Investment Primer
Floating Rate Loans
Floating rate loans, also known as leveraged loans, bank loans or senior floating
rate loans, are short-term debt obligations that banks and other financial
entities make to large corporations that typically have below investment grade
credit ratings. The loans finance mergers and acquisitions, leveraged buyouts
(LBOs), recapitalizations, capital expenditures and other general corporate
purposes. The loans are then syndicated, or sold, to institutional investors. The
loans earn a spread which is a reflection of credit risk plus a floating base rate,
typically LIBOR.1 The base rate (e.g., LIBOR) resets on a regular basis, typically
every 30 to 90 days, therefore the coupon is said to adjust, or “float,” as the base
rate changes.
J ose p h L y n c h
portfolio manager
Bank Loan Management
Floating rate loans are generally considered “senior” secured debt in the capital
structure of a company. In the event of default or bankruptcy, the holders of the
loans may be in a better position to maximize recovery because they often have
a first priority claim, or lien, on the assets of the borrower and could be repaid
before other securities issued by the company, such as high yield debt, preferred
or common stock. Floating rate loans are generally “secured” by assets such as
equipment, receivables, inventory, real estate, stock, trademarks and patents.
S te p hen Case y
portfolio manager
Bank Loan Management
June 2012
In this primer, we provide a broad overview of this asset class.
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Floating rate loans are structured, arranged and administered by one or several
commercial or investment banks known as “arrangers.” Arrangers serve the investmentbanking role of raising investor dollars for an issuer in need of capital. The issuer pays
the arranger a fee for this service. In order for issuers whose credit ratings are below
investment grade to attract the interest of non-bank investors, they typically need to
offer spreads paying LIBOR+200 basis points or higher.
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In the U.S., the floating rate loan market started in the mid-1980s with large leveraged
buyout loans and today has become the dominant way for issuers to tap banks and other
institutional capital providers for loans. The reason is simple: floating rate loans are
generally a less expensive method of borrowing and are pre-payable at par.2
The predominance of leveraged loans in the U.S. has also made it a rated market, with
Standard & Poor’s rating about 70% of all new leveraged loans up from 45% in 1998
(and there were virtually no ratings before 1995). This is not surprising, considering
1
LIBOR represents the London Interbank Offered Rate. This is the rate at which banks lend each other money in the wholesale
money market.
2
Standard & Poor’s, “A Guide to the Loan Market,” September 2009.
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investment primer: Floating Rate Loans
that most investors in the U.S. leveraged loan market are now non-bank institutional
investors who are accustomed to having ratings on the debt instruments they buy.3
F ig u re 1 : S & P / L S TA L e v eraged L oan I nde x Par A mo u nt
O u tstanding b y fa c ilit y R ating
NR: 6%
C: 1%
CC: 1%
CCC-: 0%
CCC: 4%
A-: 0%
D: 2%
BBB+: 0%
BBB: 1%
BBB-: 5%
BB+: 6%
BB: 12%
CCC+: 4%
B-: 3%
B: 13%
BB-: 20%
B+: 21%
Source: S&P/LSTA Leveraged Loan Index—March 2012 Review. See disclosures at the end of this material, which are an important
part of this presentation. Credit ratings are subject to change at any time. The ratings above are issued by S&P. Ratings of BBB and
higher are considered to be investment grade while ratings of BB and lower are considered to be non-investment grade (junk bonds).
LOAN CREDIT AGREEMENT
All floating rate loans are governed by a credit agreement which serves in a similar
capacity to an indenture for a bond. Lenders also stand to benefit from certain protective
covenants that are often placed on most loans.
There are three primary types of loan covenants: financial, negative and affirmative.
Financial covenants enforce minimum financial performance measures against the
borrower, such as a company maintaining a minimum EBITDA (earnings before
interest, taxes, depreciation and amortization). The presence of these maintenance
covenants — so called because the issuer must maintain quarterly compliance or suffer
a technical default on the loan agreement — is a critical difference between loans
and bonds. Bonds, by contrast, usually contain incurrence covenants that restrict the
borrower’s ability to issue new debt, make acquisitions or take other actions that would
breach the covenant.
Negative covenants limit the borrower’s activities in some way. Negative covenants,
which are highly structured and customized to a borrower’s specific condition, can
limit the type and amount of investments, new debt, liens, asset sales, acquisitions
and guarantees.
Affirmative covenants state what action the borrower must take in order to be in
compliance with the loan. These covenants are usually boilerplate and require a
borrower to pay the bank interest and fees, maintain insurance, pay taxes and so forth.
3
Standard & Poor’s, “A Guide to the Loan Market,” September 2009.
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investment primer: Floating Rate Loans
Lenders will look to these covenants as a means to renegotiate the terms of a loan if the
issuer fails to meet any covenant. Loan holders, therefore, almost always are first in line
among prepetition creditors and, in many cases, are able to renegotiate with the issuer
before the loan becomes severely impaired.
