The US Institutional Corporate Loan Market and an Overview of Ways to Invest Moderator: Elliot Ganz, LSTA Panelists: Gretchen Bergstresser, CVC David Mechlin, CSAM Dan Norman, Voya Tel Aviv, November 14, 2017
Topics for Today Introduction to the U.S. Institutional Corporate Loan Market Ways to Invest in the Loan Market Collateralized Loan Obligations Separately Managed Accounts (SMAs) Co-mingled Accounts Mutual Funds Current Trends in the Loan Market 2
What are Institutional Corporate Loans? Extensions of credit to non-investment grade corporate borrowers originated by major banks A global market in excess of $1 trillion Issued by mid- to large-sized companies to finance acquisitions and other growth initiatives Senior in the capital structure; secured by a lien on borrower s assets Repaid before other creditors/equity upon a credit event Collateral typically provides substantially higher recoveries Floating rate with coupon return comprised of a nominal credit spread over LIBOR Rates reset every 45-60 days on average (duration of approximately 0.2 years) Structurally less liquid (i.e., longer settlement times) but actively traded in an established secondary market Average trade volumes in excess of $500 billion annually over the past 5 years Large, syndicated loans to noninvestment grade companies Secured by the borrower s assets Rank highest in a borrower s capital structure Floating rates of interest 3
Senior in the Capital Structure with a Lien on Assets Seniority and Collateral for Senior Loans Borrower Assets Borrower Liabilities % of Borrower Liabilities Cash (in certain cases) Receivables Paid First Inventory Plant & Equipment Pledged to: Senior Secured Loans 40%-60% Property (including real estate) Intangible Assets (patents, trademarks) Downstream guarantees from a holding co. Upstream guarantees from subsidiaries Senior Unsecured Notes High Yield Bonds 20%-40% Paid Last Preferred/Common Equity 20%-40% 4
Institutional Corporate Loans Are an Important Component of the U.S. Debt Markets Money Market $2,807B Fed Agencies $1,995B US Debt Market Universe Asset Backed $1,327B Inst. Corp Loans $960B HY Bonds $1,550B US Corporate Debt Inst. Corp. Loans $960 Bil Muni s $3,715B HG Bonds $6,608B HY Bonds $1,550Bil Mortgage Related $8,728B Treasury $13,192B, HG Bonds $6,608 Bil Total Size of the US Debt Market $40.9T as of 12/31/15 Total Size of US Corporate Debt $9.1T as of 12/31/16 Source: Credit Suisse 5
Par Amount Outstanding: US and Europe $1,200 $1,000 $800 Billions $600 $400 $200 $0 2002 2003 2004 2005 2006 2007 2008 US 2009 2010 Europe 2011 2012 2013 2014 2015 2016 ME March 2017 Source: S&P Capital IQ 6
The U.S. Institutional Corporate Loan Market Provides Substantial Trading Liquidity Trade Volume Avg. Size of the S&P/LSTA Leveraged Loan Index Turnover Ratio (%) $1,000 100% $750 75% $500 Billions 50% $250 25% $- 2010 2011 2012 2013 2014 2015 2016 0% Source: The LSTA Trade Data Study 7
The US Institutional Corporate Loan Market is Very Diversified Across Industries 8
10% 9% 8% 7% 6% 5% 4% 3% U.S. Institutional Corporate Loans Exhibit Strong Relative Values 2% 2010 2011 2012 2013 2014 2015 2016 2017 Senior Loans (Discount Yield to 3 Year Call) US HY (YTW): +1 bps US IG (YTW): -228 bps Yield and Duration Comparisons S&P/LSTA Leveraged Loan Index and Various Asset Classes Data as of September 30, 2017 Effective Yield (%) 6 5 4 3 2 1 0 Senior Loans Historically competitive yield with virtually no duration risk US HY MBS 5-7 Year Treasuries US IG Municipal Bonds 0 1 2 3 4 5 6 7 8 Effective Duration (years) Discounted yield to 3-year call assumes: (i) all loans pay off at par in 3 years, (ii) discount from par is amortized evenly over the 3 years as additional spread, and (iii) no other principal payments during the 3 years. Discounted yield is calculated based upon the current market price, not on par. The Index is not subject to any fees or expenses. Investors cannot invest directly in an index. Past performance does not guarantee future results and there is the possibility of loss. The S&P/LSTA Leveraged Loan Index is an unmanaged total return index that captures accrued interest, repayments, and market value changes. Source charts: S&P/LCD, BAML and Bloomberg 9
U.S. Institutional Corporate Loans Have Relatively Low Losses as Compared to High Yield Bonds 5% Institutional term loans Sr. Unsec'd HY bonds 70% Institutional term loans Sr. Unsec'd HY bonds 4% 3% 60% 50% 40% 2% 1% 30% 20% 10% 0% Default rate Expected loss 0% Loss given default Loans are senior and secured, contributing to a lower loss rate Loss given default is low for loans - 19% because recovery rates are so high 80% Loan repayment rates are high, averaging 2.7% per month since 2001 Loans are floating rate (based over LIBOR), so interest rate risk is minimal Source: S&P Capital IQ/LCD, Moody s Investors Service, Bloomberg 10
