FIXED INCOME CAN SENIOR LOANS HELP A PENSION PLAN? EXECUTIVESUMMARY

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1 FIXED INCOME CAN SENIOR LOANS HELP A PENSION PLAN? BY ROBERT KINSEY SENIOR CLIENT PORTFOLIO MANAGER FAMILIAR All types of firms issue senior loans (Outback Steakhouse, AMC Theaters, Cricket Mobile, to name a few). The loans generally have a maturity of seven years when issued. Typically rated below investment grade, the loans are often secured by collateral, including such things as property, equipment, machinery and other physical assets. DEFENSE FOR RISING RATES Senior loans are generally not particularly sensitive to interest rate changes since the rate paid by the borrower floats at a predetermined rate above the London InterBank Offered Rate (LIBOR). Senior loans take priority over other forms of debt owed by the issuer. If the issuer goes bankrupt, senior debt theoretically must be repaid before other creditors receive payment. 4.94% 4.35% COMPETITIVE RETURNS Senior loans show comparable risk-adjusted returns in both the short-term and the long-term. Source: Bloomberg, as of 12/31/12. Past performance does not guarantee future results. SENIOR LOANS TREASURIES HIGH YIELD S&P % 1.72% 1.63% 1.92% 0.91% 0.72% 0.78% 1.04% 0.80% 0.28% 1-YEAR 3-YEAR 15-YEAR EXECUTIVESUMMARY In today s low interest rate climate, pension plans are having a difficult time earning enough to match their future liabilities investing in investment-grade debt. Adding senior loans, whose coupons adjust as interest rates rise, may be an option for plans to earn additional yield today and in the future. u Liability driven investing could theoretically immunize a pension portfolio, but because of today s low rates it may be an impractical and expensive option for many plans u Senior loans are secured against collateral of the firms which borrowed the money. Historically they have had comparable returns to high yield bonds u A mix of senior loans and investment grade bonds could offer a pension plan comparable returns to a 100% investment-grade portfolio with potentially lower volatility For Institutional Use Only Not for Use with Retail Investors INSIGHTS

2 Pension funds are in a pickle. Plan sponsors are required to discount their future pension liabilities based on prevailing yields, and since yields are near historic lows, those liabilities have ballooned. The aggregate funded status for U.S. plans of S&P 500 companies is 79%, while the funded status for state and municipal plans is even lower. 1 At the same time, these plans are having a hard time generating the returns needed to close the gap from the asset side. Interest rates on safe bonds, which generally make up a large part of the investment allocation, are near historical lows as the result of years of slow growth, low inflation and quantitative easing. Sponsors might be compounding the problem with unrealistically high return on asset assumptions that are unlikely to be realized considering the current low yields of many investment-grade bonds. The financial impact is being felt in the boardroom. Dow Chemical recently estimated that the change in the discount rate alone added $2.2 billion to its pension liabilities. 2 And according to Andrew Biggs of the American Enterprise Institute, if accrued public pension benefits are valued using riskless treasury yields, unfunded liabilities today top $4 trillion. 3 Many sponsors have looked to minimize pension liability risk by closing or freezing their plans or by adopting a strategy to match their investment portfolios to the future liability stream. Such Liability Driven Investing (LDI) holds out the mathematical prospect that pension liabilities can be immunized, thus reducing the impact of shortfalls on corporate financial statements. But for many pension plans, implementing a full or even partial immunization now is impractical. A future rise in domestic interest rates may alleviate some of the pension liability stress as it increases the discount rate, but many plan sponsors are left looking for measures that will help them in the near-term. Are there asset classes that may provide tactical benefits as they wait for the likely rise in interest rates? We believe that senior, or leveraged, loans might bridge the gap for not only pension funds contemplating LDI in the future but also investors that are hamstrung by the low yields and high duration risk of their traditional bond allocation today. The limited duration of this $644 billion LIBOR-based market is complemented by a current yield that topped 5.16% and a total return of 9.43% in Historically, the sector has low correlations to other asset classes typically used by pension funds. While few observers are forecasting returns for senior loans much above the coupon in 2013, we believe this non-investmentgrade asset class with limited duration risk and substantial carry potential can be a beneficial addition to a pension fund s fixed income allocation. Senior loans might bridge the gap for pension funds hamstrung by today s low yields. 2

