The evolving market for floating-rate loans

Transcription

1 TAXABLE FIXED INCOME FUNDS FLOATING-RATE LOANS WHITE PAPER 2012 The evolving market for floating-rate loans This report outlines the key characteristics, evolution and potential portfolio allocation benefits of floating-rate loans an asset class which may be of interest to investors and their advisors in the current market environment. While floating-rate loans (also referred to as senior secured loans, leveraged loans, bank loans or syndicated loans) have been around in one form or another for more than 30 years, in the past decade the market has evolved from a traditional lending market to its current position as a fully developed asset class within the capital markets. 1 AN INTRODUCTION TO FLOATING-RATE LOANS Key characteristics of floating-rate loans (pages 3 6) The process of floating-rate loan issuance (pages 6 7) Types of companies issuing floating-rate loans today (page 8) Given this evolution, we expect floating-rate loans to become a more prevalent part of investors asset allocations moving forward, particularly given their diversification potential and the measure of protection they may help provide in rising-interest-rate and higherinflation environments. In this paper, we address three major topics we expect will be of particular interest to clients researching the floating-rate loan market. Contributors Ty Anderson, managing director, global head of high-yield strategies Eric Meyer, managing director, head of U.S. loan portfolio management Jason Vassil, director, fixed-income product specialist 2 THE EVOLUTION OF THE FLOATING-RATE LOAN MARKET A rise in popularity in the 1990s (page 9) Greater transparency for floating-rate loans (page 9) A brief history of the floating-rate loan market (page 10) 3 FLOATING-RATE LOANS WITHIN ASSET ALLOCATION Diversification opportunities relative to traditional high-yield (pages 11 12) Seeks a measure of protection from higher interest rates (page 12) Seeks a measure of protection from higher inflation (page 14) Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. Investment products: No bank guarantee I Not FDIC insured I May lose value

2 Summary of floating-rate loan key characteristics SENIOR SECURED Floating-rate loans are senior in a firm s capital structure and secured by the issuing company s assets, historically resulting in attractive default and recovery rates (see page 5 6 for details). DIVERSIFICATION Investment-grade and floating-rate loans have offered a negative correlation to each other for the 10-year period ended 9/30/12 (see page 12 for details). Given this negative correlation, adding a 30% floatingrate loan allocation to a hypothetical all-investmentgrade bond portfolio would have reduced overall portfolio risk as of 9/30/12 (see page 12 for details). POTENTIAL PROTECTION FROM HIGHER INFLATION The total balance sheet of the Federal Reserve hit an all time high of $2,787 billion, according to the Federal Reserve as of 9/27/12. This influx of liquidity could be cause for inflationary pressures. Generally, inflation is associated with periods of higher interest rates and stronger economic growth. Historically, during these periods, floating-rate loans have shown solid performance relative to intermediateterm, investment-grade (see page 13 for details). This characteristic is supported by the high correlation between floating-rate loan returns and inflation, and the low correlation of intermediate-term, investment-grade and inflation (see page 14 for details). Past performance is historical and does not guarantee future results. POTENTIAL PROTECTION FROM HIGHER INTEREST RATES Floating-rate loans offer a coupon that resets to higher interest rates, helping to mitigate interest-rate risk. In fact, as interest rates move higher, this coupon reset may lead to potentially higher returns for floatingrate loans as additional income payments boost returns and drive demand. While past performance does not guarantee future results, in any 12-month period from 2/92 through 9/12 in which interest rates increased by one percentage point or more, floating-rate loans substantially outperformed intermediate-term, investment-grade (see page 13 for details). IMPORTANT RISK INFORMATION Bond and loan investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lowerquality ( junk ) and non-rated securities present greater risk of loss than investments in higher-quality securities. Floating rate loans tend to be rated below investment grade. The fund may use derivatives, including as part of its Global Tactical Asset Allocation (GTAA) strategy. Investing in derivatives entails special risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. In certain situations, it may be difficult or impossible to sell an investment at an acceptable price. This fund is non-diversified and can take larger positions in fewer issues, increasing its potential risk. The fund may lend securities to approved institutions. See the prospectus for details. 2» The evolving market for floating-rate loans