Institutional Corporate Loans Have Returned 5.8% on Average Over 20 Years S&P/LSTA Leveraged Loan Index ML US Corp Index ML US High Yield Index 60% 50% 40% 30% 20% 10% 0% -10% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016-20% -30% Source: S&P/LSTA Leveraged Loan Index 11
Institutional Corporate Loans Have Exhibited Lower Volatility and Attractive Sharpe Ratios Loans have continued to experience less volatility as compared to most traditional income asset classes, particularly high yield bonds Provides a unique asset allocation tool and has resulted in attractive Sharpe Ratios Rolling 12-month Annualized Standard Deviation of Returns January 2009 to September 2017 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 S&P/LSTA Leveraged Loan Index Bloomberg Barclays US Corporate - High Yield - 2% Issuer Capped Bloomberg Barclays US Treasury Bellwethers (10 Yr) 0.00 2009 2010 2011 2012 2013 2014 2015 2016 2017 Annualized Standard Deviation Data as of September 30, 2017 8.00 6.00 4.00 2.00 0.00 Sharpe Ratio Data as of September 30, 2017 5.00 4.00 3.00 2.00 1.00 0.00 1.17 3.97 2.47 3.34 2.85 1.26 1.64 0.97 1.19 1 Year 3 Years 5 Years S&P/LSTA Leveraged Loan Index 5.72 2.38 5.18 1 Year 3 Years 5 Years S&P/LSTA Leveraged Loan Index Bloomberg Barclays US Corporate High Yield - 2% Issuer Capped Bloomberg Barclays US Corporate High Yield - 2% Issuer Capped The Indices are not subject to any fees or expenses. An investor cannot invest directly in an index. Past performance does not guarantee future results and there is the possibility of loss. Source charts clockwise left to right: FactSet 12
While Secondary Loan Market Prices Have Fluctuated Over the Past 5 Years, Annual Interest Income has Averaged 5% 102 AVG Trade Price Median Trade Price 12% Total Return Interest Return 100 10% 98 8% 96 6% 94 4% 2% 92 90 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 0% -2% 2012 2013 2014 2015 2016 Source: LSTA Trade Data Study & S&P/LSTA LLI 13
Pricing: Rolling Three-Month New-Issue Institutional Spreads by Specific Rating L+600 L+500 L+400 L+300 L+200 L+100 L+0 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 BB+ BB BB- B+ As of 10/5/06, LCD S&P s CCR and Moody s Corporate Family Ratings for rated spread and upfront fee calculations. 14
There are Many Ways to Invest in The U.S. Institutional Corporate Loan Market Separately Managed Accounts Customized Large Investment Tailored Liquidity Provisions Comingled Funds Medium Investment Size Periodic Liquidity Provisions Ease of Administration Mutual Funds Retail Funds/ETF Ease of Investment Small Investment Size Daily Liquidity CLOs Structured Vehicle Different Risk Tranches (Rated Floating Rate Notes vs. Equity) Inherently Less Liquid 15
Sizing the Buyers Estimates of Performing Loan Holders LMFs (16-18%) CLOs (57-60%) Hedge, SMA (14-18%) Non-Loan MFs, BDCs (2-4%) Ins (1-3%) Other (2-5%) 16 Source: TR-LPC, Barclays Research, S&P/LCD, Lipper, Bloomberg, EPFR, HFR, CreditFlux, Fed, Bloomberg Barclays Index 16
Introduction to CLOs
How a CLO Works: Transparent Portfolio of Loan Assets That Support CLO Debt and Equity Illustrative Underlying Credit Assets Illustrative CLO Balance Sheet Class A Notes [Aaa/AAA] [60-62] % Assets Class B Notes [AA] [9-13] % Class C Notes [A] [5-9] % Class D Notes [BBB] [4-6] % Cashflows Class E Notes [BB] [4-6] % Subordinated Notes Not Rated [9-11] % Losses CLOs invest in pieces of loans to mostly well-known U.S. and international companies and the portfolios are actively managed by experienced asset managers The interest and principal of the loans pay the interest (and principal) of the CLO notes, starting at the AAA notes and working the way down the waterfall If there are losses on loans from defaults, those losses impact the equity holdings first ` 18
CLO Yield and Relative Value
Where is the Value in the CLO Capital Structure? 1,000 New Issue U.S. CLO Tranche Spreads 900 800 700 Spread (bps) 600 500 400 300 200 100 0 AAA AA A BBB BB B CLO note yields increase materially as one moves down the rating scale At every rating level, CLO notes tend to yield more than the equivalently rated investments in other asset classes Source: BAML 20
