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SPONSOR DIRECTORY

The Syndications and Trading Association - LSTA 366 Madison Avenue, 15th Floor New York, NY 10017 Contact: Alicia Sansone Executive Vice President Tel. 212-880-3002 [email protected] www.lsta.org

Eaton Vance Management 2 International Place Boston, MA 02110 Contact: Scott Ruddick Head of Institutional, North America Tel. 617-672-8300 [email protected] www.eatonvance.com

Highbridge Principal Strategies, LLC 40 West 57th Street New York, NY 10019 Contact: Faith Rosenfeld Tel. 212-287-6747 [email protected] www.highbridge.com

ING Investment Management 230 Park Avenue, 14th Floor New York, NY 10169 Contact: Erica Evans Head of Institutional Sales and Service Tel. 212-309-6552 [email protected] www.inginvestment.com

Invesco 1166 Avenue of the Americas New York, New York 10036 Contact: Kevin Petrovcik Managing Director Tel. 212-278-9611 [email protected] www.invesco.com

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CONTENTS

4 14 10

Floating-Rate Poised to Perform 4

Floating-Rate Loans Seek Greater Prominence in Portfolios 10

“Great De-Leveraging” Raises Profile of Floating Rate Loans 14

This special advertising supplement is not created, written or produced by the editors of Pensions & Investments and does not represent the views or opinions of the publication or its parent company, Crain Communications Inc.

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Floating-Rate Loans Poised to Perform

Although business lending may predate the rise of the and markets by centuries, loans as a mainstream asset class have only recently gained recognition among the institutional investment community. Now many investment professionals believe that the post-crash environment – with its uncertain out- look for long-term economic growth, volatility, financial weakness at every level of government, and the prospect of steadily rising interest rates and inflation — may offer ideal investment conditions for floating-rate corporate loans to perform well, especially compared to other fixed-income alternatives. Corporate loans, or more formally “senior secured floating-rate instruments,” are the senior-most debt obligations of non- investment grade corporate borrowers (the same cohort of companies that issue high-yield bonds). Being the on the balance sheet and secured by means that loans provide a more protected repayment stream to investors, with losses that have historically averaged less than half those of high-yield bonds, according to Standard & Poor’s and recovery statistics.

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At the same time, with floating interest rates that The explosive growth of the syndicated loan market are periodically reset at a spread over the London Inter- over the past two decades has brought with it a substantial Bank Offered Rate (LIBOR), loans actually benefit from increase in investment management firms focused on increases in interest rates, as opposed to traditional serving institutional investors in the loan market. It has bonds whose market value decreases when interest rates spurred the development of loan tranches and other rise. The floating-rate feature appeals to investors who investment vehicles designed specifically to meet the want to have a fixed-income component to their portfo- distinct investment preferences of institutional buyers. lios, but feel the current economic environment, with in- Loan-market liquidity has also increased substantially, terest rates at a 30-year low and turning upward, is not an as a result of robust growth in secondary loan trading, opportune time to be betting on interest rates remaining the development of standardized trading, distribution flat or dropping, which is the inherent interest rate bet in and settlement protocols, and the greater transparency any fixed rate bond. and reliability of third-party pricing. Portfolio managers who recognize this have been moving substantial amounts of new money into loan History of steady returns assets in recent months. Retail investors alone were Returns to loan investors have been mostly stable, positive reported by Lipper FMI to have moved almost $3 billion and consistent for the thirteen years since the S&P/LSTA into loan mutual funds during the month of December Leveraged Loan Index began. The two-year worldwide 2010. “Duration risk has become much more of a reality liquidity crisis in 2008 and 2009 affected the loan market to investors as long bond yields have moved up sharply in as it did other credit and equity markets, driving loan- recent months,” said Scott Page, vice president, portfolio market returns down by 30% in 2008 and back up by 52% manager and director of Eaton Vance's Floating-Rate in 2009. Patient “buy-and-hold” investors who held their Loan Group. “For investors who wish to reduce duration loan portfolios through the crisis would have earned a net in their portfolios, floating-rate bank loans are the simplest return of about 8% over the two years, despite the to understand, easiest to trade and most liquid of any resulting recession and some of the highest default levels major fixed-income asset class.” ever recorded. In 2010, the index returned about 10%, as the credit environment improved and loan default rates From “bank loan” to “asset class” fell to below 2%. The investor base for loans has been expanding beyond traditional banks and specialized investment vehicles, like collateralized loan obligations, which were the main- S&P/LSTA Leveraged Loan Index stay of the market until recently. The new investors are more likely to be oriented toward total returns, rather than focused on a spread over LIBOR that they would multiple times. “We believe the institutional loan buyer base is shifting from spread-based buyers like CLOs to total yield-based buyers like managed accounts, high yield and loan mutual funds, and other institutional vehicles,” said David Frey, portfolio manager at Highbridge Principal Strategies. “As a result, we are optimistic that the favorable new issue pricing we have seen recently will continue.” Mr. Frey also thinks that loan demand – much of which is driven by corporate –

