US loans Attractive floating yield 1 August 215 CIO WM Research Barry McAlinden, CFA, strategist, barry.mcalinden@ubs.com; Philipp Schöttler, strategist We think US senior loans, offering a yield of 5.3%, are an attractive addition to other fixed income assets for investors able to tolerate lower liquidity. Slow primary market issuance and strong demand from CLOs have provided a supportive backdrop for US loans this year. We believe this favorable backdrop will persist in the near term. US regulatory factors such as leveraged lending guidance and risk retention rules pose potential risks but do not alter our constructive view on US loans at this time. US loans have delivered decent total returns of 2.6% since the beginning of the year, outperforming high quality fixed income segments, and by and large meeting our expectations. The yearto-date performance of US loans stems from their income return, as loan prices have weakened again to their beginning-of-the-year value of USD 95.9. The average US loan spread (when measured at a 3-year call date and which includes the benefits of LIBOR floors) tightened from a peak level of LIBOR plus 56 basis points (bps) at year-end 214, to LIBOR plus 493bps in April. Since then, spreads have widened again to LIBOR plus 535bps as general market sentiment worsened. In particular, the weakness in lowerrated energy sector issuers weighed on US credit segments. But at only 5%, the sector has a relatively small weight within the US loans index when compared to 14% within US high yield. Thus, the underperformance of the energy sector in recent months explains the outperformance of loans over US high yield, which has achieved total returns of 1% year-to-date. Supportive technical backdrop The supply-demand backdrop has been favorable for senior loans. New issue markets are open but deal flow is running nearly 4% below last year's record pace. The majority of new-issue proceeds this year has been used for acquisition purposes; however, the terms of these deals have been less aggressive, with a focus on strategic mergers and acquisitions (M&A) over private leveraged buyouts. Another reason for the supply slowdown has to do with originators adhering to more strict compliance with the Federal Reserve's leveraged lending guidance. The criteria include the borrower's ability to repay over a reasonable period (e.g., 5 7 years for senior unsecured debt) and deal leverage being below 6 times. There has been stricter enforcement of this criteria by regulators, which have cut down on "non-pass" deals. In addition, while M&A activity has been steady, it is down from 214 peak levels, contributing to the reduction in loan supply. Source: UBS database Fig. 1: Performance in 215 (USD) Total return since 31 December 214, in % 15 14 13 12 11 1 99 98 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 US HY US IG Loans IG 1-5 year Treasuries Source: Bloomberg, UBS, as of 7 August 215 Fig. 2: US loan prices considerably below 1 in USD 18 16 14 12 1 98 96 94 92 9 212 213 214 215 US HY Index price US loan Index price Source: BoA, S&P LCD, UBS, as of 7 August 215 This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.
Against a modest supply backdrop, the institutional source of loan demand has been consistently present. The buyer base of collateral loan obligations (CLOs) includes banks, pension funds, insurance companies, and asset managers. CLOs continue to be an appealing investment choice for these entities as each risk tranche, from AAA to equity, has attractive risk-reward properties for their respective buyer base. New CLO issuance declined in July but is expected to remain strong and exceed USD 1bn through year-end. Flows from retail investors have been inconsistent, but we expect inflows to be more prevalent as the Fed should soon begin its first monetary tightening cycle in nine years. Floating-rate assets, such as loans, are therefore expected to gain in popularity again among retail investors. However, we continue to expect CLOs, and not funds, to remain the primary outlet for new loans that come to market. Leveraged loans in the credit cycle In the context of a four-stage credit cycle, we believe that we are in the third, or the re-leveraging phase, which may persist for some time. Fig. 5 shows the annual year-over-year returns for both US leveraged loans and high yield bonds going back to 1997. For the decade leading up to the financial crisis, loans had a lower total return beta compared to high yield bonds. This beta rose close to one during the crisis as deleveraging among market participants exacerbated the losses in both asset classes. Since then, the correlation of loans and high yield bonds has remained fairly high; that said, loans did not correct by the same magnitude as high yield bonds during both the 213 taper tantrum ( 1% loans versus 5% high yield) and the 214 energy-related corrections ( 2% loans versus 5% high yield). This is not surprising since loans have lesser exposure to the causes of each downturn, with lower sensitivity to interest rates and a smaller weighting to energy companies (5% loans versus 15% high yield). As a floating-rate asset class, loans usually perform well when interest rates are on the rise. Fig. 6 shows that US loans and high yield bonds on average showed positive and superior total returns over other fixed income asset classes in past periods, when Treasury yields were rising. One caveat to that is today's prevalence of LIBOR floors in the US loan market, where 9% of outstanding US loans have a LIBOR floor. The average floor value of 1bps means that coupon rates will only start adjusting upwards once that threshold has been passed. LIBOR floors also add a small fixed duration element to the asset class. Nevertheless, we believe that demand for loans in a rising rate environment will pick up as investors position themselves, leading to attractive returns this time as well. The average total return of 8% should not be expected this time when rates rise because the overall yield level is still close to record lows. However, we think that loans will significantly outperform fixed income assets with a higher interest rate sensitivity. Fig. 3: Leveraged loan issuance volume in USD bn 7 6 5 4 22 256 243 265 295 3 