February 2015 » White paper
Opportunity in
leveraged companies
Key takeaways
David L. Glancy
Portfolio Manager
• Leverage can create
attractive investment
opportunities.
• Leveraged-company
securities offer
different performance
characteristics than
the broad stock and
bond markets.
• Leveraged-company
investing requires
specialized managerial
skill for analyzing balance
sheets and corporate
capital structures.
• Putnam’s David Glancy
is skilled in leveragedcompany investing,
with more than 25 years
of experience.
The fundamental and financial opportunities inherent in leveraged companies can
provide strong upside potential for investments across their capital structures.
Leverage tends to accelerate business changes at a company, potentially increasing
returns on equity.
Leverage also creates complexity, which makes it more likely that securities of
these companies — common and preferred equity, high-yield bonds, and bank
loans — will be mispriced, offering great opportunities to investors who can analyze
them correctly. When a company employs different types of leverage — from bank
loans and bonds to preferred equity shares — each type of security can have distinct
investment characteristics. Debt can have a variety of effects on cash flow and earnings, which is what ultimately matters to equity investors. The equity of companies
that use debt successfully to grow operations can appreciate quickly, particularly
during periods of economic recovery when borrowing costs may be low.
Investing successfully in leveraged companies requires thorough understanding
of corporate finance, accounting, and the intricacies of the capital structure. It takes
unique skills and experience to analyze the layers of capital structures and find
nuggets of exceptional value.
One of the most experienced portfolio managers specializing in leveraged
companies is Putnam’s David Glancy. He has devoted his 28-year career to investing
in leveraged companies and has managed portfolios that invest in leveraged companies over several economic and market cycles. He is fluent in the arcane language of
corporate finance and accounting arrangements, giving him the ability to thoroughly
dissect corporate balance sheets and fully grasp opportunities and risks. He has had
firsthand experience participating in corporate reorganizations that helped to unlock
value for investors.
This paper provides background on investing in the equity and debt securities
of leveraged companies and highlights two strategies managed by Mr. Glancy to
pursue current and future opportunities among leveraged companies.
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FEBRUARY 2015 | Opportunity in leveraged companies
Leveraged businesses employ
large amounts of debt by issuing
high-yield bonds or bank loans,
and where successful, this
strategy can increase returns on
equity and lift the performance
of all the company’s securities.
“Rising stars,” or early-stage growth companies, that
use borrowing to finance their operations while they
develop new products and a customer base. Many young
technology and biotechnology companies have this
business model.
“Fallen angels,” or former investment-grade companies, that had been in stronger capital positions but have
become more heavily dependent on debt.
Special situation companies that use debt as part of
a restructuring, or as part of a merger, acquisition, or
privatization.
Defining leveraged companies
A leveraged company is any company that employs
significant leverage in its capital structure through any
combination of borrowing from banks and other lenders
and through issuing fixed-income, convertible, or
preferred equity securities. Many of these companies
lack the operating history or balance-sheet strength to
merit an investment-grade bond rating from the major
rating agencies.
How leverage can increase a company’s return
on equity
Why would a company add leverage? A company can
generate higher returns on equity if it increases its use
of debt. When a company uses debt, its equity holders
avoid risking additional equity because the new money
is borrowed from others. Any future increase in returns
(above the cost of debt service) accrues to the same equity
base (Figure 1).
To understand the concept of leverage, it may be helpful
to recognize that a home mortgage is a type of leverage.
A mortgage is debt that finances the purchase of a home.
A homeowner’s down payment is equivalent to equity,
and the mortgage represents leverage. This metaphor of
a mortgage also helps illustrate the power that leverage
can have. For many people, a mortgage is the catalyst that
makes it possible to move from renting a home to owning
one. Similarly, for businesses, debt leverage is like a catalyst
that can accelerate changes at a company, allowing it to
grow more rapidly and increase its equity value over time.
Of course, the interest payments that come with the
debt add to the company’s operating expenses and
thereby reduce profits. However, as long as the company’s
cash flow can cover the interest payments, even a smaller
profit margin can result in a higher return on the equity
invested by shareholders.