will continue to grow. “Some of the key drivers of M&A Source: S&P/LSTA Leveraged Loan Index activity are slow organic growth, low interest rates and improving CEO confidence,” he said. “That seems to be the situation today, so we are optimistic that M&A Many loan professionals believe returns may not be activity will increase and present new loan-investment quite so high in 2011, but they could be close. “Loans have opportunities.” traditionally offered stable, predictable returns to The loan market gives traditional institutional in- investors,” said Dan Norman, senior vice president and vestors access to the top of the corporate liability struc- group head of ING's Senior Loan Group. “The liquidity ture – secured loans – instead of being limited to bonds crisis a couple of years ago ended an eleven-year streak (which are unsecured or subordinated) and equity. In the of positive returns, but we have now had two successive past, by ceding the better secured, floating-rate loan positive years. I think there is every reason to believe assets to the commercial banks, investors left quite a bit loans are on their way to establishing a new streak of on the proverbial table in terms of attractive risk/reward attractive positive returns.” returns, cash-flow stability and portfolio diversification. Mr. Norman, like many loan managers, expects loan But they essentially had no choice. Until recently, there returns could exceed historical averages in 2011, based on were few investment vehicles providing large-scale a combination of gross yields and continuing capital ap- institutional access to the loan asset class. preciation. If he is right – and many other banks and loan