3 1 I An introduction to floating-rate loans Floating-rate loans are variable-rate, senior-secured-debt instruments issued by non-investment-grade companies. Floating-rate loans have three characteristics which make them unique as compared to most traditional fixedincome investments. Each of these characteristics will be discussed in more detail throughout the paper. Building on these key characteristics, we will also explore how allocating a portion of a portfolio to floating-rate loans can help add greater diversification and a measure of protection from rising interest rates and higher inflation. Of course, diversification neither assures a profit nor guarantees against loss. In the floating-rate loan structure, two or more parties agree to make a loan to a borrower, with each lender having a separate claim on the debtor, although there is a single loan contract. Given that floating-rate loans are not publicly registered securities, they differ from traditional in regard to who can generally purchase loans. Direct purchases of floating-rate loans are generally limited to institutions or accredited investors. However, today non-accredited or non-institutional investors are easily able to gain access to floating-rate loans through mutual funds. Floating-rate loans have come to serve an important purpose in today s lending markets as they provide companies with an alternative to funding operations through high-yield bond issuance or bilateral commercial bank loans. Historically, while banks made up the vast majority of lenders, in the past decade institutional investors, such as mutual funds, have become the most prevalent market lenders, according to S&P/LSTA. BENEFITS OF FLOATING-RATE LOAN ISSUANCE Benefits to the borrower Lower borrowing cost relative to bond and equity issuance An additional source of funding that would not be available through bilateral loan agreements or individual lines of credit Less expensive and more efficient to administer than bilateral or individual credit lines Benefits to the lender Contractual control of company activities Senior in capital structure Collateral Diversification Most loan agreements require that a company maintain a pre-determined level of financial ratios (e.g., debt/coverage) in order to avoid violating the loan terms Loan holders are first to be paid income and principal, leading to greater recovery rates in case of default Generally, loans are secured by assets that can be transferred to the holder of the loan in case of default, leading to higher recovery rates Because multiple parties are involved in lending to a corporate entity, investors avoid excessive single-name exposure Floating-rate loans at a glance Floating-rate loans are issued with floating-rate coupons that are tied to a variable rate index, most commonly, the London Interbank Offered Rate (LIBOR), and reset every 30 to 90 days. 1 Floating-rate loans are senior in a firm s capital structure, meaning investors receive principal and income before equity or other debt holders. Floating-rate loans are secured by the issuing company s assets, which can be transferred to the loan holder in case of default. The evolving market for floating-rate loans» 3

4 KEY CHARACTERISTICS OF FLOATING-RATE LOANS While floating-rate loans are debt of non-investment-grade companies, there are some key differences between floating-rate loans and traditional non-investment-grade, each of which this paper will discuss in detail. CHARACTERISTICS OF FLOATING-RATE LOANS AND HIGH-YIELD BONDS Characteristic U.S. loans U.S. high-yield Relative benefits Fixed/floating rate Floating rate Mostly fixed rate Loans offer floating-rate coupons, which potentially offer less interest-rate risk Seniority Senior Senior or subordinated Loans are the most senior debt in the capital structure of noninvestment-grade companies Security Secured Unsecured Loans are generally secured by company assets, potentially leading to higher recovery rates Term at issuance 6 to 9 years 7 to 10 years Loans are generally slightly shorter-term Liquidity Lower Higher However, loans generally are less liquid than high-yield FLOATING-RATE COUPON One key characteristic of floating-rate loans is that their coupons float and are tied to a variable interest rate such as LIBOR. Therefore, a floating-rate loan will be issued with a coupon that pays a predetermined excess rate above that variable interest rate. This excess rate, or spread, will be determined by several factors, including the credit quality of the loan at issuance, maturity of the loan and collateral. 2 Generally speaking, the higher the risk of the loans (i.e., the lower their credit quality), the higher the spread associated with the loan. Historically, average yields on loans have ranged anywhere from 4.3% to 19.9% depending on the credit quality of the loan (source: S&P/ LSTA, 3/31/02-8/31/11). As the example at right highlights, when a loan coupon s variable rate increases, the loan s interest payment increases accordingly. Loan coupons generally reset to the new variable rate every 30 to 90 days depending on the issue. This floating-rate component of loans helps to mitigate interest-rate, or duration, risk. 3 Unlike a fixed-rate instrument, whose price will increase or decrease inversely to the interest-rate move, the price of floating-rate loans would not be expected to increase or decrease due to interest-rate moves; however, the higher interest rates should provide investors with higher income payments as the loan coupon payments reset. A point to note: While interest payments are not expected to impact loan pricing, other factors, such as negative credit events and changes in loan supply and demand, would potentially impact loan prices. What happens to a variable-rate loan when LIBOR moves from 50 bps to 100 bps? Loan coupon = LIBOR bps Before LIBOR increase LIBOR (50 bps) bps = loan coupon (300 bps) After LIBOR increase LIBOR (100 bps) bps = loan coupon (350 bps) Source: S&P/LSTA. A basis point (bps) is one hundredth of a percentage point. This example is hypothetical and is not intended to represent the performance of any DWS Investments fund. 4» The evolving market for floating-rate loans