Securities of leveraged companies can provide
strong returns
Leveraged-company equities offer the potential to outperform the stock market by a significant margin, particularly
during a period of economic recovery. Since these
companies use debt heavily, they tend to have their best
performance when credit is widely available, interest rates
are low, and strong economic momentum supports business earnings. An example of such a period occurred
Types of leveraged companies
Companies become leveraged for different reasons. The
following are common types of leveraged companies:
Capital-intensive businesses, such as telecommunications companies, that borrow money to build and
maintain network infrastructure.
Figure 1. Leverage can increase return potential to equity investors
Capital structure
Income
Return on equity
Company A
$200 in equity
$50
$50/$200 = 25%
Company B (leveraged)
$100 in equity +
$100 in debt
$40
($50–$10 interest cost)
$40/$100 = 40%
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Debt securities of leveraged companies offer
total return and lower volatility potential
following the end of the 2001 recession. The federal
funds rate was reduced to less than 2% and the economic
growth rate accelerated from 1.6% in the last quarter of
2001 to 7.5% in the third quarter of 2003. Altogether, over
five years, leveraged-company stocks doubled the return
of the S&P 500 (Figure 2). High-yield bonds and bank loans
also provided strong returns in the same period.
The debt securities of leveraged companies include
high-yield bonds and bank loan securities, investments
that can provide attractive total return through a
combination of current income and capital appreciation.
In addition, the debt of leveraged companies tends to
be less volatile than the equity securities, as measured
by standard deviation over multi-year periods. With
these characteristics, debt securities can help to
diversify a portfolio of leveraged-company equities.
Adding high-yield bonds and bank loans to a portfolio
of leveraged-company equities can significantly reduce
its volatility (Figure 4).
Relative performance can vary in other time frames,
but as the economy gradually began to recover from
the 2008 financial crisis, leveraged-company stocks,
high-yield bonds, and bank loans once again showed
their ability to perform well relative to the broad equity
market (Figure 3).
Figure 2. Leveraged-company stocks, bonds, and bank loans were competitive with stocks
during the last economic recovery, 12/31/01–12/31/06
12.56%
10.61%
6.19%
Leveraged-company stocks
5.75%
Stocks
High-yield bonds
Bank loans
Figure 3. Leveraged-company security indexes have remained competitive with stocks in
the current recovery, 6/30/09–12/31/14*
17.08%
18.25%
12.61%
7.71%
Leveraged-company stocks
Stocks
High-yield bonds
Bank loans
1Expansion start date as determined by the National Bureau of Economic Research.
Figures 2 and 3 are for informational purposes only and do not reflect the performance of any Putnam investment product, which will differ.
Leveraged-company stocks are measured by the Credit Suisse Leveraged Equity Index, which includes companies that issue high-yield corporate
bonds included in the Credit Suisse High Yield Bond Index; stocks are measured by the S&P 500 Index, a broad measure of stock market performance; high-yield bonds are measured by the JPMorgan Developed High Yield Index, which represents high-yield fixed-income securities issued in
developed countries; and bank loans are measured by the S&P/LSTA Leveraged Loan Index, which represents bank loans issued to leveraged companies. Indexes are unmanaged and do not reflect any fees or expenses, and you cannot invest directly in an index. Past performance is not indicative of
future results, and results may differ over other performance periods.
Putnam Capital Spectrum Fund and Putnam Equity Spectrum Fund have no long-term performance history.
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FEBRUARY 2015 | Opportunity in leveraged companies
Figure 4. Diversification across equity and
debt securities reduced volatility in 3-year
index performance, 12/31/11–12/31/14
An x-ray of the capital structure
The capital structure is represented as an inverted triangle
because, in most leveraged companies, bank loans tend
to compose the largest slice of the corporate capital structure, in terms of value, followed by bonds and equities
(Figure 5). This reflects the relatively high debt burdens of
leveraged companies.
12.46%
Bank loans are at the top of the structure because, in the
event of a corporate reorganization, they have the first
claims on cash flows. In addition, bank loans are considered
secured because they are typically backed by collateral,
such as a company’s buildings or equipment, or its receivables from customers.
7.64%
CS Leveraged Equity Index
Blended Index
Source: Putnam Investments.
This chart is for informational purposes only. It does not reflect the
performance of any Putnam fund, which will differ. Leveraged-company
stocks are represented by the Credit Suisse Leveraged Equity Index.
