yields The yields today for floating-rate loans are superior to all U.S. Fixed Income investments with the exception of High Yield bonds. (see Exhibits III and V) Returns (%) 60 51.8 50 40 30 20 7.5 10.0 5.5 4.2 5.0 4.2 1.9 5.2 5.1 6.8 10.1 10.0 10 2.4 1.8 5.3 2.0 4.6 0.5 0-10 -20-30 -29.5-40 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Basic Loan Mechanics The periodic interest payments made on loans float over the level of a reference index, typically the LIBOR rate. Additionally, they often carry a floor that provides a minimum level for the reference index. As with floating-rate bonds, loan coupon payments typically reset every quarter. Therefore, only the size of the oncoming coupon payment is known in advance, and it is a function of the value of LIBOR, the value of the floor (if any), and the quoted margin, or contractual spread, over LIBOR offered by the loan. Let s look at a real-world example: Western Digital, a technology company, issued a $3.8 billion 7-year loan to fund the acquisition of SanDisk. The industry refers to this loan as paying LIBOR + 550 basis points (bps) with a LIBOR floor of 75 bps. Since LIBOR is currently around 70 bps, the floor is active and the size of the next coupon is 0.75% + 5.5% = 6.25%. If LIBOR were to increase above 75 bps by the subsequent reset date, then the coupon would increase to LIBOR + 5.5%. Otherwise, it would remain at 6.25% even if LIBOR declined below 70 bps. How Do We Assess the Compensation Offered By Loans? Exhibit V: Loans Annual Returns Past performance does not guarantee future results. Data reported for full-year from 1997 to 2015. * YTD as of June 30, 2016. Data as of June 30, 2016. Sources: JP Morgan and BBH Analysis. As with other Fixed Income securities in our portfolios, we look at measures of yield, the credit spread, and the level of attractiveness suggested by our corporate valuation framework. However, given the floating-rate nature of loans and the fact that loans are pre-payable at any time by the borrower, there is an additional element of uncertainty surrounding the cash flows that makes the computation of such measures slightly YTD* 1 At the time of default, recovery rates based on trading prices are 70% for First Lien Senior Secured Loans, 44% for Senior Unsecured Bonds and 35% of principal for Subordinated Bonds according to Moody s Corporate Default and Recovery Rates data. The 15-year average default rate for loans is approximately 3.3% which tracks the High Yield bond average default rate of 3.3%. Source: JP Morgan.
BBH Strategy Insight Page 4 more challenging. The one measure of compensation that is exempt from this uncertainty is the spread over the reference index, known as the Quoted Margin (QM), which is the contractual spread over LIBOR paid by the issuer of a floating-rate loan. The QM captures the market s perception of the credit risk of the borrower, and it indicates what companies need to pay to borrow at different times in the market. One challenge to loan valuation is the pre-payment risk, or refinancing risk, of a borrower repaying the loan with the proceeds from a new loan at a lower QM. This situation denotes what the industry calls the negative credit convexity of loans, which is similar to the pre-payment option embedded in Mortgage-Backed Securities. It leads to the following question: By how much should we reduce a loan s expected compensation to properly incorporate the issuer s option to re-price the loan? At BBH, we introduce uncertainty around the future behavior of the quoted margin using multiple simulations. These simulations, combined with the forward LIBOR curve, generate multiple cash flows for the loan. The average amount added to the forward LIBOR curve needed to discount these cash flows to the market price denotes the option-adjusted spread (OAS) of the loan. For the Western Digital example mentioned above, we calculated at the time of purchase that this option cost was approximately 50 bps, which barely affected the attractiveness of this loan in the eyes of our valuation framework. Recent Loan Purchase Opportunities The Western Digital loan is a good example of opportunities BBH has captured for our clients able to invest in below Investment Grade credit. We purchased the 1st Lien Secured Term Loan rated 2 Ba1/BB+ at a discount price of 97 for an all-in yield to maturity of 6.8% and a yield of 7.4% if refinanced in three years. For clients with Investment Grade policy constraints there are other opportunities to be had in higher quality loans. For example, we participated in the recent loans for Dell Inc. s acquisition of EMC Inc. that carried Investment Grade ratings of