3 POTENTIAL BENEFITS: REAL INCOME, WITH INTEREST RATE PROTECTION Quantitative easing is a global phenomenon with yields in the developed world at or near historic lows. At some point, this low rate regime will change, and such a reset will, undoubtedly, have a deleterious effect on developed world sovereign, securitized, and investmentgrade corporate bond markets that exhibit meaningful duration sensitivity. Here in the U.S., the widely watched Barclays U.S. Aggregate Bond Index may be the epicenter of the upcoming rising rate tremblers. Potential LDI investors may have been unable to implement a program due to the low level of high grade interest rates which constrain the CHART 1 Low Historical Correlation with Other Asset Classes 15-year correlation data (12/31/98 12/31/12) return of an immunized bond portfolio while elevating the present value of their long-term pension liabilities. Simply put, the cost to initiate an LDI program might well be too high for sponsors who are underfunded at present or unpalatable to those who believe that high grade interest rates are poised to rise within the next few quarters or years. In this environment, we believe senior loans may be an asset class that can help. Senior loans have considerably less interest rate risk than most fixed rate bonds since the coupons on most senior loans reset to LIBOR quarterly. Additionally, the low correlation of loans to other asset classes utilized by institutional investors may enhance a portfolio s overall diversification. Of course, diversification does not guarantee a profit or protect against loss. We expect the technical underpinning of this below-investment-grade market to remain strong in 2013 as its client base has broadened and liquidity has improved. Collateralized loan obligation (CLO) origination which had a near-death experience during the financial crisis has rebounded, with $27.5 billion in issuance through late March. 5 Loan default rates are low and we believe they will remain so for the near-term. Yet, risk premia or spreads are well above average. With healthier corporate balance sheets, improving profitability, and limited need to refinance, or roll new maturities, we believe that the credit profile of the overall loan market is good. SENIOR LOANS RUSSELL 2000 RUSSELL 3000 BARCLAYS GLOBAL AGGREGATE HIGH YIELD BONDS GLOBAL BONDS TREASURIES BARCLAYS U.S. AGGREGATE BOND S&P 500 SENIOR LOANS RUSSELL RUSSELL 3000 BARCLAYS GLOBAL AGGREGATE HIGH YIELD BONDS GLOBAL BONDS TREASURIES BARCLAYS U.S. AGGREGATE BOND S&P 500 u u u u u u u u u Source: Factset, 12/31/12. Senior loans are represented by the Credit Suisse Leveraged Loan Index. High yield bonds are represented by JPMorgan Domestic High Yield Index. Global bonds are represented by the JPMorgan EMBI Global Diversified Bond Index. Treasuries are represented by the Barclays U.S. Aggregate Treasury Index. Investment-grade bonds are represented by the Barclays U.S. Aggregate Bond Index. Indices are unmanaged and cannot be purchased directly by investors. Index definitions can be found on page 7. Past performance does not guarantee future results. 3 INSIGHTS

