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Floating-Rate LoansPoised to Perform

4

Floating-Rate Loans Seek Greater Prominence in Portfolios

10

“Great De-Leveraging” Raises Profile of

Floating Rate Loans

14

CONTENTS

410 14

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4



Floating-Rate Loans Poised to Perform

lthough business lending may predate the rise of the bond andequity markets by centuries, loans as a mainstream asset classhave only recently gained recognition among the institutionalinvestment community. Now many investment professionalsbelieve that the post-crash environment – with its uncertain out-look for long-term economic growth, stock volatility, financial weaknessat every level of government, and the prospect of steadily risinginterest rates and inflation — may offer ideal investment conditionsfor floating-rate corporate loans to perform well, especially comparedto other fixed-income alternatives.

Corporate loans, or more formally “senior secured floating-ratedebt instruments,” are the senior-most debt obligations of non-investment grade corporate borrowers (the same cohort of companiesthat issue high-yield bonds). Being the senior debt on the balancesheet and secured by collateral means that loans provide a moreprotected repayment stream to investors, with credit losses thathave historically averaged less than half those of high-yield bonds,according to Standard & Poor’s default and recovery statistics.

A

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5

At the same time, with floating interest rates thatare periodically reset at a spread over the London Inter-Bank Offered Rate (LIBOR), loans actually benefit fromincreases in interest rates, as opposed to traditionalbonds whose market value decreases when interest ratesrise. The floating-rate feature appeals to investors whowant to have a fixed-income component to their portfo-lios, but feel the current economic environment, with in-terest rates at a 30-year low and turning upward, is not anopportune time to be betting on interest rates remainingflat or dropping, which is the inherent interest rate bet inany fixed rate bond.

Portfolio managers who recognize this have beenmoving substantial amounts of new money into loanassets in recent months. Retail investors alone werereported by Lipper FMI to have moved almost $3 billioninto loan mutual funds during the month of December2010. “Duration risk has become much more of a realityto investors as long bond yields have moved up sharply inrecent months,” said Scott Page, vice president, portfoliomanager and director of Eaton Vance's Floating-RateLoan Group. “For investors who wish to reduce durationin their portfolios, floating-rate bank loans are the simplestto understand, easiest to trade and most liquid of anymajor fixed-income asset class.”

From “bank loan” to “asset class”The investor base for loans has been expanding beyondtraditional banks and specialized investment vehicles,like collateralized loan obligations, which were the main-stay of the market until recently. The new investors aremore likely to be oriented toward total returns, ratherthan focused on a spread over LIBOR that they wouldleverage multiple times. “We believe the institutionalloan buyer base is shifting from spread-based buyers likeCLOs to total yield-based buyers like managed accounts,high yield and loan mutual funds, and other institutionalvehicles,” said David Frey, portfolio manager at HighbridgePrincipal Strategies. “As a result, we are optimistic thatthe favorable new issue pricing we have seen recently willcontinue.”

Mr. Frey also thinks that loan demand – much ofwhich is driven by corporate mergers and acquisitions –will continue to grow. “Some of the key drivers of M&Aactivity are slow organic growth, low interest rates andimproving CEO confidence,” he said. “That seems to bethe situation today, so we are optimistic that M&Aactivity will increase and present new loan-investmentopportunities.”

The loan market gives traditional institutional in-vestors access to the top of the corporate liability struc-ture – secured loans – instead of being limited to bonds(which are unsecured or subordinated) and equity. In thepast, by ceding the better secured, floating-rate loanassets to the commercial banks, investors left quite a biton the proverbial table in terms of attractive risk/rewardreturns, cash-flow stability and portfolio diversification.But they essentially had no choice. Until recently, therewere few investment vehicles providing large-scaleinstitutional access to the loan asset class.

The explosive growth of the syndicated loan marketover the past two decades has brought with it a substantialincrease in investment management firms focused onserving institutional investors in the loan market. It hasspurred the development of loan tranches and otherinvestment vehicles designed specifically to meet thedistinct investment preferences of institutional buyers.Loan-market liquidity has also increased substantially,as a result of robust growth in secondary loan trading,the development of standardized trading, distributionand settlement protocols, and the greater transparencyand reliability of third-party pricing.

