Investment Primer Floating Rate Loans

Transcription

1 Investment Primer Floating Rate Loans Joseph Lynch portfolio manager Bank Loan Management Stephen Casey portfolio manager Bank Loan Management January 2013 Floating rate loans, also known as leveraged loans, bank loans or senior floating rate loans, are short-term debt obligations that banks and other financial entities make to large corporations that typically have below investment grade credit ratings. The loans finance mergers and acquisitions, leveraged buyouts (LBOs), recapitalizations, capital expenditures and other general corporate purposes. The loans are then syndicated, or sold, to institutional investors. The loans earn a spread which is a reflection of credit risk plus a floating base rate, typically LIBOR. 1 The base rate (e.g., LIBOR) resets on a regular basis, typically every 30 to 90 days, therefore the coupon is said to adjust, or float, as the base rate changes. Floating rate loans are generally considered senior secured debt in the capital structure of a company. In the event of default or bankruptcy, the holders of the loans may be in a better position to maximize recovery because they often have a first priority claim, or lien, on the assets of the borrower and could be repaid before other securities issued by the company, such as high yield debt, preferred or common stock. Floating rate loans are generally secured by assets such as equipment, receivables, inventory, real estate, stock, trademarks and patents. In this primer, we provide a broad overview of this asset class. HOW FLOATING RATE LOANS WORK Floating rate loans are structured, arranged and administered by one or several commercial or investment banks known as arrangers. Arrangers serve the investment-banking role of raising investor dollars for an issuer in need of capital. The issuer pays the arranger a fee for this service. In order for issuers whose credit ratings are below investment grade to attract the interest of non-bank investors, they typically need to offer spreads paying LIBOR+200 basis points or higher. In the U.S., the floating rate loan market started in the mid-1980s with large leveraged buyout loans and today has become the dominant way for issuers to tap banks and other institutional capital providers for loans. The reason is simple: floating rate loans are generally a less expensive method of borrowing and are pre-payable at par. 2 The predominance of leveraged loans in the U.S. has also made it a rated market, with Standard & Poor s rating about 70% of all new leveraged loans up from 45% in 1998 (and there were virtually no ratings before 1995). This is not surprising, considering that most 1 LIBOR represents the London Interbank Offered Rate. This is the rate at which banks lend each other money in the wholesale money market. 2 Standard & Poor s, A Guide to the Loan Market, September

2 investment primer: Floating Rate Loans investors in the U.S. leveraged loan market are now non-bank institutional investors who are accustomed to having ratings on the debt instruments they buy. 3 Figure 1: S&P/LSTA Leveraged Loan Index Par Amount Outstanding by facility Rating NR: 3.5% D: 2.4% C: 0.7% CC: 0.1% CCC-: 0.3% CCC: 3.9% CCC+: 3.9% B-: 3.6% BBB: 1.2% BBB-: 5.8% BB+: 6.0% BB: 10.9% B: 15.9% BB-: 18.0% B+: 24.1% Source: S&P/LSTA Leveraged Loan Index December 2012 Review. See disclosures at the end of this material, which are an important part of this presentation. Credit ratings are subject to change at any time. The ratings above are issued by S&P. Ratings of BBB and higher are considered to be investment grade while ratings of BB and lower are considered to be non-investment grade (junk bonds). LOAN CREDIT AGREEMENT All floating rate loans are governed by a credit agreement which serves in a similar capacity to an indenture for a bond. Lenders also stand to benefit from certain protective covenants that are often placed on most loans. There are three primary types of loan covenants: financial, negative and affirmative. Financial covenants enforce minimum financial performance measures against the borrower, such as a company maintaining a minimum EBITDA (earnings before interest, taxes, depreciation and amortization). The presence of these maintenance covenants so called because the issuer must maintain quarterly compliance or suffer a technical default on the loan agreement is a critical difference between loans and bonds. Bonds, by contrast, usually contain incurrence covenants that restrict the borrower s ability to issue new debt, make acquisitions or take other actions that would breach the covenant. Negative covenants limit the borrower s activities in some way. Negative covenants, which are highly structured and customized to a borrower s specific condition, can limit the type and amount of investments, new debt, liens, asset sales, acquisitions and guarantees. Affirmative covenants state what action the borrower must take in order to be in compliance with the loan. These covenants are usually boilerplate and require a borrower to pay the bank interest and fees, maintain insurance, pay taxes and so forth. 3 Standard & Poor s, A Guide to the Loan Market, September