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researchers are publishing estimates in the same range – risk and interest-rate risk. The higher the credit quality then the loan market’s “new normal” returns may actu- of the bond issuer and the lower the likelihood of default, ally be somewhat higher than their pre-crash “old nor- the more a bond becomes essentially a bet on the direction mal.” of interest rates. In the high-yield world, the situation is The loan market’s performance through the most more complicated, partly because the credit risks vary challenging credit environment since the 1930s has con- considerably between loans and bonds. firmed to many observers and investors the durability of Also, the nature of the interest-rate bet inherent in senior, secured loan assets from a credit perspective. It each instrument is different. Because loans are gener- has also contributed to growing interest by institutional ally the senior-most debt of the issuer and are secured by investors in senior secured loans as a mainstream asset collateral and other protective features, they typically de- class – one that deserves a permanent position in a fixed- fault less frequently than high-yield bonds. Moreover, income allocation whether it be an individual, pension when they do default, loan investors generally recover at fund, endowment or other long-term portfolio – rather a consistently higher rate than bond investors, as a than just a position as an alternative or opportunistic in- result of having collateral. Recoveries post- vestment. average 70% for loans versus 40% for bonds. As a result, The real strength of loans as an asset class, many credit losses on loan portfolios typically run less than 50% loan industry professionals believe, will not be apparent of the losses on high-yield bond portfolios. until the economy encounters a sustained period of ris- High-yield bonds and loans differ even more ing interest rates. Just as bonds performed brilliantly markedly in terms of how each asset reacts to changes in with the wind of falling interest rates at their back, many interest rates. With bonds, interest rates are fixed for the loan investors expect their asset class to shine if and term of the instrument. With loans, interest rates are when interest rates begin their climb, which has been variable or floating, defined as a spread over a base rate long anticipated by some. “Even if an investor is unsure that changes periodically. Typically the base rate is the which way interest rates will move long term,” said Mr. three-month LIBOR. Recent loan contracts have included Frey of Highbridge, “given that interest rates are cur- a LIBOR floor, a minimum base rate that applies even if rently still near historical lows, prudence might dictate the actual LIBOR rate is lower. This is intended to provide hedging one’s fixed income bet by holding both loans and investors with a higher minimum return during abnormally bonds.” low interest-rate periods. Typical LIBOR floors have been in the 1.5% to 1.75% range. Risk-Reward Profile With both bonds and loans, investors are taking a Though both loans and bonds are considered fixed position with respect to future interest rates. Some aspect income, they diverge in other ways. of the value of the investment — either its current market value or its future income stream — will rise or fall with changes in interest rates. But the impact on the investor’s Liabilities and Equity portfolio – in terms of , accounting and future income – differs greatly from bonds to loans. With bonds, Loans Senior, secured, fixed principal future cash flows, which include interest coupon payments return, floating-rate interest plus principal, are fixed (unless the issuer defaults). If in- “Fixed terest rates change so the fixed rate on the bond is out of Bonds Unsecured or subordinated, Income” fixed principal return, fixed-rate sync with current interest-rate levels, the market price interest } of the bond will adjust up or down accordingly. With loans, principal payments are fixed and the in- Equity Lowest claim on assets, no fixed return, unlimited upside potential terest payments self-adjust to changes in interest rates. As a result, the price of the loan is generally not affected since the loan is always paying a market rate. In a rising interest rate environment, the economic value of the loan increases, since the income it generates rises along with Loans and bonds are typically regarded as “fixed-in- interest rates. Fixed-interest instruments, like bonds, come” investments. While this is true insofar as the decrease in both relative economic value and actual market principal amount that an issuer contracts to repay at price as interest rates rise. (Although generally immune maturity is fixed in both cases, the two asset classes to interest-rate movements, loan prices may still vary in diverge in other respects, presenting distinct risk/reward the secondary market for non-interest-rate related profiles. reasons like the overall supply and demand of loans, market Bond investments combine two main risks: credit liquidity, risk appetite and issue-specific credit factors.) continued on page 8

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Driven by our own benchmarks.

Client Performance Risk Centric Excellence Management

Maintain a long-term perspective even in the most complex markets. At Eaton Vance, we build on the knowledge we’ve gained in over more than eight decades. Our portfolio managers and career analysts, the best minds in the industry, adhere to time- tested principles. They follow a disciplined investment process, founded on rigorous fundamental research and an emphasis on risk management. Eaton Vance’s dedicated institutional team expands on these strengths, delivering consultative, hands-on service to our clients. Their exceptional insight into our equity, À[HGLQFRPHÁRDWLQJUDWHVWUXFWXUHGDQGDOWHUQDWLYHVWUDWHJLHV can help reveal opportunities for long-term success, whatever the market environment. For more information contact Scott Ruddick, Head of Institutional, North America 617.672.8300

‹(DWRQ9DQFH,QYHVWPHQW0DQDJHUV,QYHVWLQJHQWDLOVULVNDQGWKHUHFDQEHQRDVVXUDQFHWKDW(DWRQ9DQFH DQGLWVDIÀOLDWHV ZLOODFKLHYHSURÀWVRUDYRLG incurring losses. Past performance does not predict future results.