The hypothetical portfolio is composed of a 50% allocation to the Credit
Suisse Leveraged Equity Index, a 30% allocation to the JPMorgan
Developed High Yield Index, and a 20% allocation to the Barclays U.S.
High Yield Loan Index, which is an unmanaged index that provides broad
and comprehensive total return metrics of the universe of U.S. dollar
denominated syndicated term loans. Indexes are unmanaged and do not
reflect any fees or expenses, and you cannot invest directly in an index.
Past performance is not indicative of future results, and results may
differ over other performance periods. Standard deviation measures
how widely a set of values varies from the mean. It is a historical measure
of the variability of return earned by an investment portfolio.
Putnam Capital Spectrum Fund and Putnam Equity Spectrum Fund
have no long-term performance history.
Bonds have second priority after loans. Since most bonds
are not secured by collateral, they generally pay higher
yields to compensate investors for risk. These bonds are
typically part of the high-yield asset class.
At the level of equities, preferred shares generally earn
a dividend, but lack voting rights, while common equity
shares have voting rights, but might not earn a dividend.
In the event of a company reorganization or liquidation,
preferred shareholders are positioned ahead of common
equity shareholders for distributions. Convertibles are
technically bonds, except that they can be exchanged
for specified amounts of common stock when the stock
reaches a predetermined price. This feature influences their
performance. Warrants are options issued by a company
that permit the owner to buy shares of common stock at
a specified price. Rights are new shares issued to owners
of existing shares in proportion to their current holdings,
which raises new capital for the company without diluting
the ownership of current shareholders.
Analyzing leveraged companies
Selecting attractive securities of leveraged companies
requires a different focus than general equity investing.
Traditional equity investing styles — growth and value
investing — focus on finding companies with aboveaverage earnings growth or below-average valuations.
Selecting leveraged companies requires thorough understanding of corporate finance, accounting, and the
intricacies of the corporate capital structure.
Why be a common equity shareholder and rank last in
the hierarchy? The reason is that common equity shareholders own what is left after investors at all other levels of
the capital structure receive what is due them. For all of the
higher levels, the claims are more or less fixed. In short,
when the company outperforms, all of the extra benefit
flows to the common equity shareholders.
The capital structure is a hierarchy of claims on a
company, and each level has different features and a
different priority. As the capital structure diagram shows,
the hierarchy places bank loans at the top, followed by
bonds (also called debentures or fixed-income securities),
convertibles and preferred equity, common equity, and
rights and warrants.
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Figure 5. Understanding corporate capital structure
Higher
protection
Less
protection
Yes
Bank loans
Low
No
High-yield debt
High
No
Convertibles and
preferred equity
Low
No
Common equity
Low (if any)
No
Rights and
warrants
No
Yield potential
Collateral
This illustration does not represent the structure of the Spectrum funds or their protection against an issuer’s default or bankruptcy.
Also, individual companies may have different capital structures. The illustration instead shows that securities at different levels of
a capital structure vary in the actual and perceived protection for investors in the case of bankruptcy, and that these protections
diminish at each successively lower level. Investors should consider which type of security best fits their specific risk-and-return goals.
A skilled and experienced investment manager may be able to find a
variety of attractive opportunities hidden in a leveraged company’s
capital structure, from high-yielding income securities to undervalued
equities and bonds.
Putnam Capital Spectrum and
Putnam Equity Spectrum
These two strategies can benefit from
leveraged companies and the recovery of the
U.S. economy in coming years.
The Putnam Capital Spectrum strategy seeks total return.
The manager pursues the total return opportunities of
leveraged companies by investing in equities, fixed-income
securities, and bank loans that can offer a combination of
capital appreciation and current income. Diversification
across these different types of securities can help reduce
volatility compared with a strategy that invests only in equities. Debt securities have a risk profile that is different from
equities because they have a par value at maturity. As debt
securities approach the maturity date, their prices “pull”
toward the par value. Equities, on the other hand, have no
par value and theoretically have the potential to appreciate
to ever higher levels, depending on company performance.
Putnam has two portfolios managed by David Glancy:
Putnam Capital Spectrum and Putnam Equity Spectrum.
They offer alternatives to investors trying to navigate
through today’s volatile market conditions. In the context
of the ongoing U.S. economic recovery from the financial
crisis of 2008, we believe the range of attractive investment opportunities in leveraged companies has expanded.