3 investment primer: Floating Rate Loans Lenders will look to these covenants as a means to renegotiate the terms of a loan if the issuer fails to meet any covenant. Loan holders, therefore, almost always are first in line among prepetition creditors and, in many cases, are able to renegotiate with the issuer before the loan becomes severely impaired. PRICING ON FLOATING RATE LOANS The return on a floating rate loan is derived from three components: the base rate (typically LIBOR), the credit spread and the issue price. The base rate usually resets every 30 to 90 days, resulting in a floating rate. In low rate environments and/or during difficult market conditions, arrangers may offer LIBOR floors as an incentive for lenders. As the name implies, LIBOR floors put a floor under the base rate for loans. For example, if a loan has a 1.5% LIBOR floor and three-month LIBOR falls below this level, the base rate for any resets defaults to 1.5%. The credit spread on a loan reflects credit quality and certain market-based factors, such as liquidity and market technicals. The original issue discount (OID) is the discount from par value at the time a loan is sold to investors, and is offered in the new issue market as a spread enhancement. A loan may be issued at 99 to pay par. The OID in this case is said to be 100 basis points, or one percent. LOAN MARKET INVESTORS There are four primary types of investors in the market: institutional investors, retail investors, banks and finance companies. Institutional investors participate in the loan market principally through separately managed accounts and structured vehicles known as collateralized loan obligations (CLOs). CLOs are special-purpose vehicles set up to hold and manage pools of leveraged loans. Retail investors can access the loan market through loan participation mutual funds which are mutual funds invested in leveraged loans. (These are sometimes known as prime funds because they were originally marketed to investors as a money market-like fund that would approximate the prime rate). Banks are typically commercial banks that provide unfunded revolving credits, letters of credit (LOCs) and although they are becoming increasingly less common amortizing term loans, under a syndicated loan agreement. Finance companies have consistently represented less than 10% of the leveraged loan market, and tend to play in smaller deals $25 million to $200 million. These investors often seek asset-based loans that carry wide spreads and that often feature time-intensive collateral monitoring. In addition, hedge funds, high yield bond funds, pension funds, insurance companies and other proprietary investors also participate in loans. 3

4 investment primer: Floating Rate Loans (continued) Figure 2: Primary Market for Highly Leveraged Loans (Excludes Banks) 2012 Insurance Companies: 4% Finance Companies: 2% Prime Rate Fund: 15% Collateralized Loan Obligations (CLOs): 55% Hedge, Distressed & High-Yield Funds: 23% Source: S&P Capital IQ Leveraged Commentary and Data, Loan Stats, December See disclosures at the end of this material, which are an important part of this presentation. Excludes left and right agent commitments (including administrative, syndication and documentation agent as well as arranger). For 1H08, all deals includes block sales like TXU while new deals include only deals launched and structured this year. Excludes RC-only ABLs. TRADING FLOATING RATE LOANS Investors are free to trade floating rate loans after the loan is allocated. Loan sales are typically structured as assignments. In an assignment, the assignee becomes a direct signatory to the loan and receives interest and principal payments directly from the administrative agent. Investors usually trade through dealer desks at the large underwriting banks. Figure 3: Secondary Loan Market trading Annual Trade Volume (billions) $550 $500 $450 $520 $510 $474 $400 $413 $409 $393 $350 $ EST Source: The 3Q 2012 LSTA Secondary Trading & Settlement Study. 4

5 investment primer: Floating Rate Loans (continued) LOAN MARKET SIZE/COMPOSITION The breadth of the loan market is found in the S&P/LSTA Leverage Loan Index, which cites total assets in the category of $551 billion as of December 2012 across over 800 unique issuers and multiple industry sectors. The majority of the assets are held in CLOs, with the balance held in separate accounts and retail mutual funds. Figure 4: S&P/LSTA Leveraged Loan Index Par Amount Outstanding by industry Other: 15.4% Health care: 10.3% Drugs: 1.9% Leisure: 2.2% Aerospace and Defense: 2.3% Food products: 2.4% Food service: 2.5% Oil and gas: 2.8% Cable television: 3.5% Chemical/Plastics: 3.6% Hotels/motels/inns and casinos: 3.7% Business equipment and services: 8.0% Publishing: 6.0% Electronics/electric: 5.8% Broadcast radio and television: 3.8% Automotive: 3.9% Telcommunications: 5.4% Retailers (other than food/drug) 5.4% Financial Intermediaries: 5.5% Utilities: 5.8% Other Air Transport 1.08% Beverage and Tobacco 0.11% Building and Development 1.62% Clothing/Textiles 0.15% Conglomerates 0.78% Containers and glass products 1.05% Cosmetics/Toiletries 0.88% Ecological Services and Equipment 0.75% Equipment Leasing 0.55% Farming/Agriculture 0.11% Food/Drug Retailers 0.99% Forest Products 0.02% Home Furnishings 0.54% Industrial Equipment 1.38% Insurance 1.80% Nonferrous Metals/Minerals 1.12% Steel 1.52% Surface Transport 0.95% Source: S&P/LSTA Leveraged Loan Index December 2012 Review. See disclosures at the end of this material, which are an important part of this presentation. 5