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continued from page 6

Comparing returns credit risk. (The accompanying table illustrates these Bonds have two primary elements of risk, which investors differences, based on the assumptions presented, which want to be paid for: interest-rate or duration risk and mayvaryovertime.) credit risk. Since floating-rate loans have no interest- The figures suggest that, with the interest-rate bet rate/duration risk, the entire coupon is available to premium removed, loans pay investors as much or some- compensate the loan investor for credit risk. In effect, times more than bonds for taking equivalent credit risk. comparing loan and bond returns requires netting out the But the loan advantage is actually better than that when portion of the bond return that compensates the holder one adjusts for the higher recoveries that loan investors for taking the interest-rate bet embedded in the bond by typically receive when issuers default. Although default virtue of its fixed interest rate. rates vary through economic and credit cycles, typical de- An investor gets paid almost 3.5% on a 10-year fault rates of 3% per annum would result in net credit Treasury bond and about 10 to 15 basis points for a costs of about 2% for high-yield bonds (which are usually three-month T-bill. Although each has the same credit unsecured or subordinated), but just below 1% for secured risk, the difference – about 3.25% – represents the mar- loans. ket’s premium to investors for taking the 10-year in- Many professional loan managers believe they can terest-rate risk. To compare high-yield bonds and loans widen the differential even further through good credit as pure credit instruments requires subtracting that selection and active portfolio management. “A lot of 10-year/three-month Treasury differential (3.25%) from people have a perception that the credit loss on non-in- the bond coupon. So if high-yield bond yields (depend- vestment grade senior loans is fairly high, but history ing on the credit rating) typically range between 7% seems to demonstrate otherwise, even during the recent and 10%, then the pure credit yield after deducting the crisis,” said Highbridge’s Mr. Frey. “Moreover, a substantial premium for the interest-rate bet would be a range ap- portion of the company-specific credit risk can be reduced proximately between 4% to 7%. Meanwhile, the range through a well diversified portfolio, and seasoned active of typical loan yields for a similar range of is 6% managers typically have default rates that are a fraction to 7%, all of it compensation to the investor for taking of the overall market.” ◆

Weighing Returns Loans fare well compared to high-yield bonds.

Loan/Bond Return Comparison

Range of Interest Return on Anticipated Loss Given Credit Net Return Coupon Rate Bet Credit Risk (Net Default Rate Default Cost to Investor Yields Premium of Interest Rate (annual) for Credit Bet) Risk

Senior Loans 6-7% 0.0% 6-7% 3.0% 30% 0.9% 5.1-6.1%

High-Yield Bonds 7-10% 3.25% 3.75%-6.75% 3.0% 60% 1.8% 2%-5%

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Looking for Solutions to Rising Interest Rates?

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ING Investment Management Offers a Full Range of Senior Loan Investments for Institutional Clients

Floating rate senior loans can provide a natural hedge against rising interest rates. ING’s Senior Loan Group is a leader in senior loan asset Call us now to learn more management, offering investment solutions in this strategy for more about how senior loans than 15 years. As a part of ING Investment Management, a leading can benefi t your portfolios. globally coordinated asset manager with $515 billion in assets under management, the ING Senior Loan Group can provide senior loans Contact: Erica Evans solutions tailored to your investment needs. Head of Institutional Sales and Service (212) 309-6552 ING’s Senior Loan Group consists of 44 members in the U.S. and Europe dedicated to senior loans and providing global expertise ING Investment Management and unparalleled access to this private market. Group Heads 230 Park Avenue, New York, NY 10169 Dan Norman and Jeff Bakalar have over 49 years of combined www.inginvestment.com investment experience.