History of steady returnsReturns to loan investors have been mostly stable, positiveand consistent for the thirteen years since the S&P/LSTALeveraged Loan Index began. The two-year worldwideliquidity crisis in 2008 and 2009 affected the loan marketas it did other credit and equity markets, driving loan-market returns down by 30% in 2008 and back up by 52%in 2009. Patient “buy-and-hold” investors who held theirloan portfolios through the crisis would have earned a netreturn of about 8% over the two years, despite theresulting recession and some of the highest default levelsever recorded. In 2010, the index returned about 10%, asthe credit environment improved and loan default ratesfell to below 2%.

Many loan professionals believe returns may not bequite so high in 2011, but they could be close. “Loans havetraditionally offered stable, predictable returns toinvestors,” said Dan Norman, senior vice president andgroup head of ING's Senior Loan Group. “The liquiditycrisis a couple of years ago ended an eleven-year streakof positive returns, but we have now had two successivepositive years. I think there is every reason to believeloans are on their way to establishing a new streak ofattractive positive returns.”

Mr. Norman, like many loan managers, expects loanreturns could exceed historical averages in 2011, based ona combination of gross yields and continuing capital ap-preciation. If he is right – and many other banks and loan

Source: S&P/LSTA Leveraged Loan Index

S&P/LSTA Leveraged Loan Index

pi06LSTA_p.qxp 1/28/11 10:46 AM

researchers are publishing estimates in the same range –then the loan market’s “new normal” returns may actu-ally be somewhat higher than their pre-crash “old nor-mal.”

The loan market’s performance through the mostchallenging credit environment since the 1930s has con-firmed to many observers and investors the durability ofsenior, secured loan assets from a credit perspective. Ithas also contributed to growing interest by institutionalinvestors in senior secured loans as a mainstream assetclass – one that deserves a permanent position in a fixed-income allocation whether it be an individual, pensionfund, endowment or other long-term portfolio – ratherthan just a position as an alternative or opportunistic in-vestment.

The real strength of loans as an asset class, manyloan industry professionals believe, will not be apparentuntil the economy encounters a sustained period of ris-ing interest rates. Just as bonds performed brilliantlywith the wind of falling interest rates at their back, manyloan investors expect their asset class to shine if andwhen interest rates begin their climb, which has beenlong anticipated by some. “Even if an investor is unsurewhich way interest rates will move long term,” said Mr.Frey of Highbridge, “given that interest rates are cur-rently still near historical lows, prudence might dictatehedging one’s fixed income bet by holding both loans andbonds.”

Risk-Reward ProfileThough both loans and bonds are considered fixedincome, they diverge in other ways.

Loans and bonds are typically regarded as “fixed-in-come” investments. While this is true insofar as theprincipal amount that an issuer contracts to repay atmaturity is fixed in both cases, the two asset classesdiverge in other respects, presenting distinct risk/rewardprofiles.

Bond investments combine two main risks: credit

risk and interest-rate risk. The higher the credit qualityof the bond issuer and the lower the likelihood of default,the more a bond becomes essentially a bet on the directionof interest rates. In the high-yield world, the situation ismore complicated, partly because the credit risks varyconsiderably between loans and bonds.

Also, the nature of the interest-rate bet inherent ineach instrument is different. Because loans are gener-ally the senior-most debt of the issuer and are secured bycollateral and other protective features, they typically de-fault less frequently than high-yield bonds. Moreover,when they do default, loan investors generally recover ata consistently higher rate than bond investors, as aresult of having collateral. Recoveries post-bankruptcyaverage 70% for loans versus 40% for bonds. As a result,credit losses on loan portfolios typically run less than 50%of the losses on high-yield bond portfolios.