These portfolios can benefit as individual U.S. businesses
and the broader economy continue to strengthen.
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FEBRUARY 2015 | Opportunity in leveraged companies
The Putnam Equity Spectrum strategy seeks capital
appreciation. The manager pursues the growth potential
of leveraged companies by investing in equity securities.
amounts, because the market for leveraged-company
securities tends to be inefficient. After analyzing the
opportunities and scenarios for each company, the portfolio manager revisits his forecasts to determine his level
of confidence and conviction in each one.
By focusing on equities, this strategy can harness the
greatest upside potential of leveraged companies. When
these companies are in great business distress, all of
their securities can become deeply discounted. However,
equities can fall further in price. Common equity shares
can fall by a greater magnitude because they are the
lowest in the capital structure, and typically do not provide
current income as debt securities do. Equities also have the
potential to appreciate in value to a greater extent.
After determining the securities he finds most attractive, Mr. Glancy carefully constructs each portfolio by
balancing the risks of different securities. He has latitude
to establish large weightings in individual securities, with
the goal of providing the best overall trade-off between
potential return and risk.
Short-selling capability expands opportunities
Although the strategies invest primarily in companies
that are leveraged, they do not use leverage themselves as
a primary investment strategy.
Unlike most Putnam offerings, these strategies have
the capability to short-sell securities, which may allow
them to profit from securities that the portfolio manager
considers to be overvalued rather than undervalued.
In the inefficient area of leveraged companies, many
securities tend to be mispriced, but this tendency can
result in overvaluations as well as undervaluations. When
Mr. Glancy identifies securities he considers overvalued,
he can use the tool of short-selling to seek a positive
return (see sidebar on the next page for an example). The
securities that are borrowed to effect short sales will be
collateralized by cash instruments.
The strategies invest with a rigorous
fundamental process
The investment process is based on thorough fundamental
research into the securities of leveraged companies,
focused on identifying securities with the most attractive
total return potential relative to risk. The investment
universe consists of companies with high debt levels relative to their earnings before interest payments, taxes, and
depreciation (also known as EBITD) are taken into account.
Of course, short-selling has risks. If a short-sold security
increases in value, the short position loses value, offsetting
the cash held as collateral and perhaps additional assets.
The transaction could result in a net loss. To manage the
risks of short-selling, Putnam currently expects to use only
cash for collateral. This measure limits the impact to the
portfolios if the short positions do not succeed.
In analyzing companies, portfolio manager David Glancy
has access to Putnam’s complete range of investment capabilities. He consults with two research groups in particular:
Putnam’s High Yield Credit group and Putnam’s Global
Equity Research team.
The first research step is to analyze each company as a
business and understand its sources of cash flow, and the
risks to it. The second is to analyze the company’s capital
structure and see what opportunities and risks it poses.
The opportunities and risks within the capital structure
result from the company’s ability to generate sufficient
cash flow to cover the liabilities at each level of the capital
structure. The chief risks are the possibilities of bankruptcy,
reorganization, or liquidation. The different scenarios for
the company can have a varying impact on each type of
security. For example, bank loans might be most attractive
if a bankruptcy is probable. However, securities at any level
of the capital structure might be mispriced by different
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The advantage of the flexibility to use short-selling is
that it allows Mr. Glancy to exercise more of his research,
insights, and skills. In the process of analyzing companies as
candidates for the portfolio, he may find securities that are
priced above their worth. Short-selling allows a strategy to
seek to profit from these opportunities, rather than exclude
them from the portfolio.
Short-selling can make the strategies more competitive
as long-term investments because it gives the portfolios
an additional tool to use during bear markets. When the
prevailing market trend is negative, it provides a bountiful
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setting for short-selling strategies. In these periods,
short-selling securities can give the strategies a source
of positive results to offset the impact of a bear market.
In periods when stock prices generally increase, the
opposite may be true.
How short-selling works:
A hypothetical example
1. The manager identifies security Z, which
he believes is priced above its worth based
on analysis of the company and its capital
structure.