Dan Norman Jeff Bakalar

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©2011 ING Investments Distributor, LLC

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The financial press has been awash with articles about recent research report. possible “bond bubbles” and the risks of holding fixed-rate Floating-rate loans – loans to non-investment grade debt as economic and fiscal forces come together to cause companies – have been the purview of commercial banks interest rates to rise over the next few years. But most of for hundreds of years. It is only over the past two decades the articles focus on investment re-allocation from one that loans have evolved from a “buy-and-hold” asset on part of the bond market to another, such as from Treas- the books of banks to a full-fledged publicly underwrit- ury bonds to corporates, or from investment-grade bonds ten and traded asset class. Most akin to public high-yield to high-yield ones. Others advocate moving out of bonds bonds because of the type of companies being financed, and fixed income completely and into either , with the volume of institutional term loan issuance actually their high volatility, or extremely short-duration assets, exceeded that of public high-yield bonds during the years which have no volatility, but no yield either. immediately before the crash. Little attention has been devoted to the option of Since the crash, high-yield bond volumes have ex- moving out of bonds but remaining in fixed-income in- ceeded floating-rate loan issuance, a development that is struments that involve no interest-rate bet. “Loans are not surprising. With interest rates hovering near their one of the few, and often the most attractive, short-dura- lowest point in a generation, corporations have been tion investment alternatives that pay high current in- eager to issue fixed-rate bonds to lock in low borrowing come,” said Dan Norman, senior vice president and group rates for years to come. Precisely because so many com- head of ING's Senior Loan Group. “Floating-rate corpo- panies feel the current environment is the most attrac- rate loans generally allow investors to earn an attractive tive time to sell fixed-rate bonds, investors are wary of current return in the range of 5% to 6% and still have up- having such a large portion of their fixed-income portfo- side potential in case interest rates rise due to economic lios allocated to bonds. growth and/or renewed inflation.” “With bond yields near historic lows, the risk of loss Other managers agree. “We think the case for put- attached to any upward move in interest rates is very ting floating-rate loans in portfolios may now be the most real,” said Greg Stoeckle, managing director and head of compelling in the 20-year history of the asset class,” global bank loans at Invesco. “Hence, sophisticated insti- wrote Scott Page, vice president, portfolio manager and tutional investors have been looking for an asset class director of Eaton Vance Floating Rate Loan Group, in a that provides current income, like bonds, but protects,

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and actually supplements, current income in the event of an opportunity to split their fixed-income position into its rising interest rates.” two component parts: the credit bet and the interest-rate Many investors still regard the term “fixed income” bet. Previously, when bonds were the only game in town as being synonymous with “bonds,” reflecting the wide for fixed-income investors, buying debt without some gulf that existed – legally, culturally and institutionally amount of interest-rate bet attached to it was virtually – between public debt instruments (primarily bonds) and impossible. Similarly, investors who wanted a “pure” private debt instruments (primarily loans) until just 10 to credit bet had to counter the interest-rate risk via an in- 15 years ago. Bonds were securities, underwritten and terest-rate swap or similar derivative instrument. sold to institutional and retail buyers by investment bankers and distributed in a public market. Loans were Risk Matrix not securities, but were private financings arranged by The advent of loans as an asset class has introduced a lending officers who worked for commercial banks that greater credit risk component into the fixed income world. held the loans on their books until maturity. The gap between loans and bonds first began to erode Fixed Income Instruments as loans and the deals they were financing became so Credit Risk/Interest Rate Risk Matrix large that individual banks had to “syndicate” them to larger groups of other banks, with the role of syndicator High High Yield increasingly coming to resemble that of an underwriter in Credit Risk Corporate Bonds the bond market. The erosion accelerated as non-bank in- Floating-rate stitutional investors, such as insurance companies, mu- Corporate Loans Long-term tual funds and securitized vehicles, started to buy into Corporate Bonds loan syndications. Eventually bankers began to structure Low Long-term dedicated term-loan tranches with features, such as Short-term Credit Risk Treasury Bonds longer terms, fully funded and non-amortizing balloon Treasury Bills payments, specifically oriented toward the needs of these institutional investors. Low Interest High Interest The advent of floating-rate corporate loans as an es- Rate Risk Rate Risk tablished institutional asset class now provides investors