6 investment primer: Floating Rate Loans (continued) DIVERSIFICATION AND RETURNS OF FLOATING RATE LOANS In terms of credit quality, floating rate loans typically fall between investment grade corporate bonds and high yield bonds. Floating rate loans tend to have a better credit rating than high yield bonds issued by the same borrower, due to their security and seniority. Figure 5: risk and reward tradeoff Emerging Market Debt High Yield Bank Loans Core Plus Short Duration Core Expected Volatility For illustrative purposes only. The seniority and security of bank loans as well as their floating rate nature make them relatively more stable than high yield bonds. The two primary loan market indices, the CSFB Leverage Loan Index and the S&P/LSTA Leverage Loan Index, which were created in 1993 and 1997, respectively, have each realized only one year of negative returns since they first became available. Figure 6: S&P/LSTA Leveraged Loan Index Total Returns by Year 51.6% 55% 45% 35% 25% 15% 5% 7.6% 5.2% 3.7% 5.0% 4.1% 1.9% 9.8% 5.1% 5.0% 6.7% 2.0% 10.1% 1.5% 9.7% -5% -15% -25% -35% -29.1% Source: S&P/LSTA Leveraged Loan Index December 2012 Review. See disclosures at the end of this material, which are an important part of this presentation. 6

7 investment primer: Floating Rate Loans CORE RISK IS CREDIT RISK There are a variety of risks associated with this asset class that any prospective investor should understand fully before investing. The principal factors that banks and institutional investors contend with in buying loans are default risk and loss-given-default risk. Default risk is simply the likelihood of a borrower being unable to pay interest or principal on time. Among the primary ways that accounts judge these risks are credit ratings, financial condition, industry sector trends, management strength and ownership structure. Loss-given-default risk measures how severe a loss the lender would incur in the event of default. Investors assess this risk based on the collateral backing the loan and the amount of other debt and equity subordinated to the loan. Default and loss-given-default concerns are tempered by the loans placement within the capital structure of the company. As the senior-most debt instrument in the capital structure, floating rate loans are typically secured by the majority of the assets of the borrower and are often in a better position to maximize recovery due to having a first priority claim on the assets of the borrower, and are typically repaid before other securities issued by the company. senior secured debt (floating rate loans) high yield debt (unsecured or subordinated) preferred stock common stock Higher priority of payment lower sample capital structure Potential Benefits of Floating Rate Loans We believe floating rate loans can be a valuable part of a diversified portfolio, offering several advantages: Current Income: Meaningful yield opportunities, particularly in the current low interest rate environment. Protection against rising interest rates: With their floating rates, these loans are designed to benefit from rising interest rates and thus can potentially generate increased income in a rising rate environment. Capital preservation: Typically structured as senior, secured instruments, floating rate loans generally hold a first-priority lien on the assets of the borrower and, in the event of a default or bankruptcy, typically result in higher recoveries. 7

8 investment primer: Floating Rate Loans Effective way to enhance diversification: Floating rate loans have historically offered low correlation to other asset classes. Favorable risk/return profile: Floating rate loans have historically demonstrated an attractive risk/return profile relative to other asset classes. Please contact your Neuberger Berman representative for additional information. Neuberger Berman LLC 605 Third Avenue New York, NY This material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such. Opinions expressed are as of the date herein and are subject to change without notice. This material is not intended to be a formal research report and should not be construed as an offer to sell or the solicitation of an offer to buy any security. Past performance is not indicative of future results. The Strategy may invest in senior loans and other debt securities which may be rated below investment grade. The risks of investing in such securities, such as risk of default, could result in loss of principal. Economic and other market events may reduce demand for certain senior loans held by the Strategy, which may impact their value. Loans and other debt securities are also subject to the risk of increases in prevailing interest rates. Generally, bond values will decline as interest rates rise. However, because floating rates on senior loans only reset periodically, changes in prevailing interest rates can be expected to cause some fluctuation in the value of these securities. Similarly, a sudden and significant increase in market interest rates, a default in a loan in which the Strategy owns an interest, or a material deterioration of a borrower s creditworthiness may cause a decline in the value of these securities. Floating rate loans may be more susceptible to adverse economic and business conditions and other developments affecting the issuers of such loans. Although senior floating rate loans are generally collateralized, there is no guarantee that the value of collateral will not decline, causing a loan to be substantially unsecured. No active trading market may exist for many loans, and some loans may be subject to restrictions on resale, which may also prevent the Strategy from obtaining the full value of a loan when sold. This document is issued for use in Europe and the Middle East by Neuberger Berman Europe Limited, which is authorised and regulated by the UK Financial Services Authority ( FSA ) and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER. Neuberger Berman is a registered trademark. 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