185139 139 166 2 1 Institutional 48 535 234 157 77 Pro Rata Source: S&P LCD, UBS, as of 7 August 215 Fig. 4: CLO issuance remains robust in USD bn 2 15 1 5 (5) (1) 67 528 466 375 (15) Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 CLO issuance Prime fund flows Source:,S&P LCD, UBS, as of 3 June 215 Fig. 5: Leveraged loans are highly credit sensitive Year-over-year returns (left), in %, and spread (right), in bps 8 6 4 2 (2) (4) 97 99 1 3 5 7 9 11 13 15 34 2, 1,5 1, 5 Leveraged loans yoy returns HY bonds yoy returns HY OAS (right) Source: S&P LCD, UBS, as of 3 April 215 Fig. 6: Loans usually perform well when rates rise Average annualized returns of US assets in month when 1-year Treasury rates fell/rose since 1997 2% 15% 1% 5% 15% 16% 13% 5% 8% 8% % -5% -2% interest rates fall -4% interest rates rise Treasuries Investment grade corporate bonds High yield corporate bonds Senior loans Source: Bloomberg, S&P LCD, UBS, as of 31 July 215 CIO WM Research 1 August 215 2
Loans are attractive We think US senior loans, offering a yield of 5.3%, are an attractive addition to other fixed income assets for investors able to tolerate lower liquidity. The current healthy state of US corporate balance sheets and our outlook for low default rates over the next 12 months provide a supportive fundamental backdrop for US loans. The supportive technical backdrop is also likely to persist, in our view, as strong demand for loans is matched against more modest, but healthy supply levels. In fact, we believe loans are well positioned to perform well in a scenario where rates remain lower for longer, or are gradually rising. In the former scenario, the 4 5% yield level that loans offer should remain appealing to investors. In a scenario where rates move higher on account of economic strength, we would expect loans to outperform other high quality fixed income segments that will be adversely affected by their duration exposure. A short introduction to senior loans Loans are usually issued by sub-investment-grade rated companies, which is why they are also sometimes referred to as leveraged loans. In that respect, the asset class shares some characteristics with the high yield bond market. There is some overlap in companies that have both loans and high yield bonds outstanding, although not all loan issuers also have bonds. With more than USD 83bn outstanding, the US loan market is sizable but still almost 4% smaller than the US high yield market. There are some crucial distinctions between loans and bonds to be aware of: 1. Duration: The coupon rate on senior loans is floating, which means that it is reset regularly based on the development of a short-term benchmark rate plus a stated coupon. In the case of US loans, the benchmark is usually the 3-month USD LIBOR and the reset is done every 45 to 6 days on average. As a consequence, the rate duration of senior loans is close to zero and the interest rate risk is thus very low, which is especially beneficial in times of rising rates. A recent development since the financial crisis has been the introduction of LIBOR floors, or minimum reset rates. Approximately 9% of the US leveraged loan index currently contains a LIBOR floor of 1bps on average. Thus, a majority of loans will only see their coupon rates increase once LIBOR rises above 1%. LIBOR floors also add a small fixed duration element to the asset class. 2. Credit risk: As implied by their name, senior loans have a higher ranking within a company's capital structure. That means, in case of a default, this part of the debt will be first in priority to obtain recovery values. Additionally, senior loans are typically secured by the borrower's asset giving the lender or investor additional security. Furthermore, loans usually involve protective covenants that provide the lender with forceful control over the borrower. These features lead to lower default rates as well as higher recovery values for loans than for high yield bonds. The average annual credit loss over the last 2 years is 1% on US loans and 2.6% on US high yield bonds, mainly due to a considerably higher recovery rate of 7% on average on US loans, compared to 4% on high CIO WM Research 1 August 215 3
yield bonds. In summary, the credit risk of senior loans is considerably lower than for high yield bonds. However, the leveraged nature of issuers does makes the loan asset class highly sensitive to credit cycle fluctuations. 3. Liquidity: Loans are traded "over the counter" (OTC) between different banks and mostly loan fund managers. the secondary market liquidity of loans is lower than that of most other credit asset classes. This relative illiquidity is part of the attractive risk premium offered by the asset class. Investors can get access to the market via such a loan fund which usually offers liquidity on a monthly, weekly, or even bi-weekly basis. Furthermore, to protect fund investors from the adverse effect of a forced selling of the underlying loans when prices are low, these funds can "gate" at times of market stress. This means that a liquidation of the investment might not be possible immediately in times of distressed markets, but may take time. While this feature is a useful protection for long-term investors, it has to be considered carefully before making an investment in loans, and makes loans mostly a "buy-and-hold" asset class. 4. Call risk: The majority of loans are immediately callable, although some have a USD 11 "soft call" where the issuer has to pay a USD 1 penalty to refinance at a lower rate for the first six months or one year following issuance. Many issuers have taken advantage of strong market conditions and "repriced" their loans to lower credit spreads by taking advantage of this continuous call feature. Similar to the high yield bond market, call features will constrain the price appreciation potential of loans during strong market conditions. Thus, we do not expect the average loan price to trade above USD 1 for a sustained period. However, the call feature is usually compensated for by higher coupon rates, and callable loans and bonds tend to outperform non-callable securities in times of rising interest rates. CIO WM Research 1 August 215 4
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