SENIOR SECURED BONDS GLOBAL SENIOR SECURED BONDS: IN BRIEF. WHY SHOULD INVESTORS CONSIDER

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1 February 2019 BARINGS VIEWPOINTS February 2019 SENIOR SECURED BONDS AN UNDERAPPRECIATED SUBSET OF HIGH YIELD GLOBAL SENIOR SECURED BONDS: IN BRIEF. WHY SHOULD INVESTORS CONSIDER ADDING THIS ASSET CLASS TO THEIR PORTFOLIO? HERE ARE FIVE REASONS. As we enter what may be the twilight hours of an elongated credit cycle, an increase in defaults is not only possible, but probable. Against this backdrop, a credit-intensive, global approach to high yield investing is key. While the pendulum of investor sentiment has swung from one extreme to another, seasoned investors who have followed the market through multiple credit cycles and downturns have made the observation: For those willing to surrender a nominal amount of yield in favor of greater protection given a default, global senior secured bonds a lesser known and perhaps underappreciated subset of high yield can be an attractive option due to their seniority in the capital structure. FIGURE 1: SR. SECURED BONDS OFFER CAPITAL STRUCTURE SAFETY SENIOR SECURED LOANS/BONDS HIGH YIELD BONDS EQUITY SOURCE: BARINGS. FOR ILLUSTRATIVE PURPOSES ONLY. SENIOR SUBORDINATE 1. Senior secured bonds sit high in the capital structure, backed by collateral. If a corporation defaults on its debt obligation sold to investors (the bond it issues), it can be forced into bankruptcy liquidation. In such a case, its assets are sold off to repay its debts, which are repaid in a prescribed order of priority with senior debt first, ahead of junior/subordinated debt. If a bond is classified as secured versus unsecured, it is backed by issuer collateral, or some form of assets, thereby placing it at the top of the repayment waterfall. Collateral can take the form of various assets including real estate, equipment, vehicles, and intangible items like software or trademarks and lenders may be offered different security packages by buying into a specific claim or lien over the collateral. Such collateral may then be used to satisfy any outstanding claims by the senior secured lenders. Secured lenders are effectively the most preferred creditors in a company s capital structure, having first call on a particular pool of assets ahead of even the most senior unsecured lenders. 1

2 2. Senior secured bonds have experienced lower default rates and higher recovery rates than traditional high yield bonds. Recovery rates are the proportion of debt that is repaid or recovered after an issuer defaults or debt is restructured. The rate of recovery will depend on a number of factors, including the nature of the collateral assets, the current market for them, and the legal and practical steps involved in recouping the principal assets. Because senior secured bonds are the first to get paid out in the capital structure, and due to their backing by hard assets, in the event that a company defaults, they tend to have a higher recovery rate than traditional unsecured high yield bonds. In fact, during the period from , the average recovery rate for defaulted senior secured bonds was 62.3%, compared to 47.9% for senior unsecured bonds and 28.0% for subordinated debt (FIGURE 2). The bottom line for any debt investor is that secured lenders will always have a seat at the table in negotiations regarding a restructuring, and will be treated as senior throughout the process. FIGURE 2: MOODY S GLOBAL AVG. CORPORATE DEBT RECOVERY RATES MEASURED BY ULTIMATE RECOVERIES (%) 100% 80% 80.4% 62.3% 60% 47.9% 40% 28.0% 20% 0% Loans Sr. Secured Sr. Unsecured Subordinated SOURCE: MOODY S CORPORATE DEFAULT & RECOVERY RATES. AS OF DECEMBER 31, It is important to note that senior secured high yield bonds will not necessarily serve as a volatility dampener or offer more protection from downside risk. Rather, relative to nonsenior high yield instruments, their high position in the capital structure simply means that in the event of a default and restructuring, they have first priority in claiming a company s underlying assets pledged as collateral, thereby offering greater potential recovery. This priority standing can be attractive to investors who may be wary of investing in a subinvestment grade asset class, particularly amid a maturing credit cycle. 3. Senior secured bonds are issued by recognizable brands and industry leaders. Some of the most widely known brands and leaders within their respective industries Burger King, Hertz, Bausch Health Companies and Travelex, to name a few have senior secured high yield bond facilities outstanding. These companies issue bonds for a variety of reasons, including refinancing existing debt, or as part of a finance package to complete a merger or acquisition. Investors can potentially benefit by gaining corporate exposure to large, diversified companies with robust cash flows through senior secured bonds. 2

