CapitalMarkets Focus On... Senior Loans Understanding the Asset Class As investments based on senior loans become more popular, it is important that investors fully understand what they are and how they work. This white paper helps explain the asset class and provides an overview of its potential benefits and risks. Senior loans key attractions to investors are potential protection from rising interest rates, as well as relatively high yields often without the volatility high yield bonds may exhibit. Floating rate instruments such as senior loans typically generate higher income when short-term interest rates rise, and less when rates fall. The reason for this is senior loans reset to the London Interbank Offered Rate (LIBOR), and LIBOR typically reflects a rise or decline in shortterm rates. Historically, loan prices have tended to be less influenced by changing interest rates than high yield bonds which have much more duration. While these instruments can play a valuable role in a portfolio, they come with special risks beyond those conventionally associated with fixed income investing. Investors and their financial advisors should be familiar with these risks, which this paper summarizes. What are senior loans? Senior loans are loans typically made to companies that have below-investment-grade credit ratings (see section entitled Credit risk on page 3 for more information on credit ratings). Loan interest rates generally reset every 30 to 90 days, based on changes to a benchmark interest rate such as LIBOR the rate at which banks loan each other money in the London wholesale money market. This resetting feature may help protect investors from the risk of rising interest rates. In addition, investors the holders of such loans have a higher priority claim, or seniority, on a borrower s cash flows or assets compared to holders of conventional bonds. This means that if a company defaults on its loan obligations, and declares bankruptcy, these investors are higher on the list of creditors to be paid back. Finally, such loans are usually backed by collateral, which can help lenders recover up to all of their loans value in the event of default. Interest rate structure The interest rates on senior loans reference an index customarily LIBOR. Because senior loans often have higher potential for default, they are frequently sold with an additional yield premium over and above the base interest rate dictated by the index. The amount of that premium and other specifics depend on the borrower s creditworthiness and the terms of the specific loan. For example, if LIBOR is 5% and the premium on a particular loan is 3%, the company taking out the loan would pay investors an interest rate of 8%. The benchmark rate may fluctuate, while the premium remains fixed for the life of the loan. Therefore, if LIBOR were to rise to 6%, the loan would reset, and the company would pay an interest rate of 9% (6% for LIBOR, plus the 3% premium). Interest rate sensitivity Unlike conventional bonds, senior loans promise investors a floating coupon rate that resets periodically. Since bond prices and yields move inversely, changes in prevailing interest rates can have a dramatic impact on the price of a bond. However, since a floating rate loan s coupon regularly resets in line with its benchmark interest rate, changes in prevailing interest rates tend to have a more modest impact on their value. Capital structure Senior loans are called senior because of their position in the capital structure of the borrowing company. Essentially, in the event of bankruptcy, companies with such loans are required to meet Robert Kinsey Senior Client Portfolio Manager, Fixed Income Not FDIC Insured May Lose Value Not Bank Guaranteed 1234
A Typical Company s Capital Structure this senior obligation before paying most other debts, a provision that adds a level of stability for investors. As mentioned above, many of these loans are also collateralized, or backed by specific assets of the borrower, and consequently have had higher historical recovery rates than unsecured bonds. How do these loans compare to other fixed income investments? Senior loans have been erroneously considered an alternative to money market mutual funds, CDs and other types of conventional fixed income investments. In fact, loans are typically below-investment-grade securities, and as such, they may experience more extreme price volatility. Investors should be aware of several important differences between the potential advantages and risks of investing in loans versus conventional fixed income offerings. Potential advantages of investing in senior loans Following is a list of four compelling reasons to consider investing in senior loans or mutual funds that invest in them. Senior Loans: Higher Income Potential Versus Other U.S. Fixed Income Sectors (as of 3/31/12) Yield Senior Loans Preferred Equity 7% 6 5 4 3 2 1 0 Equity 6.43 Credit Suisse Leveraged Loan First Claim on Assets Last 3.41 Barclays Capital U.S. Corporate Investment