By: Niklas Nordenfelt, CFA
Senior Portfolio Manager,
Co-Manager of Sutter High Yield Fixed Income
Paolo L. Villasenor
Product Manager
Understanding Bank Loans:
Opportunities for Diversification and Risk Reduction
December 2008
Volatile credit markets have changed the makeup of investment
portfolios across all plan types. This challenging environment
has caused plan sponsors to review and rethink their asset
allocation. While diversification has always been at the forefront
of risk management, diversification within fixed income markets
has been traditionally limited to a plan’s outlook on duration,
sector, curve positioning or issue selection. Traditional fixed
income mandates benchmarked to broad market indices will
remain anchors to the overall fixed income portfolio, but a further
consideration of less-traditional fixed income sectors may identify
additional fixed income strategies that can improve not only
portfolio diversification, but also other investment goals such as
return enhancement and risk mitigation. Leveraged loans (also
known as “bank loans”) represent such an asset class, and may
provide plan sponsors with new investment opportunities.
What Is a Leveraged Loan?
The name of the asset class can be misleading. The connotation of
“leverage” in some circles may deter some investors for whom the
asset class might be appropriate, so a proper definition of the term
“leveraged loans” is important to understanding the asset class.
For starters, a “loan” refers to a “syndicated loan,” which is an
extension of credit provided by a group of lenders,with a single
set of terms. Syndicated loans are structured, arranged, syndicated
and administered by one or several commercial or investment
banks known as “arrangers.” Syndicated loans are senior to bonds
within a firm’s capital structure, and the type of syndicated loan
is further defined by the credit rating of the borrower.
investment-grade companies, and often constitute important
pieces of their overall capital structure. The vast majority of
loans trading in the secondary market are “leveraged,” senior
secured, fully-funded term loans, and thus, to institutional
investors, “bank loan” strategies are generally synonymous with
“leveraged loan” strategies.
Use of Leveraged Loans within Capital Structure
Leveraged loans are typically a large piece of the capital
structure of a below-investment-grade company. They are senior
to both senior subordinate bonds and equity, and generally
feature more restrictive covenants. Below-investment-grade
companies use leveraged loans primarily to finance acquisitions,
Leveraged Buyouts (LBOs), capital expenditures and general
corporate purposes. A typical leveraged structure is capitalized
with between 50-55 percent loans, 30-35 percent bonds, and
20-25 percent equity.
Exhibit 1: Sample Capital Structure of Below-Investment-Grade Company
100%
80%
70%
CFA® and Chartered Financial Analyst® are trademarks owned by the CFA Institute.
50%
60%
50%
40%
30%
25%
20%
10%
25%
0%
Subordinate
Sample Capital Structure
n Equity
Depending on the borrower’s credit rating, loans are
categorized as either “investment grade loans” or “leveraged
loans.” Investment grade loans—loans issued to higher-rated
companies—are a very small part of the bank loan market as
investment grade companies tend to have more funding options
available to them. In contrast, leveraged loans are akin to high
yield bonds and defined as syndicated loans made to less-thaninvestment-grade companies, generally rated below BBB-/Baa3.
Leveraged loans are common sources of financing for below-
Senior
90%
n Sr. Subordinate Bonds
n Leveraged Loans
Primary Market for Leveraged Loans
Investors in leveraged loans are primarily institutions that can
be specifically categorized as Collateralized Loan Obligations
(CLOs); banks; hedge, distressed and high yield funds; prime
rate funds; finance; and insurance companies. The leveraged
loan market has grown steadily from $73B outstanding par
amount in 1998 to $591B in outstanding par as of September
2008 (Exhibit 2).
Exhibit 2: Par Amount of Outstanding Leveraged Loans ($ in Billions)
$700
600
$557
$591
500
$400
400
300
$248
$193
200
100
0
$73
$14
$130 $132
$101 $117
$148
$35
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 9/19/08
Source: Standard and Poor’s LCD
Prior to 2000, the primary investors of loans were banks, insurance
companies and prime rate funds. However, with the growth of
the Collateralized Debt Obligation (CDO) market, the dominant
participants became CLOs. In more recent times, hedge, distressed
and high yield funds have become much larger participants at the
expense of banks and prime rate funds (Exhibit 3).