PRICING ON FLOATING RATE LOANS
The return on a floating rate loan is derived from three components: the base rate
(typically LIBOR), the credit spread and the issue price. The base rate usually resets
every 30 to 90 days, resulting in a “floating” rate. In low rate environments and/or
during difficult market conditions, arrangers may offer LIBOR floors as an incentive
for lenders. As the name implies, LIBOR floors put a floor under the base rate for loans.
For example, if a loan has a 1.5% LIBOR floor and three-month LIBOR falls below this
level, the base rate for any resets defaults to 1.5%. The credit spread on a loan reflects
credit quality and certain market-based factors, such as liquidity and market technicals.
The original issue discount (OID) is the discount from par value at the time a loan is
sold to investors, and is offered in the new issue market as a spread enhancement. A
loan may be issued at 99 to pay par. The OID in this case is said to be 100 basis points,
or one percent.
LOAN MARKET INVESTORS
There are four primary types of investors in the market: institutional investors, retail
investors, banks and finance companies.
Institutional investors participate in the loan market principally through separately
managed accounts and structured vehicles known as collateralized loan obligations
(CLOs). CLOs are special-purpose vehicles set up to hold and manage pools of
leveraged loans.
Retail investors can access the loan market through loan participation mutual funds
which are mutual funds invested in leveraged loans. (These are sometimes known as
“prime funds” because they were originally marketed to investors as a money marketlike fund that would approximate the prime rate).
Banks are typically commercial banks that provide unfunded revolving credits, letters of
credit (LOCs) and—although they are becoming increasingly less common—amortizing
term loans, under a syndicated loan agreement.
Finance companies have consistently represented less than 10% of the leveraged loan
market, and tend to play in smaller deals — $25 million to $200 million. These investors
often seek asset-based loans that carry wide spreads and that often feature time-intensive
collateral monitoring.
In addition, hedge funds, high yield bond funds, pension funds, insurance companies
and other proprietary investors also participate in loans.
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investment primer: Floating Rate Loans (continued)
F ig u re 2 : Primar y M arket for H ighly L e v eraged L oans
( E x c l u des B anks ) — 2 0 11
Finance Companies: 4%
Insurance Companies: 5%
Prime Rate Fund: 19%
Collateralized Loan
Obligations (CLOs): 50%
Hedge, Distressed &
High-Yield Funds: 22%
Source: S&P Capital IQ Leveraged Commentary and Data, Loan Stats, April 2012, Volume 14, Number 4. See disclosures at the end
of this material, which are an important part of this presentation.
Excludes left and right agent commitments (including administrative, syndication and documentation agent as well as arranger).
For 1H08, all deals includes block sales like TXU while new deals include only deals launched and structured this year.
Excludes RC-only ABLs.
TRADING FLOATING RATE LOANS
Investors are free to trade floating rate loans after the loan is allocated. Loan sales
are typically structured as assignments. In an assignment, the assignee becomes a
direct signatory to the loan and receives interest and principal payments directly from
the administrative agent. Investors usually trade through dealer desks at the large
underwriting banks.
F ig u re 3 : S e c ondar y L oan M arket trading
Annual Trade Volume
(billions)
$550
$520
$510
$500
$474
$450
$413
$409
‘10
‘11
$400
$350
$300
‘07
‘08
‘09
Source: Loan Syndications and Trading Association—The 2011 Secondary Loan Market Year-in-Review.
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investment primer: Floating Rate Loans (continued)
LOAN MARKET SIZE/COMPOSITION
The breadth of the loan market is found in the S&P/LSTA Leverage Loan Index, which
cites total assets in the category of $498 billion as of December 2011 across over 750
unique issuers and multiple industry sectors. The majority of the assets are held in
CLOs, with the balance held in separate accounts and retail mutual funds.
F ig u re 4 : S & P / L S TA L e v eraged L oan I nde x Par A mo u nt
O u tstanding b y ind u str y
Containers and glass products: 2%
Aerospace and defense: 2%
Leisure: 2%
Building and development: 2%
Food products: 3%
Food service: 3%
Hotels/motels/inns and casinos: 3%
Other: 14%
Chemical/plastics: 3%
Health care: 11%
Automotive: 4%
Cable television: 4%
Business equipment
and services: 8%
Broadcast radio and television: 4%
Telcommunications: 5%
Publishing: 7%
Retailers (other than food/drug): 6%
Electronics/electric: 6%
Utilities: 6%
Financial Intermediaries: 6%
Other
Air Transport Beverage and Tobacco Clothing/Textiles Conglomerates Cosmetics/Toiletries Drugs Ecological Services and Equipment Equipment Leasing Farming/Agriculture Food/Drug Retailers 0.92%
0.26%
0.15%
0.82%
0.89%
1.21%
0.35%
0.47%
0.17%
0.97%
Forest Products Home Furnishings Industrial Equipment Insurance Nonferrous Metals/Minerals Oil and Gas Rail Industries Steel Surface Transport 0.18%
0.45%
1.12%
1.78%
0.92%
1.76%
0.11%
0.18%
0.99%
Source: S&P/LSTA Leveraged Loan Index—March 2012 Review. See disclosures at the end of this material, which are an important
part of this presentation.