Grade Barclays Capital U.S. Aggregate Barclays Capital U.S. Treasury 3-Month CD Source of chart data: Barclays Capital Research, JPMorgan Research, CS Research, as of 3/31/12. The source of the 3-Month CD yield is Bloomberg. The yields illustrated are yield-to-worst with the exception of the Credit Suisse Leveraged Loan, whose yield is calculated by adding discount margin to maturity to 3-Month LIBOR. The Credit Suisse Leveraged Loan is an unmanaged index that tracks the performance of senior loans. The Barclays Capital U.S. Corporate Investment Grade is a widely used indicator of the U.S. investment-grade corporate bond market performance. The Barclays Capital U.S. Aggregate covers the USD-denominated, investment-grade, fi xed rate, taxable bond market of SEC-registered securities. The index includes bonds from the U.S. Treasury, government-related, corporate, MBS (agency fi xed rate and hybrid ARM passthroughs), ABS and CMBS sectors. The Barclays Capital U.S. Treasury includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. Indices are unmanaged and cannot be purchased directly by investors. performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. Past performance does not guarantee future results. 2.22 1.19 0.26 1. Higher income potential Since senior loans are typically made to borrowers whose credit rating is below investment grade and carry relatively high credit risk, investors are paid a premium (described above) over the interest rate, or yield they would receive if they invested in higher rated bonds. This additional yield is provided to compensate investors for assuming a higher risk of default. 2. Hedge against rising interest rates and inflation For a fixed rate instrument like a conventional bond, the coupon rate does not change during the life of the bond, so a rise in prevailing interest rates can lower the value of the bond. However, in a floating rate loan, the coupon rate is not fixed. If the benchmark rate rises, the yield of a floating rate loan will reset, or float, accordingly, helping to preserve the value of the investment and allowing investors to potentially benefit from higher interest rates. Additionally, since interest rates have historically tended to rise in periods of rising inflation, investing in loans that are tied to benchmark interest rates may help offset the effects of inflation. 3. Comparable potential returns with lower historical risk versus stocks Senior loans have the possibility of generating relatively solid returns for investors, with potentially lower volatility than stocks. From 3/31/97 to 3/31/12, the Credit Suisse Leveraged Loan, 1 composed of senior loans, returned an average of 4.9% annually compared to average annual returns of 6.1% during the same period from the S&P 500. 2 However, the Credit Suisse Leveraged Loan produced these results with lower volatility, as measured by the standard deviation of annual returns. 3 Standard deviation is a statistical measure of performance fluctuations. It is calculated using historical period returns around a mean, but can t be used to predict fund performance. Generally, the higher the standard deviation, the greater the expected volatility of returns. 2
Annual Standard Deviation 15-year quarterly through 3/31/12 Low Correlations with Other Asset Classes Senior loans correlation vs. other asset classes (3/31/97 3/31/12) S&P 500 18.7% Credit Suisse Leveraged Loan 9.0 Source of chart data: FactSet, 3/31/12. 4. Low historical correlation to other asset classes Investment managers often refer to correlation when assessing how different investments perform at the same time. If two investments perform similarly, they are said to be positively correlated. If they tend to move in opposite directions, they are said to be negatively correlated. Combining investments with low correlations to one another is an essential part of building a well-diversified portfolio; when one component falls, another might rise. Senior loans have low historical correlations to other common asset classes, making them potentially useful for diversification purposes. Having exposure to such loans may reduce volatility in a broader portfolio, while helping to improve overall performance. Of course, diversification does not guarantee a profit or protect against loss. Key risks of investing in senior loans While all investments carry some degree of risk, senior loans involve certain specific risks, which investors should understand as they work with their advisors to build an appropriate investment strategy. Credit risk Credit risk is the risk that a borrower will default on its obligation to pay interest or repay principal. If a borrower defaults, a lender may lose money. If the borrower has posted collateral, loan investors can seize and liquidate the collateral to recoup their investments. It is important to note that such collateral may be insufficient to pay the lender back completely, or could prove difficult to liquidate. Additionally, the courts may, in some cases, prevent