5 SENIORITY Another attractive characteristic of floating-rate loans is that they are senior in the capital structure of noninvestment-grade companies. What this means to investors is that a loan s interest and principal is potentially paid before that of any other equity or debt holders in a firm s capital structure. As a result, the risk of losses on loans relative to traditional non-investment-grade is reduced. For a typical firm, loans comprise about 45% to 50% of the firm s capital structure. Therefore, as income and principal are repaid, loan investors are paid first. If a company defaults, then equity and bond holders take losses first. In short, income and principal repayments flow from the top down (from floating-rate loan investors to equity investors) and losses flow from the bottom up (from equity investors to floating-rate loan investors). As a result, floating-rate loan investors carry lower risk than other investors in the capital structure. SECURED BY ASSETS In the floating-rate loan market, collateral usually includes tangible and intangible assets of the borrower, including assets such as property, equipment, intellectual property, accounts receivable and inventories, among others. In the case of default, these assets can be sold and proceeds dispensed to the loan investor. This aspect of loans is highly attractive because it helps to mitigate downside risks associated with the investment. It is also important to note that in some cases loans may be over-collateralized. This simply means there are generally more assets or collateral than the outstanding value of the loan. While this aspect of floating-rate loans does not immunize investors from potential losses, it does help to minimize potential losses, as highlighted by floatingrate loans higher recovery rates, which will be discussed in more detail later in this paper. In addition, this may help provide investors with a measure of protection from potential deterioration of asset or collateral value. A TYPOLOGY OF FLOATING-RATE LOANS Floating-rate loans (Senior secured loans) (Generally 45% to 50% of firm s capital structure) Floating-rate loans Characteristic Most senior debt obligation in capital structure Secured by assets Benefit Interest and principal paid before equity and debt holders A measure of downside protection in case of default Second-lien loans Mezzanine loans Junior secured capital Floating-rate loans High-yield Unsecured capital (second-loss capital) Senior unsecured Equity First-loss capital Seniority Senior subordinated Subordinated Equity Characteristics and benefits of floating-rate loans Source: Deutsche Asset Management. The evolving market for floating-rate loans» 5

6 The senior-secured aspect of floating-rate loans is an important characteristic to shareholders as highlighted by historical default and recovery rates. As a way of explanation, a default occurs when a borrower does not make interest or principal payments as agreed upon. A recovery rate is the percentage of the outstanding loan or debt value which is recovered by an investor in the case of default. For example, if a company defaults and an investor realizes a 100% recovery rate, then the entire value of the outstanding loan was recovered by an investor. On the other hand, if the recovery rate is 50%, then an investor only recouped 50% of the initial investment. From 2001 to 2011, floating-rate loans have experienced about half of the default rate of traditional noninvestment-grade. From 1987 to 2011, they provided a recovery rate of about 80% on average. Compare this latter figure to traditional subordinated debt, which has an average recovery rate of 29%. In short, this means that given the senior secured aspect of floatingrate loans, even in the case of default, investors recouped 80% of what was owed to them, while a subordinated debt investor recouped only 29%. This lower default rate and higher recovery rate highlight the potential protection floating-rate loans may offer investors relative to traditional unsecured or subordinated debt. FLOATING-RATE LOANS OFFERED ATTRACTIVE DEFAULT AND RECOVERY RATES 8% 7% 6% 5% 4% 3% 2% 1% 0% 90% 80% 70% 60% 50% 40% 30% 20% 10% 3.24% 6.21% 80.3 % 48.5% 28.7% 0% Average default rate from Average recovery rate from Floating-rate loans High-yield Senior unsecured Subordinated debt Source: Moody s Investor Services as of 12/31/11. Past performance is historical and does not guarantee future results. Default rate is for the trailing 12-month period. Default rates for 2001, 2002, 2003 and 2004 are by number of issuers. Subsequent to 2004, the default rate is dollarweighted. Default is defined as missed interest or principal disbursement, bankruptcy, distressed exchange or an ongoing covenant violation. Average recovery rates over other time periods might not be as favorable. THE PROCESS OF FLOATING-RATE LOAN ISSUANCE For those who are somewhat unfamiliar with floating-rate loans, loan structuring and issuance may seem complex, but in reality it is relatively straightforward. Floating-rate loan issuance begins when a company (or issuer) decides to raise capital through the loan market instead of the debt or equity markets. This firm will reach out to a commercial or investment bank (known as an arranger) to facilitate the loan issuance. An arranger serves the role of raising investor dollars for a firm that is need of capital. Before awarding a mandate, the issuer might solicit bids from a variety of arrangers. 6» The evolving market for floating-rate loans

