Understanding Bank Loans: Opportunities for Diversification and Risk Reduction December 28 By: Niklas Nordenfelt, CFA Senior Portfolio Manager, Co-Manager of Sutter High Yield Fixed Income Paolo L. Villasenor Product Manager Volatile credit markets have changed the makeup of investment portfolios across all plan types. This challenging environment has caused plan sponsors to review and rethink their asset allocation. While diversification has always been at the forefront of risk management, diversification within fixed income markets has been traditionally limited to a plan s outlook on duration, sector, curve positioning or issue selection. Traditional fixed income mandates benchmarked to broad market indices will remain anchors to the overall fixed income portfolio, but a further consideration of less-traditional fixed income sectors may identify additional fixed income strategies that can improve not only portfolio diversification, but also other investment goals such as return enhancement and risk mitigation. Leveraged loans (also known as bank loans ) represent such an asset class, and may provide plan sponsors with new investment opportunities. What Is a Leveraged Loan? The name of the asset class can be misleading. The connotation of leverage in some circles may deter some investors for whom the asset class might be appropriate, so a proper definition of the term leveraged loans is important to understanding the asset class. For starters, a 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. Depending on 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-thaninvestment-grade companies, generally rated below BBB-/Baa3. Leveraged loans are common sources of financing for belowinvestment-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. Use of Leveraged Loans within Capital Structure Leveraged loans are typically a large piece of the capital structure of a below-investment-grade company. They are senior to both senior subordinate bonds and equity, and generally feature more restrictive covenants. Below-investment-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 5-55 percent loans, 3-35 percent bonds, and 2-25 percent equity. Exhibit 1: Sample Capital Structure of Below-Investment-Grade Company 1% Senior 9% 8% 5% 7% 6% 5% 4% 25% 3% 2% 1% 25% Subordinate % 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 $73B outstanding par amount in 1998 to $591B in outstanding par as of September 28 (Exhibit 2). CFA and Chartered Financial Analyst are trademarks owned by the CFA Institute.
Exhibit 2: Par Amount of Outstanding Leveraged Loans ($ in Billions) $7 6 $557 $591 5 $4 4 3 $248 $193 2 $148 $11 $117 $13 $132 1 $73 $35 $14 1996 1997 1998 1999 2 21 22 23 24 25 26 27 9/19/8 Prior to 2, 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. In more recent times, 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. 27 1998 1998 Non Bank Breakout: 36.8% 45% 42% Since 27 and the onset of the credit crunch, the data from the first three quarters of 28 show a definite shift in new deal investors. While CLOs still represent the largest investors in leveraged loans, banks have significantly increased their investments (from 2 percent in 27 to 19 percent through 3Q8), and hedge, distressed and high-yield funds (or as a whole, institutional investors ) firmly remain the second-largest concentration of investors in loans, increasing their share to 29 percent (Exhibit 4). The evolution in the investor base has had profound effects. Indeed, we believe the increased volatility that the asset class has experienced is 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 should benefit the market going forward. Exhibit 4: Institutional Loan Purchases by Lender Type, 27 To-Date 6 57 5 n 27 n 1Q-3Q8 (New Deals) 4 38 29 3 26 2 19 n Banks n Non Banks 13% n CLO n Insurance Co. n Prime Rate Fund 27 27 Non Bank Breakout: 98.1% 1 2 Banks CLO Finance Co. Hedge, Distressed & High-Yield 3 6 4 3 Insurance 8 5 Prime Rate n Banks n Non Banks 57% 4% 8% 27% 4% n CLO n Finance Co. n Hedge, Distressed & High-Yield Funds n Insurance Co. n Prime Rate Fund Loans vs. Bonds While leveraged loans and high yield bonds are issued by the same companies, the characteristics of the instruments are quite different. A brief comparison summary is provided in Exhibit 5.