High-yield bonds and loans differ even moremarkedly in terms of how each asset reacts to changes ininterest rates. With bonds, interest rates are fixed for theterm of the instrument. With loans, interest rates arevariable or floating, defined as a spread over a base ratethat changes periodically. Typically the base rate is thethree-month LIBOR. Recent loan contracts have includeda LIBOR floor, a minimum base rate that applies even ifthe actual LIBOR rate is lower. This is intended to provideinvestors with a higher minimum return during abnormallylow interest-rate periods. Typical LIBOR floors have beenin the 1.5% to 1.75% range.

With both bonds and loans, investors are taking aposition with respect to future interest rates. Some aspectof the value of the investment — either its current marketvalue or its future income stream — will rise or fall withchanges in interest rates. But the impact on the investor’sportfolio – in terms of valuation, accounting and futureincome – differs greatly from bonds to loans. With bonds,future cash flows, which include interest coupon paymentsplus principal, are fixed (unless the issuer defaults). If in-terest rates change so the fixed rate on the bond is out ofsync with current interest-rate levels, the market priceof the bond will adjust up or down accordingly.

With loans, principal payments are fixed and the in-terest payments self-adjust to changes in interest rates.As a result, the price of the loan is generally not affectedsince the loan is always paying a market rate. In a risinginterest rate environment, the economic value of the loanincreases, since the income it generates rises along withinterest rates. Fixed-interest instruments, like bonds,decrease in both relative economic value and actual marketprice as interest rates rise. (Although generally immuneto interest-rate movements, loan prices may still vary inthe secondary market for non-interest-rate relatedreasons like the overall supply and demand of loans, marketliquidity, risk appetite and issue-specific credit factors.)

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Liabilities and Equity

“FixedIncome”

Loans Senior, secured, fixed principal return, floating-rate interest

Bonds Unsecured or subordinated,fixed principal return, fixed-rateinterest

Equity Lowest claim on assets, no fixedreturn, unlimited upside potential

}

continued on page 8

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11pi0028.pdf RunDate:02/07/11 LSTA Suppl Page:07 Color: 4/C

Driven by our ownbenchmarks.

Maintain a long-term perspective even in the most complex markets.

At Eaton Vance, we build on the knowledge we’ve gained in over more than eight decades. Our portfolio managers and career analysts, the best minds in the industry, adhere to time- tested principles. They follow a disciplined investment process, founded on rigorous fundamental research and an emphasis on risk management.

Eaton Vance’s dedicated institutional team expands on these strengths, delivering consultative, hands-on service to our clients. Their exceptional insight into our equity,

can help reveal opportunities for long-term success, whatever the market environment.

For more information contact Scott Ruddick, Head of Institutional, North America 617.672.8300

incurring losses. Past performance does not predict future results.

ClientCentric

PerformanceExcellence

RiskManagement

pi06LSTA_p.qxp 1/28/11 10:46 AM

Comparing returnsBonds have two primary elements of risk, which investorswant to be paid for: interest-rate or duration risk andcredit risk. Since floating-rate loans have no interest-rate/duration risk, the entire coupon is available tocompensate the loan investor for credit risk. In effect,comparing loan and bond returns requires netting out theportion of the bond return that compensates the holderfor taking the interest-rate bet embedded in the bond byvirtue of its fixed interest rate.

An investor gets paid almost 3.5% on a 10-yearTreasury bond and about 10 to 15 basis points for athree-month T-bill. Although each has the same creditrisk, the difference – about 3.25% – represents the mar-ket’s premium to investors for taking the 10-year in-terest-rate risk. To compare high-yield bonds and loansas pure credit instruments requires subtracting that10-year/three-month Treasury differential (3.25%) fromthe bond coupon. So if high-yield bond yields (depend-ing on the credit rating) typically range between 7%and 10%, then the pure credit yield after deducting thepremium for the interest-rate bet would be a range ap-proximately between 4% to 7%. Meanwhile, the rangeof typical loan yields for a similar range of credits is 6%to 7%, all of it compensation to the investor for taking

credit risk. (The accompanying table illustrates thesedifferences, based on the assumptions presented, whichmay vary over time.)