7 Once the mandate is awarded, the syndication process starts. The arranger will prepare an information memo describing the terms of the transactions. The information memo typically will include a variety of information, including the issuing firm s financial statements, terms and conditions of the loan and collateral, etc. Loans are not securities, so the offering is usually confidential and made only to qualified and accredited investors. (However, as previously mentioned, today non-qualified investors have the ability to invest in loans through mutual funds.) As the information memo is prepared, the arranger solicits informal feedback from potential investors about interest in the deal and potential pricing. After this information has been gathered, the arranger will formally market the deal to potential investors. Once investors in the loan are finalized and the loan is closed, the final terms are then documented in detailed credit and security agreements. During the process an administrative agent, which is generally a bank, is chosen to handle and transmit all interest and principal payments to investors in the loan. Following issuance, loan terms can be revised and amended from time to time, but amendments require approval from the investors. A GROWING MARKET FOR FLOATING-RATE LOANS The floating-rate loan market has grown more quickly in recent years relative to the non-investment-grade (highyield) bond market. As of 12/31/11, the floating-rate loan market had $518 billion in outstanding loans about half of the high-yield market. FLOATING-RATE LOAN ISSUANCE PROCESS Loan is a direct debt obligation of the issuing company Issuing company Company which borrows money through syndication process. Loan becomes a direct debt obligation within firm s capital structure. Lead arranger or bookrunner Bank hired by borrowing company to structure syndicate, promote and sell the loans to investors. Administrative agent Bank which handles and transmits all interest and principal payments to investors and monitors the loan. Loan investors (participants) Investors providing the funds to the issuing company by purchasing the loan. Consists of more than one investor. The secondary market for floating-rate loans While the above description highlights loan issuance on the primary market, a highly active secondary market for loans also exists. Secondary sales occur after the loan has closed and been allocated, and investors are free to trade the loan. Investors usually trade through dealer desks and can sell or buy loans in one of two ways: assignment or participation. In the assignment arrangement, the new owner of the loan (assignee) becomes a direct signatory of the loan and receives interest and principal payments directly from the issuer of the loan (through the administrative agent). Assignment typically requires consent of both the borrower and agent. In short, the purchaser of the loan becomes its legal owner. In the participation arrangement, the original investor remains the legal owner of the loan but agrees to allow another investor to share in a portion of the loan for a fee. Therefore, the new purchaser receives interest payments on a portion of the loan but is not a legal owner of the loan. The evolving market for floating-rate loans» 7

8 GROWTH OF FLOATING-RATE LOAN MARKET VS. HIGH-YIELD BOND MARKET $ billions Floating-rate loans outstanding Source: S&P/LSTA as of 12/31/11. High-yield outstanding TYPES OF COMPANIES ISSUING FLOATING-RATE LOANS Today a broad and diverse universe of companies, across multiple sectors, issues floating-rate loans. The S&P/LSTA Syndicated Loan Index contains more than 1,000 loans across nearly 40 industries from about 600 issuers, such as Georgia-Pacific, Goodyear Tire & Rubber, Delta Airlines, Ford Motor and Wrigley to name a few. FLOATING-RATE LOANS ISSUES BY COMPANIES FROM VARIOUS SECTORS Health care Business equipment and services Publishing Utilities Financial intermediaries Telecommunications Retailers (other than food/drug) Electronics/electric Broadcast radio and television Automotive Cable television Chemical/plastics Hotels/motels/inns and casinos Food service Food products Oil and gas Leisure Building and development Aerospace and defense 10.50% 8.07% 6.20% 6.05% 6.02% 5.57% 5.38% 5.21% 4.18% 4.07% 4.01% 3.85% 3.16% 2.94% 2.71% 2.33% 2.30% 2.26% 2.12% Source: Standard & Poor s and Morningstar as of 9/30/12. 0% 2% 4% 6% 8% 10% 12% 8» The evolving market for floating-rate loans