4 We also believe that any reduction in quantitative easing over the next 18 months would be the result of stable or improving macro factors, factors that would bode well for the credit profile of loan issuers in general. Furthermore, such an environment would witness a rise in short-term rates leading to increased demand for floating rate instruments. Undoubtedly, it would also witness a rise in longer term rates with a negative impact on durationsensitive portfolios. Timing interest rates is devilishly hard even more so in a post-banking-crisis world influenced by concerns about sovereign creditworthiness. Should growth prove anemic and central bank accommodation last longer than consensus, a current yield of 5.60% 6 or slightly lower, may partially offset the timing risk. Senior loans are not a risk-free asset class. However, we believe that the low return volatility of loans and their low correlation to duration-sensitive assets, highlight their prospective ability to bridge the gap for institutional fixed income investors concerned about low yields and the likelihood of rising interest rates as the domestic economy improves. Although the current carry may be reduced with the refinancing of portions of the loan market in 2013, the incremental yield and limited duration of loans compare favorably to high yield bonds as well. Underfunded pension plans and those thinking of implementing LDI after a rise in rates, may wish to add senior loans to their asset mix before rates rise and re-evaluate their ability and desire to immunize if and when the bond market has repriced to higher yields. POTENTIAL ADVANTAGES AND RISKS ASSOCIATED WITH SENIOR LOANS There are numerous factors that affect not only the opportunities, but also the risks, of senior loans. The loan market is non-investment grade and has a meaningful, but not total, overlap with unsecured high yield bonds. An individual senior loan is frequently quoted at LIBOR plus a premium; the amount of that premium is dependent on the borrower s creditworthiness and specific terms of the loan. In general, senior loans face credit risk consistent with their below BBB ratings and the highly levered nature of the borrowers; hence, it s necessary to have a deep understanding of the credit fundamentals of issuers along with the idiosyncratic nature of covenants specific to a loan. Defaults and default expectations play a role in the pricing of the market in general and individual loans in particular. As senior and secured instruments, loans have historically recovered about 65% of their value in a default; 7 equity and high yield bondholders are subordinated to senior loans and experience lower recoveries (higher losses) in the event of a default and/or restructuring. In 2012 par-weighted defaults were around 1.37%, but they reached as high as 12.8% in Ironically, loans performed very strongly in this high default year (up 44.87%) as they rebounded from their 2008 nadir. 7 As of March 31, 2013, spreads (calculated as discount margin to maturity) of about 500 basis points 8 suggest that loans are well-priced for more than a doubling of defaults, in our view. 4

5 Loans historically have low correlation with other assets in traditional pension funds. Senior loans, as a group, also have some differences to other fixed income sectors. Many senior loans are issued with a LIBOR floor, the lowest rate on which a coupon spread will be applied, even if the actual LIBOR rate is lower. In 2012, LIBOR floors on new issues averaged about 1.25%. 7 LIBOR floors affect the quarterly reset, so that a coupon typically adjusts based on either the floor rate or three-month LIBOR, whichever is higher. For instance, if LIBOR is at 0.30% today, an average loan issued last year would reset based on a spread over its floor rate, which is higher at 1.25%. We have observed that many 2013 loans are being issued with LIBOR floors closer to 1.00%. These floors tend to benefit loan holders in a stable or declining interest rate environment; however, floors will slow the pace of coupon resets in a rising rate environment until the floors are reached. Consequently, loan coupon rates may not move in lock-step with smaller rises in LIBOR. Since rising rates may be accompanied by an improving economy (and better corporate profitability), we also believe that the impact of floors may be overwhelmed by credit fundamentals and other factors that impact risk premia. Most loans are callable and have other features, so-called repricing, that increase the probability that they will be refinanced at lower rates. With the average loan price excluding stressed and distressed names close to 101, there s a likelihood that a meaningful portion of the loan market will be repriced with lower yields in Therefore, the current yield on widely watched loan indices may dip. Such repricings will likely reduce yield in the overall loan market; in fact, the average coupon reduction in January of 2013 due to repricings was close to 1.00%. But the downward pressure on loan yields associated with repricings also seems to have pushed floors lower as well. If that continues, it will augur for a quicker reset to rising LIBOR than past floors would indicate. Another aspect of the loan market worth noting is the longer settlement dates associated with it when compared to corporate bonds, treasuries and equities. Loans typically settle within six days, but some may settle as far out as T + 16, or 16 days after trade date. To offset the potential gap between loan settlements and mutual fund redemptions, many fund managers have established lines of credit. 5 INSIGHTS

