Leveraged Bank Loans. Prudential Investment Management-Fixed Income. Leveraged Loans: Capturing Investor Attention July 2006

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1 Prudential Investment Management-Fixed Income Leveraged Loans: Capturing Investor Attention July 2006 Timothy Aker Head of US Bank Loan Team Martha Tuttle Portfolio Manager, US Bank Loan Team Brian Juliano Loan Trader, US Bank Loan Team Success in today s fixed income markets may require investors to look beyond traditional fixed income asset classes. Bank loans, also known as leveraged loans, is one fixed income asset class that is receiving increased investor attention. Leveraged loans hedge against rising interest rates due to their floating rate structure, provide diversification due to their low correlation with other fixed income asset classes, and historically have provided solid returns in a variety of market environments. This paper examines leveraged loans in detail and highlights their usefulness in fixed income portfolios. Leveraged Bank Loans LEVERAGED LOANS DEFINED Loans made by banks to corporate borrowers can be divided into two classes: investment grade and leveraged loans. Investment grade loans, as the name implies, are loans to borrowers that are rated Baa3/BBB- or higher by one of the recognized rating agencies. These loans are typically revolving lines of credits used to supplement commercial paper programs for immediate working capital needs. Because of the revolving nature of these loans they are drawn down and paid back sporadically they have little application to the institutional market. A leveraged loan, on the other hand, is an unregistered loan made to a borrower that is leveraged, i.e. non-investment grade company. These are longer-term loans, typically with floating rates. A bank loan is generally classified as a leveraged loan if: the company to whom the loan is being made has outstanding debt rated below investment grade, meaning below Baa3/BBB- from Moody s and S&P; or the company s debt/ebitda 1 ratio is 3.0 times or greater; or the loan bears a coupon of +125 bps or more over LIBOR 2. As the criteria above show, leveraged loans are similar to high yield bonds in terms of the credit rating and financial profile of the corporate borrower. Indeed, many non-investment grade companies have both leveraged loans and high yield bonds outstanding at a given time. For more information contact: Kevin A. Myers Prudential Investment Management 2 Gateway Center, 4th Floor Newark, NJ EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization 2 LIBOR: London Interbank Offered Rate

2 A Brief History of Leveraged Loans Banks have made loans to noninvestment grade companies for decades. Until the mid-1990s, banks themselves were the primary investors in leveraged loans. The banks purchased the loans for their above-market yields and held to maturity. There was virtually no secondary market. In the mid-1990s, institutional investors such as insurance companies, high yield bond mutual funds, and hedge funds began realizing that leveraged loans could deliver the muchdesired combination of high yields and strong risk-adjusted returns. As demand grew, a secondary market developed, improving liquidity and transparency. Today, non-bank investors comprise more than two-thirds of the leveraged loan market: HOW DO LEVERAGED LOANS DIFFER FROM HIGH YIELD BONDS? Despite their similarities, leveraged loans and high yield bonds do differ in several important aspects. The following table compares some key differentiating characteristics: Key Differentiating Characteristics Leveraged Loans vs. High Yield Bonds Characteristic Leveraged Loans High Yield Bonds Coupon Floating Fixed Typical Maturity 5-8 years 10 years Callability Anytime Usually 3-5 year NC Effective Duration Short Intermediate Capital Structure Most senior Below bank loans Security Secured lien Unsecured Ratings Usually 2 above HY BB or lower Covenants Yes Minimal Recovery Rates* 78% 31%-41% *Post default, source: S&P ( September 2003) Investors in Leveraged Loans As of December 31, 2005 Insurance Company Finance Co. 2% 7% European Bank 9% US Bank 12% Canadian Bank 1% Asian Bank 3% Securities Firm 1% Source: Standard & Poor s as of 12/31/05 CLOs & Prime, Hedge & High Yield Funds 65% The driving force behind the growth in institutional investor demand for leveraged loans has been Collateralized Loan Obligation (CLOs), pools of bank loans segmented into various tranches. CLOs provide investors with diversified exposure to leveraged loans. Experienced CLO managers can add value by identifying attractive loans through indepth credit analysis and capturing inherent pricing inefficiencies. Floating Rate Coupon Unlike traditional high yield bonds with fixed coupons, leveraged loans carry floating rate coupons. Coupons are typically determined as a spread over the 3-month LIBOR base rate. For example, if 3-month LIBOR is currently 3.0%, a loan paying 2.5% above LIBOR (L+250 bps) would have an initial coupon rate of 5.5%. Importantly, this coupon will reset as the LIBOR base rate fluctuates; so interest payments on a floating rate leveraged loan will rise as market interest rates rise, and vice versa. This floating rate coupon feature is a major reason for the current interest in leveraged loans. Unlike high yield bonds, leveraged loans offer a hedge against rising interest rates. Shorter Maturities Leveraged loans tend to have maturities between five to eight years. They are callable at any time, in the sense that the borrower can choose to repay the loan at any time prior to the end of the loan period. Since 1997, in any given quarter on average, approximately 10% of the outstanding leveraged loans are prepaid 3. High yield bonds have longer maturities, typically 10 years. Most high yield bonds are callable only after an initial lockout period, typically the first five years. 3 Source: S&P s LCD and S&P/LSTA Leveraged Loan Index. Average quarterly repayment rate from 1Q97 to 4Q04 is 10.16%. 2