liquidation of assets to satisfy debt obligations. Yield 1.0 0.8 0.6 0.4 0.2 0.0 0.2 0.4 0.2 U.S. Treasury Source of chart data: Bloomberg, 3/31/12. U.S. Treasury bonds are represented by the Barclays Capital U.S. Treasury, a widely used indicator of U.S. investment-grade bond market performance. U.S. investment-grade bonds are represented by the Barclays Capital U.S. Aggregate Bond, a widely used indicator of U.S. investment-grade bond market performance. Emerging market bonds are represented by the JPMorgan EMBI Global Diversifi ed, a widely used indicator of emerging markets bond market performance. Stocks are represented by the S&P 500, a widely used indicator of U.S. stock market performance. High yield bonds are represented by the JPMorgan Domestic High Yield, a widely used indicator of U.S. high yield bond market performance. Senior loans are represented by the Credit Suisse Leveraged Loan, an unmanaged index that tracks performance of senior loans. Correlation factors presented are based on annual returns for the 15 years between 3/31/97 and 3/31/12. Chart is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. Indices are unmanaged and cannot be purchased directly by investors. Diversifi cation does not guarantee a profi t or protect against loss. Past performance does not guarantee future results. Moody s Investors Service (Moody s) and Standard & Poor s (S&P) are both credit rating agencies who provide rankings of the credit-worthiness of companies on their own respective standardized scales. Moody s ranks credits between Aaa and C. S&P uses a scale from AAA to D. Companies rated below Baa3 by Moody s or BBB by S&P are considered below investment grade with heightened credit risk, and typically cannot access credit on terms as favorable as their investment-grade counterparts. For this reason, investors usually receive relatively higher yields in return for lending money to lower rated companies. Interest rate risk U.S. Investment Grade Emerging Market Besides the differences between traditional bonds and senior loans already mentioned, another key difference is that, when interest rates fall, prices of already-issued fixed rate debt securities (like bonds) generally rise, and vice versa. Because interest rates on loans fluctuate, this relationship is different for this type of security. If interest rates fall (or rise), 0.0 0.3 0.3 Stocks 0.9 High Yield 3
yields on loans will also fall (or rise), and there will typically be a more modest change or no change in the price of the loans. Senior loan interest rates may not correlate to prevailing interest rates between the loans adjustment periods. That may cause the value of the loans to decline. Spread risk Though senior loans are not subject to the same interest rate risk as conventional bonds, the prices of loans may fluctuate due to spread risk. Spreads, which are determined by the market, are the additional yield premiums investors receive (versus a base interest rate such as LIBOR) as compensation for assuming additional credit risk. If spreads change, the price of the loan will also change and the investor s return will reflect current market rates. Uninsured principal risk Senior loans are not insured by the Federal Deposit Insurance Corporation (FDIC), or any other entity. Consequently, their value will fluctuate over time, and investors could lose principal. Special risks for senior loan mutual funds Mutual funds that buy senior loans carry additional risks compared to owning individual loans. The secondary market for loans is limited. This liquidity risk can prevent a mutual fund from selling non-performing loans or raising the cash necessary for shareholder redemptions Some mutual funds may purchase primarily belowinvestment-grade loans, which typically offer a higher yield than investment-grade securities since they bear higher credit risk. The net asset value (NAV) of a fund with a high concentration of such loans may fluctuate more than that of a fund with higher average credit quality, especially in response to economic downturns Some mutual funds may purchase loans that are not collateralized. If these loans default, the fund will be less likely to recover its investment Senior Loans: Lower Interest Rate Risk Versus Other U.S. Fixed Income Sectors Asset Class/ Duration (Yrs) Senior Loans 0.3 JPMorgan Domestic High Yield 4.0 Barclays Capital U.S. Aggregate 5.0 Barclays Capital U.S. Treasury 5.6 Barclays Capital U.S. Corporate Investment Grade 6.8 Source of chart data: Barclays Capital Research, JPMorgan Research, CS Research, as of 3/31/12. Duration is a measure of interest rate risk, or more precisely, the price sensitivity of a fi xed income security based on an interest rate change of 1% or 100 basis points. For example, if a bond has a 5-year duration that implies the bond will increase in value by approximately 5% if interest rates fall by 1%. On the other hand, the bond will decrease in value by 5% if interest rates rise by 1%. Senior Loans represents a generic senior loan