Since 2007 and the onset of the credit crunch, the data from
the first three quarters of 2008 show a definite shift in new
deal investors. While CLOs still represent the largest investors
in leveraged loans, banks have significantly increased their
investments (from 2 percent in 2007 to 19 percent through
3Q08), and hedge, distressed and high-yield funds (or as a
whole, “institutional investors”) firmly remain the second-largest
concentration of investors in loans, increasing their share to 29
percent (Exhibit 4). The evolution in the investor base has had
profound effects. Indeed, we believe the increased volatility that
the asset class has experienced is directly tied to the relatively lax
lending standards that a thriving securitization market helped to
encourage. The credit analysis typically applied to the asset class
was lacking with the proliferation of CLOs. Private Equity firms
gladly took advantage of the abundant liquidity by structuring
buyouts with significantly more aggressive capital structures. The
return of traditional, conservative credit analysis should benefit
the market going forward.
Exhibit 4: Institutional Loan Purchases by Lender Type, 2007 To-Date
60
Exhibit 3: Leveraged Loan Investors 1998 vs. 2007
1998
57
50
n 2007
1998 Non Bank Breakout: 36.8%
40
45%
n 1Q-3Q08 (New Deals)
38
42%
30
26
29
19
20
13%
n CLO
n Insurance Co.
n Prime Rate Fund
n Banks
n Non Banks
2007
10
2
0
2007 Non Bank Breakout: 98.1%
57%
4%
8%
4%
27%
n Banks
n Non Banks
Source: Standard and Poor’s LCD
3
n CLO
n Finance Co.
n Hedge, Distressed
& High-Yield Funds
n Insurance Co.
n Prime Rate Fund
Banks
CLO
8
6
Finance Co.
4
Hedge,
Distressed
& High-Yield
3
Insurance
5
Prime Rate
Source: Standard and Poor’s LCD
Loans vs. Bonds
While leveraged loans and high yield bonds are issued by the
same companies, the characteristics of the instruments are quite
different. A brief comparison summary is provided in Exhibit 5.
Exhibit 5: Comparison of Leveraged Loans and High Yield Bonds
Exhibit 7: Historical Recovery Rates (%)
Leveraged Loans
High Yield Bonds
Interest Rate/Coupon
Floating Rate
Fixed rate
Security
Senior Secured
Generally unsecured
Priority
Senior
Generally subordinate, but
sometimes senior
100
90
Amortization
Required quarterly principal
payments
Bullet payment at maturity
Callability
Prepayable at par without penalty
Call protected
80
70
60
50
40
20
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Source: Moody’s
As an example of the historic nature of the current pricing levels,
we calculate (as of October 15, 2008) that the market has priced
in a default rate of 58% for leveraged loans and 27.1% for high
yield bonds (assuming a recovery rate of $60, or $15 below current average prices, for loans and a recovery rate of $25, or $45
below current average prices, for bonds). Current default levels
are well below what we feel is priced into the market. Consequently, we believe that a great opportunity exists to invest in
both asset classes, and this opportunity will be discussed in an
accompanying presentation to be released in December 2008.
14
12
— Loan Defaults
— Bond Defaults
8
Jan-02
Jul-01
0
Exhibit 6: 12-Month Trailing Default Rate (%)
10
— High Yield Bonds
— Loans
30
Due to the differences in the characteristics and terms between
loans and bonds, the resultant default rates and recovery rates are
correspondingly different. Historically, default rates for leveraged
loans have been lower than that of bonds, but in the recent weak
economic environment, default rates have increased for leveraged
loans. Exhibit 6 shows that, through September 2008, high yield
bond default rates are up to 3.1 percent from a recent low of 1.3
percent. In contrast, loan default rates have risen to 3.3 percent
from a low of 0.26 percent.
6
4
2
Sources: S&P’s; Moody’s
Despite this trend, recovery rates tell a slightly different story.
While the current environment will certainly show negative
effects to recovery rates, it is notable that recovery rates for
loans continue to be greater than that of bonds. Loans have
historically provided, and should continue to provide, higher
recovery rates due to their priority (senior) status in the
capital structure, protection they typically receive through
covenants, and the fact that most loans are secured by assets
such as accounts receivables, inventory, plant machinery and
equipment (Exhibit 7).
Sep-08
Dec-07
Mar-07
Jun-06
Sep-05
Dec-04
Mar-04
Jun-03
Sep-02
Dec-01
Mar-01
Jun-00
Sep-99
Dec-98
0
Importance of credit analysis
Exposure to leveraged loans on a tactical basis or as a strategic
allocation can be beneficial to risk reduction and diversification
efforts for fixed income allocations. Most institutional investors
would be hard pressed to purchase individual leveraged loans,
so identifying a strong leveraged loan manager is vital. Although
increased volume in the leveraged loan market can be attributed
to the rise of CLOs, institutional investors can seek managers
that approach credit analysis more carefully with a thorough
understanding of the underlying issues.