3 Shorter Effective Duration The effective duration of a leveraged loan portfolio is generally shorter than the duration of a similar high yield bond portfolio. This is due to the combination of the leveraged loan s floating rate coupon, shorter maturity schedule, and faster prepayment rates. Faster prepayment rates are attributable to provisions typically contained in loan agreements, stipulating that a portion of the proceeds generated from cashflow and asset sales must be used to pay off bank debt. Higher in the Capital Structure Loans are the most senior debt in the capital structure of a corporation, with contractual requirements for payment ahead of all other creditors. Bonds of any kind are beneath loans in the capital structure. Security Feature Leveraged loans are typically secured, meaning they are structured to include a lien against the assets of the borrower. In the event of a default, the lender has the right to take possession of these assets, which then can be sold or operated for cash. In practice this liquidation option is rarely used, but it does put the lender the leveraged loan investor in an excellent position to maximize the recovery of principal and interest in a restructuring. High yield bonds, on the other hand, are unsecured, meaning they typically do not include liens against assets. Protective Covenants Because of the higher risk of default on the loans they make to non-investment grade companies, banks making leveraged loans include a series of standard covenants that restrict the borrower s ability to assume additional debt beyond certain specified limits. The documents for a leveraged loan will typically include between two to six covenants. These covenants become part of the legally binding loan contract that the borrower enters into at the time the loan is made. Some commonly used covenants require the borrower to: Maintain a minimum EBITDA Maintain a minimum net worth Maintain minimum interest coverage (EBITDA/interest) Not exceed a stated maximum for capital expenditures Limit total leverage debt/ebitda to a pre-determined level Limit senior leverage debt/ebitda to a pre-determined level Not to exceed a stated maximum for dividend payments The lender normally tests for borrower adherence to loan covenants quarterly. Should the borrower breach one of the covenants, the loan documents typically require the loan to be repaid immediately, unless the lender(s) agrees to amend the covenant. Leveraged Loan Issuance Outpaces High Yield Bond Issuance Over the past nine years, new issuance of leveraged loans has outpaced the new issuance of public high yield bonds. In 2005, new issuance in the leveraged loan market was more than three times new issuance in the high yield market. $ Billions Leverage Loan New Issuance Leveraged Loan vs. High Yield New Issuance High Yield New Issuance Source of Leverage Loan New Issuance: Standard & Poor s as of 12/31/05. Source of High Yield New Issuance: Lehman Brothers as of 12/31/

4 Leveraged Loan Characteristics Lead to High Recovery Rates After Default These characteristics particularly the higher status of leveraged loans in the capital structure of the company relative to unsecured debt and the protective nature of their covenants have helped leveraged loans exhibit remarkably high recovery rates after default. Although leveraged loans have similar default rates to high yield bonds, recovery rates, which is the average percent of principal a debt holder is paid back in the event of a default by the issuer, are 2-3 times higher for leveraged loans as for high yield debt, with an average ultimate recovery rate of 78%. Comparison of Ultimate Recovery Rates Between Leveraged Loans and Other Fixed Income Instruments January 1, September 30, 2003 % Leveraged Loans Senior Secured Notes Senior Unsec Notes Senior Sub Notes Sub Notes Junior Sub Notes High Yield Bonds Fall in this Group Source: S&P/PMD LossStats (TM) Database; January September 2003 THE VALUE PROPOSITION OF LEVERAGED LOANS The leveraged loan value proposition results from the fact that leveraged loans, due to their many distinct features, neatly address two of the primary risks in fixed income investing: interest rate risk and credit risk. Floating Rate Coupons Help Mitigate Interest Rate Risk As discussed, because the interest payments on leveraged loans are set as a percentage above LIBOR, they rise as interest rates rise (and vice versa), effectively providing a built-in hedge against rising interest rates. Protective Covenants And Senior Position Help Mitigate Credit Risk In summary, several characteristics of leveraged loans help offset their credit risk. Their more senior position in the capital structure places them ahead of many other creditors in a bankruptcy situation. Their restrictive covenants significantly limit the ability of the borrowing company to leverage itself further or take other action that could hurt creditors. The fact that they are secured via a lien placed on liquid assets of the company helps increase likelihood of repayment even in the event of a default. 4