6 CHART 2 Finding the Optimal Mix of Loans and Bonds From 1998 to 2012, a hypothetical mix of 22% senior rate bonds and 78% investment-grade bonds would have produced a comparable return to a 100% investment-grade portfolio, with less volatility. 5.9% 5.7% 100% Investment-grade Bonds FINDING THE RIGHT LOAN ALLOCATION The size of an allocation to loans may be viewed as a function of the trade-off between interest rate risk and credit risk. Based on the prior 15 years, a mix of 22% loans and 78% investment-grade bonds would have provided a comparable return to a hypothetical portfolio of 100% investment-grade bonds but with significantly less volatility. We caution investors who, after a 30-year bull market in bonds and nearly five years of extra ordinary central bank accommodation, may have become complacent about the duration risk lurking in their portfolio. Assessing one s credit risk tolerance for this senior and secured cousin of the high yield bond market is an essential first step and results will vary among investors. RETURNS 5.5% 5.3% 5.1% 4.9% 4.7% Optimal Point: 22% Senior Loans, 78% Grade Bonds 4.5%2.5% 3.0% 3.5% 4.0% 4.5% 5.0% Source: Factset as of 12/31/12. VOLATILITY 100% Senior Loans 5.5% 6.0% 6.5% Senior loans are represented by the Credit Suisse Leveraged Loan Index. Investment-grade bonds are represented by the Barclays U.S. Aggregate Bond Index. Index definitions can be found on page 7. Past performance does not guarantee future results. Potential first-time loan investors may also want to engage in scenario analysis by shocking a blend of loans and widely watched high grade indices, to appreciate the potential damaging impact of rising rates on their current allocations contrasted with the introduction of senior loans into the mix. Current participants in the high yield market may also want to look at significant allocations to loans to offset the duration sensitivity of their holdings. Pension plan managers generally know the amount they will need to earn in order to meet future liabilities. The problem now is actually earning enough to meet those future obligations when yields on traditional investment-grade debt are so low. We believe that an allocation to senior loans may offer a way to help. 6

7 INDEX DEFINITIONS The Barclays U.S. Aggregate Bond Index is an investment-grade domestic bond index. The Barclays U.S. Aggregate Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays Global Aggregate Bond Index is a broad-based measure of the global investment-grade fixed rate debt markets. The Credit Suisse Leveraged Loan Index tracks the performance of senior loans. The JPMorgan Domestic High Yield Index is an index composed of non-investment-grade corporate bonds. The JPMorgan EMBI Global Diversified Bond Index is a uniquely weighted version of the EMBI Global Index, which limits the weights of those countries with larger debt stocks by only including specified portions of these countries eligible current face amounts of debt outstanding. The Russell 2000 Index tracks small-capitalization stocks. The Russell 3000 Index tracks large and midsized stocks. The S&P 500 Index is a broad-based measure of domestic stock market performance. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. 7 INSIGHTS

8 CONTACTUS Visit ofiglobal.com Call ROBERT KINSEY SENIOR CLIENT PORTFOLIO MANAGER Robert Kinsey works closely with several of the firm s fixed income teams and is responsible for representing the efforts, outlook and investment results to current and prospective clients. Rob has been in the industry since Visit ofiglobal.com Scan this code to learn more about us: Search Google Currents for OppFunds to access our timely thought leadership Visit blog.oppenheimerfunds.com Follow us: 1. Source: IMF, Haver, CEIC, EMED, Emerging Advisors, 8/31/ Source: IMF, 8/31/ Source: Bloomberg, 8/31/ Source: Credit Suisse, 12/31/ Source: JPMorgan, 3/28/ Source: Bloomberg, 3/31/ Source: JPMorgan, 12/31/ Source: JPMorgan, 3/31/13. Special Risks Portfolio investments are subject to market risk and volatility. Fixed income investing entails credit risks and interest rate risks. When interest rates rise bond prices generally fall and the portfolio s share prices can fall. Senior loans are typically lower rated (more at risk of default) and may be illiquid instruments (which may not have a ready market). The material contained herein is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Further, this presentation does not constitute an offer or solicitation for the sale of any security or financial instrument in any jurisdiction where OFI Global is not licensed to conduct business or where the security or financial instrument is not available for sale. No security or financial instrument is offered or will be sold in any jurisdiction in which such offer or solicitation would be unlawful. These views herein represent the opinions of OFI Global Asset Management ( OFI Global ) and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of May 1, 2013, and are subject to change based on subsequent developments. OFI Global disclaims any responsibility to update such views. No forecasts can be guaranteed. Illustrations are only for the limited purpose of analyzing general market or economic conditions and demonstrating the OFI Global research process. They are not recommendations to buy or sell a security, or an indication of holdings. Information contained herein is deemed to be from reliable sources; however, accuracy cannot be guaranteed. For Institutional Use Only. This material may not be further distributed or reproduced and may not be shown to, quoted or used with retail investors OppenheimerFunds, Inc. All rights reserved. Two World Financial Center, 225 Liberty Street, New York, NY IW May 1,