investment with a quarterly reset period. Certain senior loans have a feature that prevents their interest rates from adjusting below a specifi ed minimum level, possibly resulting in the prices of these senior loans becoming more sensitive to changes in interest rates should short-term interest rates rise but remain below that minimum level. This feature is not accounted for in the duration fi gure quoted above. The JPMorgan Domestic High Yield is designed to mirror the investable universe of the U.S. dollar domestic high yield corporate debt market. The Barclays Capital U.S. Aggregate covers the USD-denominated, investment-grade, fi xed rate, taxable bond market of SEC-registered securities. The index includes bonds from the U.S. Treasury, government-related, corporate, MBS (agency fi xed rate and hybrid ARM passthroughs), ABS and CMBS sectors. The Barclays Capital U.S. Treasury includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays Capital U.S. Corporate Investment Grade is a widely used indicator of the U.S. investment-grade corporate bond market performance. Indices are unmanaged and cannot be purchased directly by investors. performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. Past performance does not guarantee future results Senior Loans and Interest Rates We believe senior loan prices exhibit less price sensitivity due to duration, such as rising or declining interest rates, than fixed rate bonds. Past performance does not guarantee future results. Interest Rates Senior Loans Prices: Fall Stable Income: Stable Rise Prices: Rise Stable Income: Stable Fall Some mutual funds invest in loans issued by foreign borrowers, which may present currency and other special risks, such as foreign taxes, changes in governmental, economic or monetary policies in the U.S. or abroad, or other political and economic factors Some senior loan mutual funds offer a fixed number of shares and are not obligated to redeem shares on a daily basis. Many such funds offer 4
shareholders periodic repurchase opportunities, also called tenders, but there is no guarantee the fund will be able to satisfy all repurchase requests. Other senior loan mutual funds are open-end mutual funds. These funds offer investors daily liquidity and are generally obligated to redeem shares Potential opportunities for senior loan investors In response to the recent financial crisis, the U.S. Government vastly expanded its spending, while the Federal Reserve cut interest rates to near zero and began expanding its balance sheet at a staggering rate. As the economic recovery continues and the government moves to absorb excess liquidity, both interest rates and inflation may rise. Indeed, by cutting interest rates to zero, the Federal Reserve left rates nowhere to go but up. Summing up Senior loans and mutual funds that invest in them have many unconventional characteristics. As a result, they offer advantages that may help strengthen a stock and bond portfolio, as well as specific risks. Before investing in a vehicle that includes senior loans, investors should work with their financial advisors to consider how such traits fit with their overall financial goals, time horizons and tolerance for risk. In an environment of rising rates and inflation, owning senior loans may help protect investors purchasing power (since such loans typically pay more income as rates rise), while seeking to maintain stable prices. 5
CapitalMarkets Get Started Visit oppenheimerfunds.com Call your financial advisor Call us, 1.800.CALL OPP (225.5677) To download the CapitalMarkets Market Charts, visit us at oppenheimerfunds.com and enter CapitalMarkets in the keyword search box. SEARCH: Website CapitalMarkets GO 1. The Credit Suisse Leveraged Loan is an unmanaged index that tracks the performance of senior loans. The index cannot be purchased directly by investors. performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. 2. The S&P 500 is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries with the U.S. economy. The index is unmanaged and cannot be purchased directly by investors. performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. 3. Source of data: FactSet, 3/31/12. Standard deviation is a statistical measure of performance fluctuations. Generally, the higher the standard deviation, the greater the expected volatility of returns. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Senior loans are typically lower rated (more at risk of default) and may be illiquid investments (which may not have a ready market). The underlying loans held in senior loan funds are subject to significant credit, valuation and liquidity risk. Diversification does not guarantee profit or protect against loss. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling 1.800.CALL OPP (225.5677). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. Two World Financial Center, 225 Liberty Street, New York, NY 10281-1008 2012 OppenheimerFunds Distributor, Inc. All rights reserved. DS0291.004.0512 June 21, 2012 qwer