Leveraged Finance Volume

Leveraged Finance Volume Returning to Pre-crash Levels US Volume

continued on page 12

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continued from page 11 losses are deducted. That's because corporate loans, rank- Of course, not all debt is created equal with respect ing senior and secured by collateral, suffer credit losses that to the mix of credit risk and interest-rate risk from one are less than half those experienced by the unsecured or fixed-income asset class to another. Three-month Treas- often subordinated high-yield bond holders. ury bills, for example, have recently been yielding 10 to The various types of fixed-income instruments allow 15 basis points, making them the proxy for the actual investors to pick their risk profile (see chart). An investor credit risk of the U.S. government (i.e., the risk of not who is primarily interested in making an interest-rate being paid back in U.S. dollars). Ten-year Treasury bonds bet should buy a long-term Treasury bond, since over 90% carry a yield of almost 3.5%. Since the credit risk is vir- of the coupon return is the interest-rate-bet premium. tually the same (i.e., the U.S. government’s ability to Even an investment-grade is mostly an print out new U.S. dollars to repay its won’t change interest-rate bet, with only 25% of the coupon represent- over ten years), the difference of just over 3.25% between ing a return on taking credit risk and the remaining 75% the three-month T-bill yield and the 10-year T-bond yield being the interest-rate-bet premium. represents the interest-rate risk premium investors are High-yield corporate bonds flip that ratio around, being paid for tying up their money for 10 years rather with the majority of the coupon (54% to 67%, depending than three months. on credit quality) compensating the investor for taking A 10-year, single-A-rated corporate bond yields about credit risk, but with still a sizable remainder (33% to 4.35%. Since 3.25% of that covers the premium on the 10- 46%) allocated toward interest-rate risk. Corporate loans, year interest rate bet, then the remainder – 4.35% minus with their adjustable interest rates, remain the only 3.25%, or 1.1% – is what the investor is being paid for major fixed-income asset class that represents a 100% taking the 10-year credit risk on the single-A corporate is- “” on credit risk. suer. Neither is a very handsome reward: 3.25% for the Once bonds are understood as “hybrid” instruments, risk that inflation and interest rates might rise over the with 30% to 90% or more of their return based on inter- next 10 years, or 1.1% for a corporate credit risk – albeit est rate movements, it is easy to see how powerful the re- a relatively good one – for the same period. cent 30-year drop in interest rates was. Investors who feel Rewards for taking credit risk in the high-yield cor- that rates are likely to remain stable or move up should porate sector are higher, as they ought to be, given the look to lighten their allocation to instruments that carry heightened risk of non-payment. Typical high-yield bonds an embedded bet that rates will fall, if an alternative is yielding in a range of 7% to 10%, depending on the is- available that does not contain such a bet. suer’s credit rating, pay an investor approximately 4% to Prior to the rise of the loan asset class, no such vi- 7% for credit risk, after deducting the 3.25% interest- able alternative was available. “The rise of the syndicated rate-bet premium. Corporate loans have recently yielded corporate loan market has certainly changed all that,” in a range of about 6% to 7%, with the entire coupon pay- said Craig Russ, vice president and portfolio manager at ing for credit risk, since there is minimal interest-rate Eaton Vance's Floating-Rate Loan Group. “Now institu- risk with the continually re-setting floating rate. tional and retail investors can enjoy the advantages of Further, corporate loan investors typically get to keep buying corporate debt without making a bet on interest more of their coupon than high-yield investors, after credit rates that they may not really want to make.” ◆

Divvying Up Risk Investors can choose where to place their bets.