9 2 I The evolution of the floating-rate loan market A RISE IN POPULARITY IN THE 1990S Over its evolution the loan market has become much more transparent, and information is increasingly available. Two key unsustainable factors led to floatingrate loan fund success and popularity in the early- and mid-1990s. First, floating-rate loans generally were not rated by any credit rating agencies until the mid-1990s, and then, until more recent years, only on a limited basis. (In 1996, Standard & Poor s began rating corporate floating-rate loans, according to the Milken Institute, 2004.) Second, the secondary market for loans was limited, as floating-rate loans were valued within floating-rate loan funds at fair value and not market value. 4 In January 1996, The Loan Syndications and Trading Association (LSTA), began providing monthly mark-to-market pricing based upon dealer quotes. 5 In late 1999, the LSTA Licensed Loan Pricing Corp. began to run the mark-to-market service, which resulted in an overnight four-fold growth in the number of loans priced daily. These two aspects of floating-rate loans caused most investors to view loan mutual funds as more conservative cash alternatives. Because of the lack of ratings, some investors were not aware that these were non-investmentgrade securities, and given the fair value pricing of loans, price movement on loans or the funds that invested in them was minimal. In short, floating-rate loan portfolios had very little pricing and investment transparency. GREATER TRANSPARENCY FOR FLOATING-RATE LOANS However, the environment for floating-rate loans changed dramatically between 2000 to 2002 as the pending recession and regulatory changes left some floating-rateloan fund investors surprised. In 2000, the Securities and Exchange Commission (SEC) mandated that floating-rate loan managers begin pricing securities at mark-to-market levels. The new pricing transparency associated with the mark-to-market rules led to floating-rate-loan funds to experience negative returns for the first time, according to Morningstar (whose Bank Loan category experienced its first monthly loss in March of 2001 following more than 12 years of consecutive monthly gains, according to Morningstar). The credit crises of 2007 to 2008 were also important for the floating-rate loan market. A deteriorating economy, increasing default rates and a vicious cycle of financial deleveraging drove loan prices to historic lows was the first calendar year loss for the floating-rate-fund category since its inception in While the market downturn was driven in a large part by technical factors such as a lack of liquidity and supply/demand factors, the subsequent rebound quickly brought back loan valuations, making up most of the 2008 losses. (See next page for a detailed history of floating-rate-loan performance.) Like any investment with credit risk, the economic environment that is advantageous for potentially increasing or reducing exposure is a key factor to success. When used correctly, floating-rate loans can offer attractive opportunities, which we will now discuss. STAGES OF FLOATING-RATE LOAN MARKET DEVELOPMENT The floating-rate loan market has grown rapidly in recent years, with total loans outstanding having grown from $35 billion in 1997 to $508 billion as of 12/31/11 (source: S&P/LSTA). Three stages of floating-rate loan history 1970s and early 1980s Mid-to-late 1980s 1990s to today The primary market for floating-rate loans was dominated by government borrowers of emerging economies. This period of development was driven by the boom in mergers and acquisitions and leveraged buyout activity. General corporate funding has become the dominant part of the floating-rate loan market. The evolving market for floating-rate loans» 9

10 A BRIEF HISTORY OF FLOATING-RATE LOANS (Morningstar Bank Loan category monthly returns, ) Pilgrim Fund launches 2000 SEC mandates mutual funds mark loans to market value 2002 Recession drives default rates to 7.41% 2009 Great credit recovery: Prices rise even as defaults hit record high of 10.87% Return % Van Kampen and Eaton Vance funds launch 6 March 2001 Bank loan category has first monthly loss 2008 Liquidity/credit crunch drives prices to all-time lows 15 12/89 12/92 12/95 12/98 12/01 12/04 12/07 12/10 12/11 Time period MORNINGSTAR BANK LOAN CATEGORY RETURNS % 6.21% 5.70% 6.60% 7.80% 6.75% 7.31% 6.28% 6.23% 6.23% 2.30% % 10.11% 5.02% 4.58% 6.61% 1.08% 30.22% 41.44% 9.44% 1.63% Source: Morningstar and DWS Investments as of 12/31/11. Source for default rates is Moody s Investor Services. Past performance is historical and does not guarantee future results. Data is for illustrative purposes and does not represent any DWS Investments fund. Category returns do not reflect fees or expenses. It is not possible to invest directly in a category. Performance over other time periods might not be as favorable. 10» The evolving market for floating-rate loans