Bottom of Capital Structure: Cash-on- Cash Equity Returns CLO Equity Returns by Vintage (and LTM 1.0 Avg.) 30% 25% 20% Return (%) 15% 10% 5% US LTM WAvg (CLO 1.0) 2011 2012 2013 2014 2015 0% 7/1/06 11/1/06 3/1/07 7/1/07 11/1/07 3/1/08 7/1/08 11/1/08 3/1/09 7/1/09 11/1/09 3/1/10 7/1/10 11/1/10 3/1/11 7/1/11 11/1/11 3/1/12 7/1/12 11/1/12 3/1/13 7/1/13 11/1/13 3/1/14 7/1/14 11/1/14 3/1/15 7/1/15 11/1/15 3/1/16 7/1/16 11/1/16 3/1/17 U.S. CLO cash on cash equity returns averaging more than 15% Source: BAML 21
CLO Equity IRR Beat Comparables Cross Asset Weighted Average IRRs 25% 22.5% 20% Average 10-year return vs CLO 1.0 Equity Average 3-year return vs CLO 2.0 Equity 18.3% 15% 10% 5% 4.6% 7.1% 7.1% 6.9% 10.7% 10.8% 3.6% 4.3% 6.7% 8.9% 11.8% 12.2% 0% S&P Lev Loan Index Citi US HY Bond Index Russell S&P 500 US Private Equity 2005-07 US CLO Equity 2005-07 EUR CLO Equity S&P Lev Loan Index Citi US HY Bond Index Russell S&P 500 US Private Equity 2012-15 US CLO Equity 2013-15 EUR CLO Equity Source: Citi Research, Cambridge Associates, as of 12/31/2016; PE returns are as of 06/30/2016 *Our priced 2.0 sample includes 125 CLO equity tranches from 2012 to 2015 vintages, about 20% of the overall universe. It is still representative of the overall universe and showing roughly the same distribution of CLO equity NAV, structure/leverage, and vintage. Paid-down deals will be excluded from the analysis so CLO 1.0 IRRs are biased to outperforming deals. *Our method takes CLO equity s monthly secondary mark and historical cashflows to calculate the running since-inception IRR for each deal, and then calculate the weighted average return of all sampled CLO 2.0 equity. *Private equity sample is based on 1,283 U.S. private equity funds (buyout, growth equity, private equity energy and mezzanine funds), including fully liquidated partnerships, formed between 1986 and 2014. CA research shows that most funds take at least six years to settle into their final quartile ranking, and previous to this settling they typically rank in 2-3 other quartiles; therefore fund or benchmark performance metrics from more recent vintage years may be less meaningful. However, when a private equity fund stops reporting its data, it will be removed from the sample base. Thus, survivorship bias exists in both the US PE performance database and our US CLO equity sample, which could skew the returns upwards. Source: Citi Research 22
CLO Default/Loss Experiences Were Lower Than Other Asset Classes Loss Rates (%) 35% 30% 25% 20% 15% 10% 5% 0% Loss Rate for IG CLO Notes Well Below Other ABS CLOs performed well through the financial crisis and beyond There have been no defaults on CLO notes rated AA or better Cumulative Default Rate (%) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Default Rate of CLO Notes Well Below Equivalently Rated Corporate Bonds CLO Notes Corp Bonds AAA AA A BBB BB CLO note default rates are far below those of other asset classes CLO note default rates are far below those of equivalently rated bonds Source: BAML, S&P, Wells Fargo 23
Testing the Resilience of CLO Notes to Loan Defaults Multiple of 01-02 Default Rate Multiple of 09-10 Default Rate 8 7 6 5 4 3 2 1 0 8 7 6 5 4 3 2 1 0 Multiple of 2001-03 Default Rate Necessary to Create a Loss N/A AAA AA A BBB BB B Multiple of 2009-10 Default Rate Necessary to Create a Loss N/A AAA AA A BBB BB B Model assumes a 40% loss given default on loans. (In contrast, the average historical loss given default/loss severity is 20-30%.) Then we determine what multiple of the 2001-2003 and 2008-2009 default experience would be necessary to create losses on the average CLO note (at each rating level) The top chart shows the multiples of 2001-2003 defaults necessary to create losses for different tranches. For instance, the default rate would need to be 4x the 2001-2003 default rate in order to create losses on a typical A rated CLO note (red bar). The bottom chart shows the multiples of 2009-2010 defaults necessary to create losses for different tranches. For instance, the default rate would need to be 3x the 2009-2010 default rate in order to create losses on a typical BBB rated CLO note (gold bar). Source: BAML 24
Comparison of Other Ways to Invest in Loans Size of Investment Separately Managed Accounts Comingled Accounts Retail Mutual Funds Large Moderate Small Minimums Customization High Limited None Tenor Customized Flexible Daily Leverage Investor Option Available Limited 25
Current Trends What is happening in the U.S. institutional corporate loan market today? Loan Issuance Secondary Market Spreads Structure CLO issuance/refinancing 26
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