Interest Rate Risk/ Credit Risk Return Allocation

Coupon Interest Return on Credit Risk Percent of Coupon Percent of Coupon Yields Rate Bet Premium (Net Interest Rate Bet) Allocated to Interest Allocated to Rate Bet Credit Risk

Treasury Bonds 3.50% 3.25% 0.25% 93% 7%

Single-A Coporate Bonds 4.35% 3.25% 1.10% 75% 25%

High-Yield Bonds 7-10% 3.25% 3.75%-6.75% 33%-46% 54%-67

Senior Loans 6-7% 0.0% 6-7% 0% 100%

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Experience Builds Trust

Invesco Senior Secured Management • One of the leading pure-play investment managers with exclusive focus on senior secured bank loans • More than $18 billion under management across retail and institutional strategies • A 20-year history in managing the asset class • A team of 41 professionals dedicated to bank loans

For more information, visit institutional.invesco.com or contact Senior Client Portfolio Manager Kevin Petrovcik, 212 278 9611, [email protected].

Helping Investors Worldwide Achieve Their Financial Objectives

Assets under management as of Sept. 30, 2010; all other data as of Dec. 31, 2010

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ADVERTISING SUPPLEMENT “Great De-Leveraging” Raises Profile of Floating Rate Loans

For years, bankers, loan portfolio managers and investors been around for 20 years, but the ‘Great De-leveraging’ have been singing the praises of floating-rate loans to a has given them a chance to prove themselves to the wider larger investment community that was indifferent. investment community,” he said. Decades of falling interest rates and a steadily growing What enabled the loan market to bounce back so economy provided a fairly benign environment for traditional quickly from the worst credit crunch since the Great fixed-income investors who felt no particular need to Depression? More than anything, it was credit structure push the definition of fixed income beyond bonds. But and asset protection. While floating-rate loans represent there is nothing like a market crash and de-leveraging to debt of the same cohort of non-investment grade compa- raise the profile of an asset class. The last three years nies that issue high yield bonds, the comparison stops certainly did that for floating-rate loans. there. Loans are senior obligations, secured by collateral – usually the key earning assets of the issuer – and they Respectable Performance have covenants that allow the lenders to take protective Though volatile, the S&P/LSTA Leveraged Loan Index steps if the company’s financial health begins to deteriorate. returned 19% over the three years from 2008 to 2010. As a result, loans generally do not default as readily as high-yield bonds, whose holders have minimal S&P/LSTA Leveraged Loan Index covenants and control, and often must sit on the sidelines as the issuer’s creditworthiness declines. Moreover, when borrowers do default, loan investors, as a result of their collateral and senior position, recover at a consistently higher rate than bond investors. Recoveries post-bankruptcy typically average 70% for loans versus 40% for bonds, according to numerous data studies over

Heavy Dose of Defaults Loan defaults reached a hefty 11% in 2009.

Default Rate

Source: S&P/LSTA Leveraged Loan Index

An investor who held the S&P/LSTA loan index through the three-year period from 2008 to 2010 would have lost 29% the first year, gained 52% the following year, and made an additional 10% in 2010, for a respectable 19% gain over the period (see chart above). This positive perform- ance is in spite of a loan market default rate that hit 11%. That was higher than even the worst level reached in the previous high-default period of 1999 to 2003, when loan default rates reached almost 8% (see chart on right). “Loans are hardly a new asset class,” points out Scott Page, vice president, portfolio manager & director of Eaton Vance Floating Rate Loan Group. “Loans have