Baa3/BBB-. The Dell 1st Lien Secured 7-year Term Loan B offered a coupon of L+325, with a 75 bps floor, and an original issue discount of 99.5 for an all-in yield to maturity of 4.1%. On occasion, the flexibility to move between bonds and loans has allowed us to capture higher yields for short-dated mandates as market segmentation creates a valuation disconnect in high quality Investment Grade credits. For example, we were able to move from fixed one-year Express Scripps (BBB+/ Baa2) bonds at a yield of 1.1% to similar maturity floating-rate loans yielding 1.8% with a lower dollar price. These examples illustrate some of the value than can be created for investors by a manager s flexibility to invest across a debt capital structure with bonds or loans, versus the typical bond-only investment policy. The Loan Liquidity Question We frequently receive questions from new investors to the loan market about loan liquidity and trade settlements. In regard to trading liquidity, the loan market has similar bid-ask spreads as the High Yield bond market with lower volatility and lower turnover. The previously mentioned institutional investor base for loans has a long-term investment horizon and better protected investments, which results in the lower volatility. The continuous improvements to loan market liquidity over the past 20 years is being driven by increasing standardization of trading and settlement protocols, elimination of most trading costs like assignment fees, and an embrace of common technology platforms. In fact, one sellside bank recently launched the first-of-its-kind electronic loan trading platform, which matches institutional buyers and sellers at a set price without the direct involvement of the sales desk. Trade settlement in the loan market is longer and more involved than for bonds. Loans trades are targeted to settle T+7, versus bond trades at T+3. However, loan trade settlements typically take longer than the seven days, and the industry is continuously working to lower actual settlement times. 3 The longer times are partially a function of a three-party settlement process between buyer, seller, and the loan s administrative agent bank that must confirm and record each trade to ensure the accuracy of the lender list and cash flow distributions. Conclusion At BBH Investment Management, we believe that floating-rate loans offer many compelling benefits for fixed income investors as a standalone mandate or as a part of a broader bond allocation. Investors looking for protection against rising rates, return stability, and downside protection versus High Yield bonds, should consider adding loans to their portfolios. Floating-rate loans are the more conservative approach to the leveraged 2 Our ratings notation uses the conventions Moody s/s&p. 3 According to the most recent LSTA Secondary Trade & Settlement Study, the industry median and mean settlement times were 13 and 17 days, respectively. BBH s loan closers typically achieve faster results than the industry as a whole.
BBH Strategy Insight Page 5 finance market. However, the greater yields offered by floating-rate loans in comparison to Investment Grade Corporate bonds, clearly comes from the higher credit risk of these typically below Investment Grade rated instruments which illustrates the importance of making the right choice in hiring a manager. At BBH, we apply the same disciplined bottom-up credit approach to all our investments and remain committed to investing only in durable credits when they are available at attractive prices. We look forward to discussing any of the topics in this commentary with our clients. Paul Kunz, CFA Co-Portfolio Manager Jorge Aseff, PhD Head of Quantitative Research
BBH Strategy Insight Page 6 Opinions, forecasts, and discussions about investment strategies represent the author's views, as of the date of this commentary, and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. RISKS Investing in the loan and bond markets is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. The interest payments of TIPS are variable, they generally rise with inflation and fall with deflation. The adjustment to a security's face value is taxable income on the income earned every year including the increase in value of the bond should rates fall. This publication is a general guide to the views of Brown Brothers Harriman & Co. and is provided to recipients who are classified as Professional Clients and Eligible Counterparties if in the European Economic Area ( EEA ), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. Brown Brothers Harriman & Co. 2016. All rights reserved. 08/2016 IM-2016-08-08-3111 Exp. Date 09/30/2016