5 Value Proposition Has Helped Leveraged Loans Achieve Attractive Risk-Adjusted Returns Leveraged loans value proposition has helped them perform well under various economic conditions. Over the ten year period ended December 2005, as market interest rates continued to trend down, the annualized total return for leveraged loans was 5.9%. Equally as important, the annualized standard deviation of returns for leveraged loans was the lowest during the same period among a broad range of other fixed income alternatives. This, of course, means that on a risk-adjusted basis, the annualized total return of leveraged loans is particularly attractive. Leveraged Loans Achieve Attractive Risk-Adjusted Returns Ten Years Ending December 31, 2005 Annualized Total Return Annualized Standard Deviation* Bank Loans (CSFB Inst Lev Loan Index) 5.9% 1.3% Structured Product (Lehman ABS Index) Broad FI Market (Lehman Aggregate Index) High Yield (Lehman High Yield Index) Investment Grade Corporates (Lehman US Credit Index) Emerging Markets (JPM EMBI+ Index) *Source: Prudential Investment Management; Monthly time periods used to calculate standard deviation. Data Points are represented by the following indices: Bank Loans: CSFB Inst Leverage Loan Index, Structured Product: Lehman ABS Index, Broad FI Market: Lehman Aggregate Index, High Yield: Lehman High Yield Index, Investment Grade Corporates: Lehman US Credit Index, Emerging Markets: JP Morgan EMBI+ Index. Past performance is not indicative of future results. An investment can not be made directly in an index. Importantly, leveraged loans have not had a negative annual return in any calendar year over the past 11 years, a period covering a range of economic cycles, as shown by the following graph. Leveraged Loans Have Shown Relatively Strong Performance Under Various Economic Conditions Over Past Ten Years CSFB Leveraged Loan Index % Economic Expansion Economic Expansion Recession Source: CS First Boston Source of Recession and Economic Expansion: National Bureau of Economic Research 5

6 They also exhibit much lower price volatility than high yield bonds. As shown by the graph below, over the last few years, leveraged loan prices have been more stable than high yield prices. One reason is that their short duration and senior status reduces their sensitivity to credit and market cycles. Leveraged Loans Have Historically Exhibited Lower Relative Price Volatility Than High Yield Bonds High Yield Prices ($) Loan Prices ($) High Yield Bids 105 Loan Bids Range of loan prices over three years 80 Pre-9/11 12/31/01 3/31/02 6/30/02 9/30/02 12/31/02 3/31/03 6/30/03 9/30/03 12/31/03 3/31/04 6/30/04 9/30/04 12/31/04 90 Source: Standard & Poor s LCD; Merrill Lynch High Yield Index & HY Market.com An Additional Bonus: Further Diversification Finally, leveraged loans offer attractive diversification benefits. One reason is that many loan issuers confine their debt issuance to loans, and do not issue in the high yield market simultaneously. Owning the loans, therefore, can provide additional corporate credit diversification that would not be possible for investors limiting themselves exclusively to high yield bonds. A second reason is due to their low correlation to other asset classes. The following table shows that over the ten year period ending on December 31, 2005, leveraged loans had a negative correlation (-6%) to traditional investment grade fixed income assets, as represented by the Lehman Aggregate Bond Index. Even for institutional investors that already have an allocation to non-investment grade fixed income in the form of high yield bonds, the correlation to leveraged loans is only 49%. Source: Lehman Brothers, JP Morgan, CS First Boston Leveraged Loans Exhibit Low Correlation to Other Fixed Income Sectors Ten Years Ending December 31, 2005 Broad Fixed Income High Emerging Bank Market Yield Markets Loans Broad FI Market (Lehman Aggregate Index) 100% High Yield (Lehman HY Index) 13% 100% Emerging Markets (JPM EMBI+ Index) 17% 49% 100% Bank Loans (CSFB Inst Lev Loan Index) -6% 49% 9% 100% 6

7 LEVERAGED LOAN MARKET ADAPTING TO INSTITUTIONAL STANDARDS It is clear why increasing numbers of non-bank institutional investors are turning to leveraged loans. The entry of institutional investors into the leveraged loan market has been a positive one. Ratings agencies, for example, have significantly increased their ratings coverage of leveraged loans. Banks that issue and syndicate leveraged loans are increasingly attuned to the needs of institutional investors, and structure new deals accordingly. Institutional investors, with their focus on active total return portfolio management and trading, have in turn had a positive impact on secondary market liquidity. As the graph below shows, secondary market liquidity has improved tremendously over the last ten years, with volume in bank loans increasing by a factor of almost 12 between 1993 and Annual Secondary Trading Volume of Leveraged Loans Has Risen Steadily Volume ($ billions) Source: Standard & Poor s as of 12/31/05 Although minimum purchase sizes and transaction fees tend to hamper liquidity somewhat, trading costs are anticipated to decline as the market continues to move to standardize trading practices and documentation. However, in the interim, investors should look for investment managers with dedicated bank loan teams, large and seasoned trading desks that can command best execution for trades, and an experienced operations, legal and systems platform for timely settlements. Prudential Investment Management-Fixed Income currently manages $3.3 billion in leveraged bank loans*. The specialized bank loan investment team includes three portfolio managers averaging 20 years investment experience, 13 dedicated bank loan analysts with senior analysts averaging 11 years experience, and a dedicated bank loan trader with two years experience. Bank loan investment professionals are based in US and UK, focusing on US and European loans, respectively. *Assets as of March 31, 2006, staff as of June

8 Copyright 2006, Prudential Investment Management, Inc. Prudential Financial and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates. Prudential Investment Management, Inc., a registered investment adviser and a Prudential Financial company. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that Prudential Investment Management believes to be reliable. We do not guarantee their accuracy. This commentary, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and these views are subject to change. There is no guarantee that the views expressed will be realized. PFI