The figures suggest that, with the interest-rate betpremium removed, loans pay investors as much or some-times more than bonds for taking equivalent credit risk.But the loan advantage is actually better than that whenone adjusts for the higher recoveries that loan investorstypically receive when issuers default. Although defaultrates vary through economic and credit cycles, typical de-fault rates of 3% per annum would result in net creditcosts of about 2% for high-yield bonds (which are usuallyunsecured or subordinated), but just below 1% for securedloans.

Many professional loan managers believe they canwiden the differential even further through good creditselection and active portfolio management. “A lot ofpeople have a perception that the credit loss on non-in-vestment grade senior loans is fairly high, but historyseems to demonstrate otherwise, even during the recentcrisis,” said Highbridge’s Mr. Frey. “Moreover, a substantialportion of the company-specific credit risk can be reducedthrough a well diversified portfolio, and seasoned activemanagers typically have default rates that are a fractionof the overall market.” ◆

Weighing ReturnsLoans fare well compared to high-yield bonds.

8



Senior Loans 6-7% 0.0% 6-7% 3.0% 30% 0.9% 5.1-6.1%

High-Yield Bonds 7-10% 3.25% 3.75%-6.75% 3.0% 60% 1.8% 2%-5%

Loan/Bond Return Comparison

Range ofCouponYields

InterestRate BetPremium

Return onCredit Risk (Netof Interest Rate

Bet)

AnticipatedDefault Rate

(annual)

Loss GivenDefault

CreditCost

Net Returnto Investorfor Credit

Risk

continued from page 6

pi06LSTA_p.qxp 1/28/11 10:46 AM

Looking for Solutions to Rising Interest Rates?

We Have Them.

Floating rate senior loans can provide a natural hedge against rising

interest rates. ING’s Senior Loan Group is a leader in senior loan asset

management, offering investment solutions in this strategy for more

than 15 years. As a part of ING Investment Management, a leading

globally coordinated asset manager with $515 billion in assets under

management, the ING Senior Loan Group can provide senior loans

solutions tailored to your investment needs.

ING’s Senior Loan Group consists of 44 members in the U.S. and

Europe dedicated to senior loans and providing global expertise

and unparalleled access to this private market. Group Heads

Dan Norman and Jeff Bakalar have over 49 years of combined

investment experience.

©2011 ING Investments Distributor, LLC

INVESTMENT MANAGEMENT

Dan Norman Jeff Bakalar

Call us now to learn more about how senior loans can benefi t your portfolios.

Contact: Erica Evans

Head of Institutional Sales and Service

(212) 309-6552

ING Investment Management

230 Park Avenue, New York, NY 10169

www.inginvestment.com

ING Investment Management Offers a Full Range of Senior Loan Investments for Institutional Clients


pi06LSTA_p.qxp 1/28/11 10:46 AM

Floating-Rate LoansSeek Greater Prominence

in Portfolios

10



he financial press has been awash with articles aboutpossible “bond bubbles” and the risks of holding fixed-ratedebt as economic and fiscal forces come together to causeinterest rates to rise over the next few years. But most ofthe articles focus on investment re-allocation from onepart of the bond market to another, such as from Treas-ury bonds to corporates, or from investment-grade bondsto high-yield ones. Others advocate moving out of bondsand fixed income completely and into either stocks, withtheir high volatility, or extremely short-duration assets,which have no volatility, but no yield either.

Little attention has been devoted to the option ofmoving out of bonds but remaining in fixed-income in-struments that involve no interest-rate bet. “Loans areone of the few, and often the most attractive, short-dura-tion investment alternatives that pay high current in-come,” said Dan Norman, senior vice president and grouphead of ING's Senior Loan Group. “Floating-rate corpo-rate loans generally allow investors to earn an attractivecurrent return in the range of 5% to 6% and still have up-side potential in case interest rates rise due to economicgrowth and/or renewed inflation.”