11 3 I Floating-rate loans within asset allocation Institutional clients have long recognized the benefits of investing in floating-rate loans. However, in the past decade more retail investors have also begun to recognize how allocating to floating-rate loans can potentially benefit a portfolio. In this next section, we explain the three unique benefits of floating-rate loans. Asset allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. DIVERSIFICATION BENEFITS RELATIVE TO TRADITIONAL HIGH YIELD Investors have historically limited fixed-income allocations to only two markets: investment-grade and subinvestment-grade. However, institutional investors have long recognized the benefits of another unique fixedincome asset class in floating-rate loans. This asset class is considered by many to be a hybrid market with a risk/ return profile that falls between that of investment-grade and non-investment-grade. Floating-rate loans and investment-grade carry different risks, and when used in combination, they may offer an opportunity for an attractive return stream that can potentially benefit investors during multiple market cycles. The chart below highlights differences in key risk characteristics. Adding floating-rate loans can aid portfolio asset allocation Diversification: The risk/return characteristics of floating-rate loans are unique in that they fall between traditional investmentgrade debt and sub-investment-grade debt, making them a key diversification tool. Diversification neither assures a profit nor guarantees against loss. Potential protection from higher interest rates: Floating-rate loans offer floating-rate coupons, which can help mitigate interest-rate, or duration, risk. Potential protection from higher inflation: Floating-rate loans have historically offered a measure of protection from higher inflation because the environments in which they tend to outperform are generally the same environments that lead to higher inflation (according to Morningstar as of 9/30/12; see page 14). Past performance is no guarantee of future results. DIFFERENCES IN KEY RISK CHARACTERISTICS Interest-rate risk Credit risk Liquidity risk Income potential Potentially optimal environment Floating-rate loans Low Medium Medium Medium Strengthening economy / rising rates Investmentgrade Non-investmentgrade Low to high Low Low Low Weak economy / falling rates Medium High Medium High Strengthening economy / flat rates Source: Deutsche Asset Management. The evolving market for floating-rate loans» 11

12 Given that investment-grade carry less credit and liquidity risk but more interest-rate risk, they will generally outperform during periods of weakening economic conditions, which are associated with higher default rates and lower interest rates. However, the opposite holds true for floating-rate loans, which contain a higher level of credit and liquidity risk but minimal interest-rate risk. Therefore, floating-rate loans generally outperform during periods of improving economic conditions, which are associated with lower default rates and higher interest rates. Of course, past performance does not guarantee future results. The differences between floating-rate loans and investment-grade are what led to the attractive risk/return characteristics. The diversification benefits of combining both floating-rate loans and investment-grade are highlighted by the fact that the correlation between floating-rate loans and investment-grade is 0.02% for the 10-year period ended 9/30/12, according to Morningstar. 7 In turn, the low correlation and diversification benefits have the potential to create a combined portfolio that offers attractive return and yield with lower overall volatility than a 100% investment-grade portfolio (as shown in the chart below). POTENTIAL TO HELP PROTECT AND ENHANCE A HYPOTHETICAL FIXED-INCOME PORTFOLIO Return 6.6% 6.5% 6.4% 6.3% 6.2% 6.1% 6.0% 70% investment-grade /30% floatingrate loans 100% investment-grade Investment-grade vs. floating-rate loans (2/92 9/12) 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% Volatility Source: DWS Investments as of 9/30/12. Past performance is historical and does not guarantee future results. Asset class representation: floating-rate loans, Credit Suisse Leveraged Loan Index, which is designed to mirror the U.S. leveraged loan market; investment-grade, Barclays U.S. Aggregate Index, which represents domestic, taxable investment-grade with average maturities of one year or more. Volatility is represented by standard deviation; the higher the standard deviation, the greater the volatility. Data is for illustrative purposes and does not represent any DWS Investments fund. Index returns do not reflect fees or expenses. It is not possible to invest directly in an index. Performance over other time periods might not be as favorable. POTENTIAL PROTECTION FROM HIGHER INTEREST RATES One of the most attractive features of floating-rate loans is the potential measure of protection they may provide from higher interest rates. There are two main reasons behind floating-rate loan performance during a higher-interest-rate environment. First, the floating coupon associated with floating-rate loans. Given that floating-rate loans reset their coupons payments every 30 to 90 days, they have minimal interest-rate, or duration, risk. Therefore, unlike fixed-rate instruments, which will experience a decline in price as interest rates increase, floating-rate loans will generally benefit from higher interest rates through higher coupon and income payments with minimal impact to the price of the loans. In short, the returns of floating-rate loans would be expected to be higher during periods of rising interest rates given the additional income that is being earned, while the returns of traditional fixed-rate would be expected to be lower during these periods. 12» The evolving market for floating-rate loans