Exhibit 5: Comparison of Leveraged Loans and High Yield Bonds Leveraged Loans High Yield Bonds Interest Rate/Coupon Floating Rate Fixed rate Security Senior Secured Generally unsecured Priority Senior Generally subordinate, but sometimes senior Amortization Required quarterly principal payments Bullet payment at maturity Callability Prepayable at par without penalty Call protected 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, but in the recent weak economic environment, default rates have increased for leveraged loans. Exhibit 6 shows that, through September 28, high yield bond default rates are up to 3.1 percent from a recent low of 1.3 percent. In contrast, loan default rates have risen to 3.3 percent from a low of.26 percent. Exhibit 6: 12-Month Trailing Default Rate (%) 14 12 1 8 6 4 Loan Defaults Bond Defaults Exhibit 7: Historical Recovery Rates (%) 1 9 8 7 6 5 4 3 High Yield Bonds Loans 2 Jul-1 Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Source: Moody s As an example of the historic nature of the current pricing levels, we calculate (as of October 15, 28) that the market has priced in a default rate of 58% for leveraged loans and 27.1% for high yield bonds (assuming a recovery rate of $6, or $15 below current average prices, for loans and a recovery rate of $25, or $45 below current average prices, for bonds). Current default levels are well below what we feel is priced into the market. Consequently, we believe that a great opportunity exists to invest in both asset classes, and this opportunity will be discussed in an accompanying presentation to be released in December 28. 2 Dec-98 Sep-99 Jun- Mar-1 Dec-1 Sep-2 Jun-3 Mar-4 Dec-4 Sep-5 Jun-6 Mar-7 Dec-7 Sep-8 Sources: S&P s; Moody s Despite this trend, recovery rates tell a slightly different story. While the current environment will certainly show negative effects to recovery rates, 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, protection they typically receive through covenants, and the fact that most loans are secured by assets such as accounts receivables, inventory, plant machinery and equipment (Exhibit 7). Importance of credit analysis 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. Most institutional investors would be hard pressed 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 issues. During the rapid expansion of the leveraged loan market over the past several years, 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 most recent period of volatility related to the broader credit crisis. 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 management, stability of financing, covenants, etc. We believe that analyzing leveraged loans is a natural extension of high yield bond analysis due to the similarities of the underlying credits. Indeed, we believe that, in order to be a good loan investor, it s 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. Risk Diversification Characteristics of the Leveraged Loan Asset Class The leveraged loan market has underperformed riskier asset classes in the near term, but actually outperformed the S&P 5 in the seven- and 1-year trailing periods (Exhibit 8). The volatility in leveraged loan returns has been far less than the other traditional asset classes over the same trailing periods ended September 28. Exhibits 9 and 1 show that the leveraged loan index exhibits consistently positive long-term returns coupled with the lowest standard deviation of six different equity and fixed income indices. Exhibit 1 highlights the consistency of the rolling five-year risk-return characteristics of the asset class compared to other broad asset classes. Exhibit 8: Returns Ended September 28 3 Years 5 Years 7 Years 1 Years CS Leveraged Loan Index.74% 2.9% 3.58% 3.71% DJIA 3.34% 5.6% 5.32% 5.45% Russell 3.26% 5.7% 4.36% 3.8% Russell 2 1.83% 8.15% 9.3% 7.81% ML High Yield Master II.91% 4.26% 6.45% 4.31% S&P 5.22% 5.17% 3.5% 3.6% Exhibit 9: Standard Deviation Ended September 28 3 Years 5 Years 7 Years 1 Years CS Leveraged Loan Index 5.7% 4.1% 3.9% 3.48% DJIA 1.96% 1.4% 12.96% 14.46% Russell 3 11.72% 1.76% 13.3% 14.53% Russell 2 14.55% 14.67% 16.89% 18.89% ML High Yield Master II 7.8% 6.28% 7.68% 7.83% S&P 5 11.39% 1.35% 12.85% 14.37% Exhibit 1: Rolling Five-Year Returns vs. Standard Deviation Return/Standard Deviation 6-Month Moving Windows, Computed Quarterly; October 1998-September 28 Return 2% 15% 1% 5% % Consistently positive 5-year rolling returns with least volatility of 6 broad market equity and fixed income indices. -5% % 5% 1% 15% l Credit Suisse Leveraged Loan Index l Russell 3 Index l Merrill Lynch High Yield Master II Standard Deviation l Dow Jones Industrial Average l Russell 2 Index l S&P 5 2% 25% 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 Lehman Aggregate index and Merrill Lynch High Yield Master II index as seen in Exhibit 11. This low correlation indicates a further opportunity to diversify fixed income exposure within an asset allocation. Exhibit 11: Correlation of Returns to CS Leveraged Loans Index 1 Years Ended September 28 DJIA.257 Russell 3.366 Russell 2.431 ML High Yield Master II.66 S&P 5.333 LB US Aggregate Bond -.71
As a whole, historical volatility for leveraged loans has been lower than other asset classes; however, this volatility is expected to increase due primarily to the recent market dislocation. While absolute volatility is expected to increase, 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. Why Leveraged Loans? As an asset class, leveraged loan exposure helps diversify fixed income allocation, 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. Dislocation in the overall credit markets can lead to further investment opportunities and will be examined in a future companion piece. Sutter Credit Strategies Leveraged loan investors since 1998 Over $1B currently invested in leveraged loans Top decile leveraged loan manager* Deep credit team, established infrastructure and strong access to loan market issuance *Source: evestment Alliance Bank Loan Universe YTD, 1-year, 2-years and since inception (April 26) ended September 3, 28 Wells Capital Management 525 Market Street, 1th Floor, San Francisco, California 9415 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 415.396.8.