Other managers agree. “We think the case for put-ting floating-rate loans in portfolios may now be the mostcompelling in the 20-year history of the asset class,”wrote Scott Page, vice president, portfolio manager anddirector of Eaton Vance Floating Rate Loan Group, in a

recent research report.Floating-rate loans – loans to non-investment grade

companies – have been the purview of commercial banksfor hundreds of years. It is only over the past two decadesthat loans have evolved from a “buy-and-hold” asset onthe books of banks to a full-fledged publicly underwrit-ten and traded asset class. Most akin to public high-yieldbonds because of the type of companies being financed,the volume of institutional term loan issuance actuallyexceeded that of public high-yield bonds during the yearsimmediately before the crash.

Since the crash, high-yield bond volumes have ex-ceeded floating-rate loan issuance, a development that isnot surprising. With interest rates hovering near theirlowest point in a generation, corporations have beeneager to issue fixed-rate bonds to lock in low borrowingrates for years to come. Precisely because so many com-panies feel the current environment is the most attrac-tive time to sell fixed-rate bonds, investors are wary ofhaving such a large portion of their fixed-income portfo-lios allocated to bonds.

“With bond yields near historic lows, the risk of lossattached to any upward move in interest rates is veryreal,” said Greg Stoeckle, managing director and head ofglobal bank loans at Invesco. “Hence, sophisticated insti-tutional investors have been looking for an asset classthat provides current income, like bonds, but protects,

T

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11

and actually supplements, current income in the event ofrising interest rates.”

Many investors still regard the term “fixed income”as being synonymous with “bonds,” reflecting the widegulf that existed – legally, culturally and institutionally– between public debt instruments (primarily bonds) andprivate debt instruments (primarily loans) until just 10 to15 years ago. Bonds were securities, underwritten andsold to institutional and retail buyers by investmentbankers and distributed in a public market. Loans werenot securities, but were private financings arranged bylending officers who worked for commercial banks thatheld the loans on their books until maturity.

The gap between loans and bonds first began to erodeas loans and the deals they were financing became solarge that individual banks had to “syndicate” them tolarger groups of other banks, with the role of syndicatorincreasingly coming to resemble that of an underwriter inthe bond market. The erosion accelerated as non-bank in-stitutional investors, such as insurance companies, mu-tual funds and securitized vehicles, started to buy intoloan syndications. Eventually bankers began to structurededicated term-loan tranches with features, such aslonger terms, fully funded and non-amortizing balloonpayments, specifically oriented toward the needs of theseinstitutional investors.

The advent of floating-rate corporate loans as an es-tablished institutional asset class now provides investors

an opportunity to split their fixed-income position into itstwo component parts: the credit bet and the interest-ratebet. Previously, when bonds were the only game in townfor fixed-income investors, buying debt without someamount of interest-rate bet attached to it was virtuallyimpossible. Similarly, investors who wanted a “pure”credit bet had to counter the interest-rate risk via an in-terest-rate swap or similar derivative instrument.

Risk MatrixThe advent of loans as an asset class has introduced agreater credit risk component into the fixed income world.

Leveraged Finance Volume

continued on page 12

Fixed Income InstrumentsCredit Risk/Interest Rate Risk Matrix

HighCredit Risk

LowCredit Risk

Low InterestRate Risk

High InterestRate Risk

High YieldCorporate Bonds

Long-termCorporate Bonds

Long-termTreasury Bonds

Floating-rateCorporate Loans

Short-termTreasury Bills

Leveraged Finance Volume Returning to Pre-crash LevelsUS Volume

pi06LSTA_p.qxp 1/28/11 10:46 AM

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Of course, not all debt is created equal with respectto the mix of credit risk and interest-rate risk from onefixed-income asset class to another. Three-month Treas-ury bills, for example, have recently been yielding 10 to15 basis points, making them the proxy for the actualcredit risk of the U.S. government (i.e., the risk of notbeing paid back in U.S. dollars). Ten-year Treasury bondscarry a yield of almost 3.5%. Since the credit risk is vir-tually the same (i.e., the U.S. government’s ability toprint out new U.S. dollars to repay its debts won’t changeover ten years), the difference of just over 3.25% betweenthe three-month T-bill yield and the 10-year T-bond yieldrepresents the interest-rate risk premium investors arebeing paid for tying up their money for 10 years ratherthan three months.