13 The second component of loans that may potentially lead to outperformance during rising-rate environments is that floating-rate loans are impacted more significantly by deterioration of general credit market or economic conditions. In general, their returns are impacted positively during periods of improving economic and credit conditions, which are also generally associated with higher interest-rate cycles. The opposite is true during economic downturns. The chart below highlights the returns of various fixed-income asset classes during periods in which interest rates rose by one percentage point or more since As would be expected, intermediate-and long-term with a high level of interest-rate risk experienced the lowest returns ( 1.11% and 4.13%, respectively). On the other hand, floating-rate loans experienced significantly higher returns (11.70%) over the same periods. The risk higher interest rates may have on an investor s fixed-income allocation is important and that is many times overlooked during portfolio construction. An allocation to floating-rate loans is a compelling option to help investors seek a potential measure of protection from higher interest rates. FLOATING-RATE LOANS OUTPERFORMED WHEN INTEREST RATES HAVE RISEN BY 1% OR MORE (Total percentage returns for asset classes, 2/92 9/12) 12% 9% 6% 3% 0% 3% 11.70% 8.34% 2.43% 2.38% 2.00% 1.49% 1.11% 4.13% 6% Floatingrate loans Highyield Ultrashort-term Shortterm Highyield muni Shortterm muni Intermediateterm Longterm Source: Morningstar as of 9/30/12. Past performance is historical and does not guarantee future results. Asset class representation: floatingrate loans, Credit Suisse Leveraged Loan Index; high-yield, Credit Suisse High Yield Index; ultrashort-term, Morningstar/Ibbotson SBBI U.S. 1-Year Treasury Constant Maturity Yield Index; short-term, Barclays 1-3 Year U.S. Aggregate Index; high-yield muni, Morningstar High Yield Muni category, which includes portfolios invest at least 50% of assets in high-income municipal securities that are not rated or that are rated by a major agency at the level of BBB and below; short-term muni, Morningstar Muni Short category, which includes portfolios invest in issued by state and local governments and have durations of less than 4.5 years; intermediate-term, Barclays 7-10 Year U.S. Aggregate Index; long-term, Barclays 10+ Year U.S. Aggregate Index. This data is for illustrative purposes and does not represent any DWS Investments fund. Index returns do not reflect fees or expenses. It is not possible to invest directly in an index. Performance for other time periods may not be as favorable. Compared to other fixed-income asset classes, floating-rate loans are typically less vulnerable to changes in interest rates and are more sensitive to credit and default risks. Because of their shorter maturities, short-term are typically less vulnerable to rising interest rates than longer-term. Municipal bond income is generally free from federal income tax; income from corporate is subject to federal income tax. The evolving market for floating-rate loans» 13