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investment primer: Floating Rate Loans (continued)
DIVERSIFICATION AND RETURNS OF FLOATING RATE LOANS
In terms of credit quality, floating rate loans typically fall between investment grade
corporate bonds and high yield bonds. Floating rate loans tend to have a better
credit rating than high yield bonds issued by the same borrower, due to their security
and seniority.
F ig u re 5 : risk and reward tradeoff
Emerging Market Debt
High Yield
Bank Loans
Core Plus
Core
Short Duration
Expected Volatility
For illustrative purposes only.
The seniority and security of bank loans as well as their floating rate nature make them
relatively more stable than high yield bonds. The two primary loan market indices, the
CSFB Leverage Loan Index and the S&P/LSTA Leverage Loan Index, which were created
in 1993 and 1997, respectively, have each realized only one year of negative returns since
they first became available.
F ig u re 6 : S & P / L S TA L e v eraged L oan I nde x T otal R et u rns by Year
51.6%
55%
45%
35%
25%
15%
5%
7.6%
9.8%
5.2% 3.7% 5.0% 4.1%
1.9%
5.1% 5.0% 6.7%
10.1%
2.0%
1.5%
3.8%
-5%
-15%
-25%
-35%
-29.1%
YTD
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: S&P/LSTA Leveraged Loan Index—March 2012 Review. See disclosures at the end of this material, which are an important
part of this presentation.
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investment primer: Floating Rate Loans
CORE RISK IS CREDIT RISK
There are a variety of risks associated with this asset class that any prospective investor
should understand fully before investing. The principal factors that banks and
institutional investors contend with in buying loans are default risk and loss-givendefault risk.
Default risk is simply the likelihood of a borrower being unable to pay interest
or principal on time. Among the primary ways that accounts judge these risks are
credit ratings, financial condition, industry sector trends, management strength and
ownership structure.
Loss-given-default risk measures how severe a loss the lender would incur in the event of
default. Investors assess this risk based on the collateral backing the loan and the amount
of other debt and equity subordinated to the loan.
Default and loss-given-default concerns are tempered by the loans’ placement within
the capital structure of the company. As the senior-most debt instrument in the capital
structure, floating rate loans are typically secured by the majority of the assets of the
borrower and are often in a better position to maximize recovery due to having a
first priority claim on the assets of the borrower, and are typically repaid before other
securities issued by the company.
senior se c u red debt ( floating rate loans )
high y ield debt ( u nse c u red or s u bordinated )
H igher
p riorit y of
p a y ment
p referred sto c k
c ommon sto c k
lower
sam p le c a p ital str u c t u re
Poetntial B enefits of F loating R ate L oans
We believe floating rate loans can be a valuable part of a diversified portfolio, offering
several advantages:
• Current Income: Meaningful yield opportunities, particularly in the current low
interest rate environment.
• Protection against rising interest rates: With their floating rates, these loans are
designed to benefit from rising interest rates and thus can potentially generate
increased income in a rising rate environment.
• Capital preservation: Typically structured as senior, secured instruments, floating rate
loans generally hold a first-priority lien on the assets of the borrower and, in the event
of a default or bankruptcy, typically result in higher recoveries.
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investment primer: Floating Rate Loans
• Effective way to enhance diversification: Floating rate loans have historically offered
low correlation to other asset classes.
• Favorable risk/return profile: Floating rate loans have historically demonstrated an
attractive risk/return profile relative to other asset classes.
Please contact your Neuberger Berman representative for additional information.
This material is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it
should not be relied upon as such. Opinions expressed are as of the date herein and are subject to change without notice. This
material is not intended to be a formal research report and should not be construed as an offer to sell or the solicitation of an offer
to buy any security. Past performance is not indicative of future results.
The Strategy may invest in senior loans and other debt securities which may be rated below investment grade. The risks of investing
in such securities, such as risk of default, could result in loss of principal. Economic and other market events may reduce demand for
certain senior loans held by the Strategy, which may impact their value. Loans and other debt securities are also subject to the risk
of increases in prevailing interest rates. Generally, bond values will decline as interest rates rise. However, because floating rates on
senior loans only reset periodically, changes in prevailing interest rates can be expected to cause some fluctuation in the value of
these securities. Similarly, a sudden and significant increase in market interest rates, a default in a loan in which the Strategy owns
an interest, or a material deterioration of a borrower’s creditworthiness may cause a decline in the value of these securities. Floating
rate loans may be more susceptible to adverse economic and business conditions and other developments affecting the issuers of
such loans. Although senior floating rate loans are generally collateralized, there is no guarantee that the value of collateral will not
decline, causing a loan to be substantially unsecured. No active trading market may exist for many loans, and some loans may be
subject to restrictions on resale, which may also prevent the Strategy from obtaining the full value of a loan when sold.
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