A 10-year, single-A-rated corporate bond yields about4.35%. Since 3.25% of that covers the premium on the 10-year interest rate bet, then the remainder – 4.35% minus3.25%, or 1.1% – is what the investor is being paid fortaking the 10-year credit risk on the single-A corporate is-suer. Neither is a very handsome reward: 3.25% for therisk that inflation and interest rates might rise over thenext 10 years, or 1.1% for a corporate credit risk – albeita relatively good one – for the same period.

Rewards for taking credit risk in the high-yield cor-porate sector are higher, as they ought to be, given theheightened risk of non-payment. Typical high-yield bondsyielding in a range of 7% to 10%, depending on the is-suer’s credit rating, pay an investor approximately 4% to7% for credit risk, after deducting the 3.25% interest-rate-bet premium. Corporate loans have recently yieldedin a range of about 6% to 7%, with the entire coupon pay-ing for credit risk, since there is minimal interest-raterisk with the continually re-setting floating rate.

Further, corporate loan investors typically get to keepmore of their coupon than high-yield investors, after credit

losses are deducted. That's because corporate loans, rank-ing senior and secured by collateral, suffer credit losses thatare less than half those experienced by the unsecured oroften subordinated high-yield bond holders.

The various types of fixed-income instruments allowinvestors to pick their risk profile (see chart). An investorwho is primarily interested in making an interest-ratebet should buy a long-term Treasury bond, since over 90%of the coupon return is the interest-rate-bet premium.Even an investment-grade corporate bond is mostly aninterest-rate bet, with only 25% of the coupon represent-ing a return on taking credit risk and the remaining 75%being the interest-rate-bet premium.

High-yield corporate bonds flip that ratio around,with the majority of the coupon (54% to 67%, dependingon credit quality) compensating the investor for takingcredit risk, but with still a sizable remainder (33% to46%) allocated toward interest-rate risk. Corporate loans,with their adjustable interest rates, remain the onlymajor fixed-income asset class that represents a 100%“pure play” on credit risk.

Once bonds are understood as “hybrid” instruments,with 30% to 90% or more of their return based on inter-est rate movements, it is easy to see how powerful the re-cent 30-year drop in interest rates was. Investors who feelthat rates are likely to remain stable or move up shouldlook to lighten their allocation to instruments that carryan embedded bet that rates will fall, if an alternative isavailable that does not contain such a bet.

Prior to the rise of the loan asset class, no such vi-able alternative was available. “The rise of the syndicatedcorporate loan market has certainly changed all that,”said Craig Russ, vice president and portfolio manager atEaton Vance's Floating-Rate Loan Group. “Now institu-tional and retail investors can enjoy the advantages ofbuying corporate debt without making a bet on interestrates that they may not really want to make.” ◆

Treasury Bonds 3.50% 3.25% 0.25% 93% 7%

Single-ACoporate Bonds 4.35% 3.25% 1.10% 75% 25%

High-Yield Bonds 7-10% 3.25% 3.75%-6.75% 33%-46% 54%-67

Senior Loans 6-7% 0.0% 6-7% 0% 100%

Coupon Yields

InterestRate Bet Premium

Return on Credit Risk(Net Interest Rate Bet)

Percent of CouponAllocated to Interest

Rate Bet

Percent of CouponAllocated to Credit Risk

Interest Rate Risk/ Credit Risk Return Allocation

continued from page 11

Divvying Up RiskInvestors can choose where to place their bets.

pi06LSTA_p.qxp 1/28/11 10:46 AM

Invesco Senior Secured Management• One of the leading pure-play investment managers

with exclusive focus on senior secured bank loans

• More than $18 billion under management acrossretail and institutional strategies

• A 20-year history in managing the asset class

• A team of 41 professionals dedicated to bank loans

For more information, visit institutional.invesco.comor contact Senior Client Portfolio Manager Kevin Petrovcik,212 278 9611, [email protected].