14 POTENTIAL PROTECTION FROM HIGHER INFLATION Another attractive feature of floating-rate loans is the potential measure of protection that they may offer from higher inflation. While floating-rate loans do not have a specific imbedded inflation hedge, their floating coupons may offer a measure of protection from inflation. There are several reasons this is the case, which we will discuss in more detail. First, inflationary pressures tend to rise during periods of economic expansion, which are also associated with higher interest rates. As discussed in the previous section, a period of economic expansion and higher interest rates tend to lead to outperformance of floating-rate loans. Given that inflation tends to move higher in these periods, loan returns historically have increased during the same periods in which inflation pressures take hold, as highlighted by their high correlation to inflation in the chart below. So while floating-rate loans may not have a direct inflation hedge imbedded in their structure, there is potentially a measure of protection from higher inflation because the environments in which floating-rate loans tend to outperform are generally the same environments that lead to higher inflation. FLOATING-RATE LOANS OFFERED POSITIVE CORRELATION TO INFLATION (10-year period ended 9/30/12) Inflation Floating-rate loans Commodities U.S. TIPS Short-term Large-cap equities Intermediate-term Source for chart: Morningstar as of 9/30/12. Past performance is historical and does not guarantee future results. Asset class representation: inflation, Morningstar/Ibbotson SBBI U.S. Inflation Index, which tracks U.S. inflation; floating-rate loans, Morningstar Bank Loan category, which includes portfolios that primarily invest in floating-rate bank loans instead of ; commodities, DJ/UBS Commodity Index; shortterm, Morningstar Short-Term Bond category, which includes portfolios that invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years; large-cap equities, Morningstar Large Blend category; U.S. TIPS, Morningstar Inflation Protected Bond category, which includes portfolios that invest primarily in debt securities that adjust their principal values in line with the rate of inflation; intermediate-term, Morningstar Intermediate-Term Bond category, which includes portfolios that invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 3.5 to 6.0 years. This data is for illustrative purposes and does not represent any DWS Investments fund. It is not possible to invest directly in a category. Correlation refers to how securities or asset classes perform in relation to each another and/or the market. A 1.0 correlation indicates that two security types move in exactly the same direction. A 1.0 correlation indicates movement in exactly opposite directions. A zero correlation implies no relation in the movements. Correlation over other time periods might not be as favorable. 14» The evolving market for floating-rate loans

15 CONCLUSION Our research finds that floating-rate loans have the potential to provide several potential benefits when added to a fixed-income portfolio s allocation. 1 DIVERSIFICATION OPPORTUNITY First, floating-rate loans may potentially offer attractive diversification opportunities when added to a traditional investment-grade bond portfolio. This is highlighted by the low correlation between the two investments. This low correlation may lead to lower volatility of a combined floating-rate loan/investment-grade bond portfolio relative to an investment-grade-only portfolio (see pages for details). Floating-rate-loan market key points As discussed in the paper, the floating-rate loan market experienced numerous transformations since its inception. It has grown to become a fully developed asset class in size, scope and liquidity and now attracts multiple investor types. Given the growth of today s floating-rate loan market and the opportunities floating-rate loans may provide investors, we believe floating-rate loans will become a more prevalent part of retail investors asset allocations moving forward. 2 POTENTIAL INTEREST-RATE RISK HEDGE Second, floating-rate loans present investors with a tool to help hedge the interest-rate risk that threatens traditional bond asset classes. While past performance is historical and does not guarantee future results, during any period from 2/92 through 9/12 when interest rates increased by one percentage point or more, floating-rate loans provided the highest return compared to a broad range of fixedincome investments, including short-term and intermediate-term (see page 13 for details). 3 POTENTIAL INFLATION-RISK HEDGE Third, floating-rate loans present investors with a tool to help hedge inflation risks that threaten traditional bond asset classes. This is highlighted through the high correlation between inflation and floating-rate loan returns (see page 14 for details). The evolving market for floating-rate loans» 15

16 NOTES 1 LIBOR (London Interbank Offered Rate) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. 2 Credit quality is a measure of a bond issuer s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. 3 Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. 4 Fair value is the estimated value of all assets and liabilities of an acquired company used to consolidate the financial statements of both companies. 5 Mark-to-market is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution's or company's current financial situation. 6 Eaton Vance Floating Rate Advantage Fund: Two International Place, Boston, MA Van Kampen Senior Loan Fund: 1 Parkview Plaza, Suite 100, P.O. Box 5555, Oakbrook Terrace, IL Correlation refers to how securities or asset classes perform in relation to each another and/or the market. A 1.0 correlation indicates that two security types move in exactly the same direction. A 1.0 correlation indicates movement in exactly opposite directions. A zero correlation implies no relation in the movements. Past performance is no guarantee of future results. The opinions and forecasts expressed herein by the fund managers do not necessarily reflect those of DWS Investments, are as of 9/30/12 and may not come to pass. OBTAIN A PROSPECTUS To obtain a summary prospectus, if available, or prospectus, download one from talk to your financial representative or call (800) We advise you to carefully consider the product s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products offered through DWS Investments Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. DWS Investments is part of Deutsche Bank s Asset Management division and, within the U.S., represents the retail asset management activities of Deutsche Bank AG, Deutsche Bank Trust Company Americas, Deutsche Investment Management Americas Inc. and DWS Trust Company. DWS Investments Distributors, Inc. 222 South Riverside Plaza Chicago, IL inquiry.info@dws.com Tel (800) DWS Investments Distributors, Inc. All rights reserved. PM (11/12) R FLOATING-WHITE