It's the perfect time for loan managers to tell their story as rising interest-rates and an improving economy make today's market one of the best for syndicated loans. Bank loans, unlike bonds, have floating-rate coupons and are senior in the capital structure, meaning they guard against interest-rate and default risk.
Once perceived as a fixed-income newbie, the loan market now has at least a solid 10-year track record. It's arguably a good defensive bet with very reasonable absolute returns. For the 11-year period ending in 2003, syndicated loans provided a median annual return of 7.12% according to the CSFB Leveraged Loan Index. The highest annual return during that period was 11.17%.
A nonprofit can invest in syndicated loans or structured vehicles such as collateralized loan obligations (CLOs) depending upon its risk tolerance and whether it's looking for an addition to its fixed-income portfolio or its alternative allocation. Managers predict foundations and endowments can expect returns up to 7% on syndicated loans and in the teens and twenties on CLOs. FEMM asked Kevin Petrovcik, managing director at INVESCO, Jack Yang, partner at Highland Capital Management, and Tony Malloy, managing director at New York Life Investment Management, to discuss the attributes of the asset class and what nonprofits should consider when choosing an investment vehicle.
FEMM: What are syndicated bank loans and how do they work? What are their benefits?
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| Tony Malloy |
TONY MALLOY: Syndicated bank loans are senior secured floating-rate obligations that are issued by the same companies issuing high-yield bonds. The difference is that they are senior in the capital structure secured by the assets of the company. If at some point cash flow is insufficient investors can tap the assets in case of default. Lastly, the coupon or rate is floating, so it re-sets every 30, 60, or 90 days. As short-term rates go up, the yield goes up. So it's a way to diversity fixed-income portfolios and hedge against rising interest rates. Over the last 10-12 years, loans have delivered returns within 1% of high-yield bonds with substantially less risk. KEVIN PETROVCIK: Syndicated bank loans are loans made by banks and other financial institutions to large- and medium-sized companies. These loans are typically used to finance leveraged buyouts, leveraged acquisitions and recapitalizations. The companies that borrow can be either public or private--the segment of the market that we lend to is typically below investment grade (B/BB rated). The loans are senior to all existing and future debt of the borrowing company and are generally secured by all assets of the company. Therefore, if there is a payment default, the recovery is higher than other forms of debt. They pay a floating-rate return, which is usually priced at a spread above LIBOR.
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| Jack Yang |
JACK YANG: Syndicated bank loans are a $1.4 trillion market. Originally developed in the late 1980s by commercial banks as a way to mitigate exposure to leveraged buyouts and comply with risk-based capital requirements by regulators, the market we now see was driven in large part by the entry of big investment banks in the mid-1990s. With the advent of additional non-bank participants came a more formal process for a dealer quote-based pricing system, documentation standards, as well as settlement, syndication, and trading practices. FEMM: What kinds of loans do you recommend for foundations and endowments? Are loans the best vehicle to hedge against the prospect of dropping bond prices as interest rates rise?
TM: We think floating-rate loans should be a core holding in fixed-income portfolios. Loans deliver very attractive risk-adjusted returns. Because it's a short duration asset, as interest rates go up, the principal value remains stable.
KP: The loans I would recommend for foundations and endowments are typically referred to as institutional term loans. This is a separate tranche of the syndicated loan that has back-ended amortization. The advantage to this tranche is that it is part of the same credit agreement and offers the same protection as the revolver or amortizing tranche, but stays funded longer. The credit spread (over LIBOR) for institutional tranches is also typically priced at a premium. Overall, loans are a very good vehicle to hedge against rising interest rates, because as interest rates rise, the base rate also rises. Unlike fixed-rate bonds, where your payment or coupon is fixed, loan payments float with interest rates and only the credit spread remains fixed.
JY: There are two types of loan investments that are attractive to foundations and endowments. As a defensive asset class, the first type of loan investing would be in a pool of highly diversified loans where an investor would expect to receive LIBOR plus a spread (depending on the underlying credit quality). A BB to B- investor may expect to look at LIBOR plus 2.5-3% as a return. As rates increase the spread would benefit the investor. The second approach would be to construct a pool of highly diversified assets and utilize leverage to exploit the stability of the underlying assets relative to the coupons that they pay. Due to the liquidity of the market and the availability of sources, a structured note or a CLO equity structure is a very attractive way to invest in the space.
FEMM: Where do bank loans fit within a foundation or endowment's asset allocation? Is it considered fixed-income or an alternative investment?
TM: The time to overweight the asset class would be in today's environment when rates are going up and the economy is strong or growing because defaults should remain relatively benign. With the economy improving, we are no longer in a period of heightened credit risk.
KP: Loans are more likely part of an alternative asset allocation. The returns of senior secured bank loans have a very low correlation with the returns of other asset classes like traditional fixed income or the equity markets. For an 11-year period ending in 2003, the CSFB Leveraged Loan Index showed a 0.14 correlation to the Standard & Poor's 500 Index and a 0.07 correlation to the Merrill Lynch Corporate Index. This low correlation provides a compelling means of diversification as an alternative.