Helping Investors WorldwideAchieve Their Financial Objectives

Experience Builds Trust

Assets under management as of Sept. 30, 2010; all other data as of Dec. 31, 2010


pi06LSTA_p.qxp 1/28/11 10:46 AM

or years, bankers, loan portfolio managers and investorshave been singing the praises of floating-rate loans to alarger investment community that was indifferent.Decades of falling interest rates and a steadily growingeconomy provided a fairly benign environment for traditionalfixed-income investors who felt no particular need topush the definition of fixed income beyond bonds. Butthere is nothing like a market crash and de-leveraging toraise the profile of an asset class. The last three yearscertainly did that for floating-rate loans.

Respectable PerformanceThough volatile, the S&P/LSTA Leveraged Loan Indexreturned 19% over the three years from 2008 to 2010.

An investor who held the S&P/LSTA loan index throughthe three-year period from 2008 to 2010 would have lost29% the first year, gained 52% the following year, andmade an additional 10% in 2010, for a respectable 19% gainover the period (see chart above). This positive perform-ance is in spite of a loan market default rate that hit 11%.That was higher than even the worst level reached in theprevious high-default period of 1999 to 2003, when loandefault rates reached almost 8% (see chart on right).

“Loans are hardly a new asset class,” points out ScottPage, vice president, portfolio manager & director ofEaton Vance Floating Rate Loan Group. “Loans have

been around for 20 years, but the ‘Great De-leveraging’has given them a chance to prove themselves to the widerinvestment community,” he said.

What enabled the loan market to bounce back soquickly from the worst credit crunch since the GreatDepression? More than anything, it was credit structureand asset protection. While floating-rate loans representdebt of the same cohort of non-investment grade compa-nies that issue high yield bonds, the comparison stopsthere. Loans are senior obligations, secured by collateral– usually the key earning assets of the issuer – and theyhave covenants that allow the lenders to take protectivesteps if the company’s financial health begins to deteriorate.

As a result, loans generally do not default as readilyas high-yield bonds, whose holders have minimalcovenants and control, and often must sit on the sidelinesas the issuer’s creditworthiness declines. Moreover, whenborrowers do default, loan investors, as a result of theircollateral security and senior position, recover at aconsistently higher rate than bond investors. Recoveriespost-bankruptcy typically average 70% for loans versus40% for bonds, according to numerous data studies over

14



“Great De-Leveraging” Raises Profile of Floating Rate Loans

Default Rate

Source: S&P/LSTA Leveraged Loan Index

F

S&P/LSTA Leveraged Loan Index

Heavy Dose of DefaultsLoan defaults reached a hefty 11% in 2009.

pi06LSTA_p.qxp 1/28/11 10:46 AM

many years. This translates into a substantial “creditexpense” differential for a diversified portfolio of loanscompared to a similar portfolio of bonds. Over time, loansincur credit losses a bit less than one-half those of bonds(see example below).

While the 2 to 1 ratio of high-yield bond credit lossesto corporate-loan credit losses tends to hold throughoutcredit cycles, the absolute advantage increases as theeconomy worsens and defaults increase. Conversely, theabsolute advantage decreases as defaults drop. A currentexample of how this structural advantage works in practiceis the recent Burger King loan. Craig Russ, vice presidentand portfolio manager in the Eaton Vance Floating RateLoan Group, views Burger King as a prototypical exampleof the loan asset class. “The secured loan is at the top ofthe capital structure, with junior capital – equity and thehigh-yield bond – providing a good cushion. And it’s gotan attractive spread.” (See sidebar for details.)