3 4. Senior secured bonds provide better principal protection despite slightly smaller yield. Senior secured high yield bond returns have been compelling on a historical basis (FIGURE 3). While that return is slightly lower than the average return generated by traditional U.S., European and global high yield bonds, it is important to note that traditional high yield bond markets have meaningful portions of unsecured credit. So, senior secured high yield bonds offer investors greater claim to principal protection versus unsecured high yield bonds. For investors willing to give up a minor amount of spread or yield, senior secured bonds can offer the benefit of added protection due to backing in the event of a default. 5. Senior secured bonds have grown exponentially in the last decade. The senior secured high yield bond market has experienced substantial growth since the global financial crisis (GFC), particularly in Europe. This is due largely to the emergence of the asset class as a viable source of funding for companies, whereas other capital-raising avenues including loans and unsecured bonds have faced limitations as banks pared lending during and after the GFC. Today, the value of the market is in excess of $309 billion (FIGURE 4). Additionally, this is not a new asset class. Senior secured high yield bonds have been in existence since the mid-1990s. The market experienced particularly strong growth in the post- GFC period, when many high yield companies looked to refinance senior secured bank loans into senior secured high yield bonds, rather than the more common unsecured bonds. As such, the proportion of secured bonds issued by high yield companies after the GFC increased markedly, especially in Europe. 60% 50% 40% 30% 20% 10% -20% -40% FIGURE 3: TOTAL RETURN (%) 0% -10% -30% 3.6% 0.9% 5.3% -3.8% SOURCE: BAML, BB-B GLOBAL HIGH YIELD SECURED BOND INDEX (HW4S). AS OF JANUARY 31, % 10.8% 10.0% 6.2% 3.1% % 48.6% 14.3% FIGURE 4: SENIOR SECURED BOND MARKET VALUE $400B $350B $300B $250B $200B $150B $100B $50B $0B % 16.3% % 3.1% 0.1% 12.8% YTD YTD SOURCE: BAML, BB-B GLOBAL HIGH YIELD SECURED BOND INDEX (HW4S). AS OF JANUARY 31, % -0.4% 3.4%

4 A Core Allocation As a subset of the high yield bond universe, we believe that global senior secured bonds like the broader high yield asset class are appropriate to consider as part of a longterm, core allocation in an investor s portfolio. In addition to delivering historically attractive returns, high yield bonds offer diversification benefit potential due to their historically low correlations with other asset classes. Relative to loans and investment grade bonds, high yield bonds have offered the opportunity to pick up additional yield over time, relative to the perceived incremental credit or default risk. Even in the event of broader market weakness, a strategic, long-term investment in high yield bonds particularly for investors willing to withstand some short-term volatility can facilitate the timely capture of evolving relative value opportunities and position investors to capture the upside as the market recovers. Whereas we believe fundamentals drive high yield returns over the long term, markets can be very inefficient in the short term. There have been several instances in the last several years, in which as a result of technical factors like issuance levels or mutual fund flows prices and spreads in the high yield market have moved dramatically, but fundamentals have arguably changed very little. It can be very difficult to time investment decisions around these short-term movements. For example, during the taper tantrum in 2013 and the Brexit vote in 2016, the entry point came and went relatively quickly. This is potentially one of the strongest arguments for a core allocation to high yield bonds at a strategic level, and for investing through the credit cycle. Impact of Active Management As we move through the late stages of the cycle, manager selection plays a critical role in attempting to minimize risk. With diverging monetary policies, and a number of potential volatility triggers on the horizon, those managers with large, global teams and the ability to constantly monitor the relative value of each issuer in the market should be well positioned. Ultimately, the flexibility to invest in high-conviction ideas, based on the continuous monitoring of credit fundamentals and relative value, can position us to take advantage of opportunities as they arise. Senior secured high yield bonds, like traditional unsecured high yield bonds, tend to be more highly leveraged than their investment-grade counterparts, and therefore may be more vulnerable in a recession. However, managers may seek to mitigate the credit risk associated with below investment grade debt by carefully analyzing the fundamentals of the issuer and assessing the bond s collateral. For this reason, a consistent focus on rigorous, bottom-up credit selection based on company fundamentals is crucial. While it is important to also take macroeconomic and external factors into consideration, to the extent that they impact company fundamentals, the most vital factor is an issuer s ability to repay debt through robust cash flow generation. The Barings Advantage At Barings, we have more than 70 high yield investment professionals across the U.S. and Europe, providing the resources and expertise required to thoroughly analyze the fundamentals of every credit we underwrite. Leveraging the expertise of our large team, we aim to select credits that can withstand headwinds and hold up through credit cycles. Whether a credit is secured or unsecured is a critical component of our underwriting process, and we tend to favor senior secured versus unsecured credit, all else being equal potentially opting for a B-rated secured bond over a BB-rated unsecured bond in a recessionary environment. We take an active approach to investing, which allows us to move away from credits that exhibit fundamental weakness in favor of healthier issuers. Looking ahead over the next 6 12 months, we do not expect leverage levels to move into unreasonable territory. While we may see isolated secular risk in some areas that are experiencing increased stress U.S. retail, for instance from a broad market perspective, barring any significant fiscal policy missteps, we do not expect to see widespread weakness. We think short bouts of volatility pose a considerable opportunity. In our experience, the market pricing does not always correspond with the underlying fundamental health of the issuing companies, especially through periods of enhanced macro-driven market volatility. Additionally, credit markets have shown a tendency to snap back very quickly after periods of market weakness and spread widening, which have more often than not been driven by technical rather than fundamentals. We often take a contrarian, long-term approach, and think high yield particularly global senior secured bonds may present a good long-term investment opportunity despite the short-term volatility. Risk Profile While we see many benefits to investing in global senior secured bonds, it is important to consider the potential risks. Although this asset class is senior in the capital structure, investors may still be exposed to losses in the case of issuer defaults. rated below investment grade by independent rating agencies may have a greater risk of default and investors should consider such risk in the context of their overall portfolios. At Barings, our primary goal is to deliver attractive risk-adjusted returns for our clients. We conduct rigorous fundamental analysis in the initial underwriting of each credit and regularly track key credit metrics to ensure that we are effectively managing risk. 4

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