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many years. This translates into a substantial “credit expense” differential for a diversified portfolio of loans compared to a similar portfolio of bonds. Over time, loans Burger King Financing incur credit losses a bit less than one-half those of bonds (see example below). While the 2 to 1 ratio of high-yield bond credit losses The recent Burger King financing shows how to corporate-loan credit losses tends to hold throughout companies utilize both loans and bonds to complete credit cycles, the absolute advantage increases as the major deals. The buyout was for just over $4 billion, economy worsens and defaults increase. Conversely, the of which just over two-thirds or $2.8 billion was absolute advantage decreases as defaults drop. A current raised as debt (loans and bonds) with the new owner example of how this structural advantage works in practice providing $1.3 billion in equity. is the recent Burger King loan. Craig Russ, vice president and portfolio manager in the Eaton Vance Floating Rate Loan Group, views Burger King as a prototypical example Loan Financing of the loan asset class. “The secured loan is at the top of Revolving credit facility – 5 years $150 million the , with junior capital – equity and the Term Loan – 6 years $1.85 billion high-yield bond – providing a good cushion. And it’s got Total Loans $2 billion an attractive spread.” (See sidebar for details.) High Yield Bond – 8 years $800 million The structural of loans, combined with their Total Debt $2.8 billion floating interest rates, is a powerful combination in terms of being able to perform well in various types of economic Equity $1.3 billion scenarios. “Loans are the fixed-income asset class for all Total Funding $4.1 billion seasons,” said Dan Norman, senior vice president and group head of ING's Senior Loan Group. “While the floating rate advantages are clear and apparent in an expansive, rising interest-rate environment, loans have Deal features, risk and reward also significantly outperformed not only traditional The loans are secured by all of Burger King’s do- fixed-income instruments such as Treasuries, investment mestic US assets and two-thirds of the stock in its grade and non-investment grade corporate bonds, but foreign subsidiaries. They bear interest at LIBOR + also equities in prior recessionary cycles. Therefore, 4.5% (4.75% for a small Euro tranche), with a LIBOR loans are attractive long-term investments for institutional “floor” of 1.75%, for a total coupon of 6.25% (6.5% in investors.” ◆ Europe). The loan was sold at a discount of 99%, bringing the yield up to 6.62% (US) and 6.88% (EURO). Portfolio Credit Costs: Doing the Math The bonds are unsecured, ranking behind the loans in the event of default. With a fixed rate of Assume two portfolios with identical credit profiles in terms of default likelihood 9.875%, they were sold at par. We look to the 8-year (a mix of single-Bs and double-Bs with a blended default probability of 4% point on the Treasury yield curve – 3% – minus the per year*), but one portfolio consists of high-yield bonds (40% recoveries on 3-month T-Bill rate of 12 basis points to estimate the average) and the other of senior secured loans (70% recoveries on average). “interest rate bet” portion of the coupon. The re- maining 7% is what the bonds pay for credit risk. HY bond portfolio: 4% defaults, with 40% recovery/60% loss Burger King, as a corporate entity, is rated B and B2 respectively by S&P and Moody’s. The loan Results in an annual 4% X 60% = 2.4% portfolio loss credit expense of: and bond were notched up (the loan) and notched down (the bond) from the corporate ratings to differ- Senior secured 4% defaults, with 70% recovery/30% loss entiate the starkly different risks, as follows: loan portfolio: • Loans were notched up two notches, to BB-and Results in an annual 4% X 30% = 1.2% portfolio loss Ba3, as lenders are expected to be repaid in credit expense of: full if Burger King defaults • Bonds were notched down to B- and Caa1, The loan portfolio credit expense is only half that of the bond portfolio, at indicating both rating agencies expect losses any level of default, because the secured loans consistently recover at a of 50% to 70% in a default higher rate than the unsecured and sometimes subordinated high-yield bonds. In absolute terms, of course, the difference becomes greater at higher default rates. For example, at a 5% default rate bonds suffer a The slight difference in coupons indicates bond- portfolio credit loss of 3% vs. loans at half of that, or 1.5%. At an 8% holders being paid from 1/8th to 3/8th percent more default rate, bonds lose 4.8%; loans 2.4%. for taking the additional risk. Typical default costs *In reality, this understates the advantage enjoyed by loans, since occasionally a borrower strapped for cash on high yield bond portfolios could run 1-2% yearly, will default on its unsecured (or subordinated) bond, but continue to make payments on its senior secured versus less than half that on loan portfolios, which loan. That will count as a bond default, but not a loan default, in compiling the statistics. So the default rate for loans is actually a bit lower than it is for bonds, even for an identical cohort of issuers. more than offsets the gross coupon differential.

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