The structural seniority of loans, combined with theirfloating interest rates, is a powerful combination in termsof being able to perform well in various types of economicscenarios. “Loans are the fixed-income asset class for allseasons,” said Dan Norman, senior vice president andgroup head of ING's Senior Loan Group. “While thefloating rate advantages are clear and apparent in anexpansive, rising interest-rate environment, loans havealso significantly outperformed not only traditionalfixed-income instruments such as Treasuries, investmentgrade and non-investment grade corporate bonds, butalso equities in prior recessionary cycles. Therefore,loans are attractive long-term investments for institutionalinvestors.” ◆



15

Burger King Financing

The recent Burger King buyout financing shows howcompanies utilize both loans and bonds to completemajor deals. The buyout was for just over $4 billion,of which just over two-thirds or $2.8 billion wasraised as debt (loans and bonds) with the new ownerproviding $1.3 billion in equity.

Deal features, risk and rewardThe loans are secured by all of Burger King’s do-mestic US assets and two-thirds of the stock in itsforeign subsidiaries. They bear interest at LIBOR +4.5% (4.75% for a small Euro tranche), with a LIBOR“floor” of 1.75%, for a total coupon of 6.25% (6.5% inEurope). The loan was sold at a discount of 99%,bringing the yield up to 6.62% (US) and 6.88%(EURO).

The bonds are unsecured, ranking behind theloans in the event of default. With a fixed rate of9.875%, they were sold at par. We look to the 8-yearpoint on the Treasury yield curve – 3% – minus the3-month T-Bill rate of 12 basis points to estimate the“interest rate bet” portion of the coupon. The re-maining 7% is what the bonds pay for credit risk.

Burger King, as a corporate entity, is rated Band B2 respectively by S&P and Moody’s. The loanand bond were notched up (the loan) and notcheddown (the bond) from the corporate ratings to differ-entiate the starkly different risks, as follows:

• Loans were notched up two notches, to BB-andBa3, as lenders are expected to be repaid in full if Burger King defaults

• Bonds were notched down to B- and Caa1, indicating both rating agencies expect losses of 50% to 70% in a default

The slight difference in coupons indicates bond-holders being paid from 1/8th to 3/8th percent morefor taking the additional risk. Typical default costson high yield bond portfolios could run 1-2% yearly,versus less than half that on loan portfolios, whichmore than offsets the gross coupon differential.

Portfolio Credit Costs: Doing the MathAssume two portfolios with identical credit profiles in terms of default likelihood(a mix of single-Bs and double-Bs with a blended default probability of 4%per year*), but one portfolio consists of high-yield bonds (40% recoveries onaverage) and the other of senior secured loans (70% recoveries onaverage).

HY bond portfolio: 4% defaults, with 40% recovery/60% loss

Results in an annual 4% X 60% = 2.4% portfolio losscredit expense of:

Senior secured 4% defaults, with 70% recovery/30% lossloan portfolio:

Results in an annual 4% X 30% = 1.2% portfolio losscredit expense of:

The loan portfolio credit expense is only half that of the bond portfolio, atany level of default, because the secured loans consistently recover at ahigher rate than the unsecured and sometimes subordinated high-yieldbonds. In absolute terms, of course, the difference becomes greater athigher default rates. For example, at a 5% default rate bonds suffer aportfolio credit loss of 3% vs. loans at half of that, or 1.5%. At an 8% default rate, bonds lose 4.8%; loans 2.4%.*In reality, this understates the advantage enjoyed by loans, since occasionally a borrower strapped for cashwill default on its unsecured (or subordinated) bond, but continue to make payments on its senior securedloan. That will count as a bond default, but not a loan default, in compiling the statistics. So the default ratefor loans is actually a bit lower than it is for bonds, even for an identical cohort of issuers.

Loan FinancingRevolving credit facility – 5 years $150 million

Term Loan – 6 years $1.85 billion

Total Loans $2 billion

High Yield Bond – 8 years $800 million

Total Debt $2.8 billion

Equity $1.3 billion

Total Funding $4.1 billion

pi06LSTA_p.qxp 1/28/11 10:46 AM


pi06LSTA_p.qxp 1/28/11 10:46 AM

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