Define the universe of leveraged opportunities
Identify companies with high debt relative to earnings
(Debt/EBITD)
Target companies recently privatized in leveraged
transactions
Security Z
•Current market price is $10
•Fundamental worth, as determined
by fund manager, is $5
Company selection
Analyze companies to •Determine scenarios for future
understand how the
cash flows
business generates
•Assess risks to future earnings
earnings
Analyze capital
structure
2. The manager then enters an agreement
with institution Y, which owns Z shares, to
borrow 100 shares for the portfolio. The
manager sells the Z shares in the market and
applies the proceeds ($10 x 100 = $1,000)
toward the collateral required for the loan.
Forecast scenarios
•Risk of bankruptcy?
•Possibility of capital structure
reorganization?
•Potential for income or capital
appreciation?
3. Fund impact
•Receives $1,000 in cash
Determine level of confidence
•Owes 100 shares of Z to institution Y
4. Outcome
•If the manager’s forecast is accurate,
the price of Z falls to $5 per share.
Security selection
Capital
Spectrum
Equity
Spectrum
•The borrowed securities are now worth $500.
•Compare total return potential of loans,
bonds, convertibles, and stocks
•Determine most attractive securities for
long positions
•Decide whether to short-sell any securities
•The manager enters the market and purchases
100 shares of Z at $5 per share, spending $500.
•The manager returns 100 shares of Z to institution Y.
•The portfolio earns $500 from the initial $1,000
transaction, not including interest and transaction
costs to purchase Z shares in the market.
•Determine equities with greatest total return
potential
•Decide whether to short-sell any securities
5. Risk
I f the manager’s forecast is inaccurate and the price
of Z rises above $10, the manager must use available
cash, and perhaps sell other portfolio holdings, to
repurchase Z shares and return them to Y.
Portfolio construction
Determine optimal weightings of long and short positions
Make large concentrations in most attractive opportunities
Balance short sales with cash positions to minimize the
chance of exceeding 100% gross market exposure
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FEBRUARY 2015 | Opportunity in leveraged companies
Active strategies for diversifying a portfolio
The Putnam Capital Spectrum and Putnam Equity
Spectrum strategies offer advantages for investing in
below-investment-grade securities that most individual
investors lack. They are professionally managed and
diversified with holdings in many different securities,
which reduces the risk of investing in the securities of
only one company. The strategies can benefit from a
recovery in the performance of leveraged companies
as the economy emerges from recession. They can
complement a core portfolio holding such as an absolute return or asset allocation strategy, or traditional
stock and bond portfolios.
Consider these risks before you invest: Investments
in small and/or midsize companies increase the risk
of greater price fluctuations. Growth stocks may be
more susceptible to earnings disappointments, and
value stocks may fail to rebound. Our focus on leveraged companies and the funds’ “non-diversified”
status can increase the funds’ vulnerability to these
factors. The use of short selling may increase these risks.
Stock prices may fall or fail to rise over time for several
reasons, including general financial market conditions
and factors related to a specific issuer company or
industry. You can lose money by investing in the funds.
For Capital Spectrum, these risks also apply: Lowerrated bonds may offer higher yields in return for more
risk. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to
rebound. Bond investments are subject to interest-rate
risk (the risk of bond prices falling if interest rates rise)
and credit risk (the risk of an issuer defaulting on interest
or principal payments). Interest-rate risk is greater
for longer-term bonds, and credit risk is greater for
below-investment-grade bonds. Unlike bonds, funds
that invest in bonds have fees and expenses. Our use of
short selling may increase these risks. Mortgage-backed
securities are subject to prepayment risk and the risk
that they may increase in value less when interest rates
decline and decline in value more when interest rates
rise. Stock and bond prices may fall or fail to rise over
time for several reasons, including general financial
market conditions and factors related to a specific issuer
or industry.
The information provided relates to Putnam Investments
and its affiliates, which include Putnam Advisory
Company, LLC, and Putnam Investments Limited®.
Diversification does not guarantee a profit or ensure
against loss. It is possible to lose money in a diversified
portfolio.
Strategies that use leverage extensively to gain exposure
to various markets may not be suitable for all investors.
Any use of leverage exposes the strategy to risk of loss.
In some cases, the risk may be substantial.
Request a prospectus, or a summary prospectus if
available, from your financial representative or by
calling 1-800-225-1581. The prospectus includes
investment objectives, risks, fees, expenses, and
other information that you should read and consider
carefully before investing.
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