JY: In the context of a par loan (a loan current in its payments and trading as a healthy credit) investment with no leverage, investors often classify this strategy in their fixed income space. When leveraged structures are used, these are classified in a variety of spaces, e.g., marketable alternatives, event driven, opportunistic, credit, or hedge funds.
FEMM: What types of investment vehicles are out there? What vehicles are best for foundations and endowments?
TM: It really depends on risk tolerance. If an investment is done in a CLO format, I think it should be classified as an alternative particularly if you're buying lower-rated tranches or equity. If the portfolio is just loans it should be classified as fixed income. Most assets we buy are par loans, not distressed, and I don't think distressed loans are necessarily suitable for foundations and endowments since the equity-like returns mean taking equity-like risk.
KP: There are many types of investment vehicles. Because loans do carry default risk, one important investor concern is diversity. A foundation or endowment can make a large investment--say $200-300 million--in a separate account, or they can make smaller investments in a commingled fund, which will provide them with the diversity. A foundation or endowment can also invest in structured bank loan products or CLOs, which can incorporate various degrees of leverage.
JY: Loan investing in the par space can be introduced by mutual funds, separate accounts, and limited partnerships. In the leveraged space, investment vehicles are available via structured notes, CLO equity tranches, and in distressed investing via hedge funds in a private equity format.
FEMM: Institutional investors have become increasingly attracted to bank debt as interest rates rise. What other benefits explain all of the institutional money chasing paper? What segments or areas look particularly attractive? Why?
TM: There have been a lot of inflows by both institutional and retail investors over the last year. There is a lot of money chasing a small supply but now we're seeing a real pickup on the new issuance side which is taking the pressure off tight spreads. We have been overweight in publishing and broadcasting because it's both an Olympic and election year and there is no longer an advertising recession. We like healthcare but only certain segments like device manufacturers and specialty services like renal care. We do not like hospitals or nursing homes because they are dependent on government reimbursement which can change in a political moment.
KP: In addition to the low interest rate risk and low correlation to other asset classes, bank loans have proven a very viable investment for a variety of reasons. Bank loans provide investors with a stable return profile, and low volatility. In addition, they provide superior credit protection due to their senior-secured status and have the highest priority claim on a company's cash flow in the event of default. This was demonstrated during the most recent credit cycle where defaulted bank loans recovered approximately 75% of their value and defaulted unsecured bonds to similar type companies only recovered approximately 35%. There will most likely be some form of capital erosion in a bank loan portfolio due to credit loss, but the high level of income generated by the portfolio will most likely offset it.
JY: With most investors having explicit allocations to long fixed income, they are expecting a period of depressed returns in the space. Loans offer a defensive strategy to this reality. Even given the lower absolute returns provided by loans, investors are willing to take a lower, absolute positive return versus a bigger hit in their long fixed-income portfolio. In regard to what segments look attractive, due to the relatively healthy credit outlook for leveraged borrowers, the structured note and CLO equity segments are still an attractive investment opportunity. Due to the cash flow streams loaded at the front end of the structures, investors can mitigate credit risk by hiring managers that have the infrastructure to assess credit risk and move out of troubled credits before they become terminal.
FEMM: The general consensus is that interest rates are going to rise in the next year or so, but with many banks, retail loan funds and hedge funds looking to put money to work in the loan market, spreads are at record lows. With that in mind, why would now be a good time to invest?
TM: We're investing for the long-term which we define as three, five, or 10 years. If that is a nonprofit's time horizon, this is a very attractive asset class, especially at a time when interest rates are rising.
KP: Many investors are seeing an opportunity to benefit from the prospect of rising rates. Also, with the recent up tick in economic activity and some emerging signs of inflation, bank loans look very attractive. The average B institutional loan was priced at LIBOR plus 2.78% last week with the average BB institutional loan priced at LIBOR plus 2.05%, according to S&P. While these levels reflect tighter markets from the beginning of the year, the tightening is primarily driven by increased investor demand and opportunistic repricings, stemming from improved business fundamentals.
JY: A number of attributes would support consideration of loans at this time. First off, it is a defensive asset class. Secondly, the loan market is relatively healthy and therefore defaults are declining at this time. Finally, due to the non-correlative nature and systemic return stream, loans have proven to be a reliable alpha engine in a variety of markets. When structured products are implemented, the advantages of loans are amplified with very positive risk/return characteristics.
FEMM: What kind of returns can be expected?
TM: We think average returns of 6-7% are reasonable.
KP: Returns depend upon the type of fund that you invest in, and the degree of leverage, if any.
JY: In the current market investors should expect to see returns coming in for par loans at LIBOR plus 2.5-3%; structured notes at LIBOR plus 6-8%; CLO equity at high teens to low twenties.