During the rapid expansion of the leveraged loan market over
the past several years, credit analysis was less emphasized by
investors who sought issues that met certain tests established by
rating agencies for inclusion in CLOs. Their primary goal was
to build portfolios as quickly as possible, and as a result, many
While credit ratings help to categorize the type of loan outstanding, a company’s credit rating is not the sole criterion by
which an attractive loan should be evaluated. External credit
ratings provide a starting point for evaluating issues, but to
successfully invest in the loan market, investors must focus on
a credit-intensive process that requires a solid understanding
of a company’s business fundamentals, corporate management,
stability of financing, covenants, etc. We believe that analyzing
leveraged loans is a natural extension of high yield bond
analysis due to the similarities of the underlying credits.
Indeed, we believe that, in order to be a good loan investor,
it’s important to understand the subordinate part of the capital
structure (the bonds). Similarly, a thorough understanding of
high yield bonds requires an understanding of the senior debt
(the bank loans) ahead of the bonds in the capital structure.
Exhibit 9: Standard Deviation Ended September 2008
3 Years
5 Years
7 Years
10 Years
5.07%
4.01%
3.90%
3.48%
DJIA
10.96%
10.40%
12.96%
14.46%
Russell 3000
11.72%
10.76%
13.03%
14.53%
Russell 2000
14.55%
14.67%
16.89%
18.89%
7.08%
6.28%
7.68%
7.83%
11.39%
10.35%
12.85%
14.37%
CS Leveraged Loan Index
ML High Yield Master II
S&P 500
Source: Zephyr Associates Style Advisor
Exhibit 10: Rolling Five-Year Returns vs. Standard Deviation
Return/Standard Deviation
60-Month Moving Windows, Computed Quarterly; October 1998-September 2008
20%
15%
Return
CLOs invested in poorly structured loans that have performed
poorly during the most recent period of volatility related to the
broader credit crisis.
Consistently positive 5-year
rolling returns with least
volatility of 6 broad market
equity and fixed income indices.
10%
5%
0%
Risk Diversification Characteristics of the Leveraged Loan
Asset Class
The leveraged loan market has underperformed riskier asset
classes in the near term, but actually outperformed the S&P
500 in the seven- and 10-year trailing periods (Exhibit 8). The
volatility in leveraged loan returns has been far less than the other
traditional asset classes over the same trailing periods ended
September 2008. Exhibits 9 and 10 show that the leveraged loan
index exhibits consistently positive long-term returns coupled
with the lowest standard deviation of six different equity and
fixed income indices. Exhibit 10 highlights the consistency of
the rolling five-year risk-return characteristics of the asset class
compared to other broad asset classes.
-5%
0%
5%
10%
15%
Standard Deviation
20%
25%
l Credit Suisse Leveraged Loan Index
l Dow Jones Industrial Average
l Russell 3000 Index
l Russell 2000 Index
l Merrill Lynch High Yield Master II
l S&P 500
Source: Zephyr Associates Style Advisor
In addition to lower volatility, the leveraged loan asset class is
also characterized by a low correlation to common equity and
fixed income styles. Of particular note is the very low correlation to the Lehman Aggregate index and Merrill Lynch High
Yield Master II index as seen in Exhibit 11. This low correlation
indicates a further opportunity to diversify fixed income
exposure within an asset allocation.
Exhibit 8: Returns Ended September 2008
Exhibit 11: Correlation of Returns to CS Leveraged Loans Index—10 Years
3 Years
5 Years
7 Years
10 Years
CS Leveraged Loan Index
0.74%
2.90%
3.58%
3.71%
Ended September 2008
DJIA
3.34%
5.60%
5.32%
5.45%
DJIA
0.257
Russell 3000
0.26%
5.70%
4.36%
3.80%
Russell 3000
0.366
Russell 2000
1.83%
8.15%
9.03%
7.81%
Russell 2000
0.431
ML High Yield Master II
0.91%
4.26%
6.45%
4.31%
ML High Yield Master II
0.660
S&P 500
0.22%
5.17%
3.50%
3.06%
S&P 500
0.333
LB US Aggregate Bond
-0.071
Source: Zephyr Associates Style Advisor
As a whole, historical volatility for leveraged loans has been
lower than other asset classes; however, this volatility is expected
to increase due primarily to the recent market dislocation.
While absolute volatility is expected to increase, we believe
the volatility is expected to remain lower relative to the other
designated asset classes due to its senior secured status within
the capital structure. Thus, the risk-reduction characteristics are
expected to hold in the future.
Why Leveraged Loans?
As an asset class, leveraged loan exposure helps diversify fixed
income allocation, reducing risk via reduced portfolio standard
deviation. Loans also provide superior credit protection given
their senior secured status, and as floating rate instruments, they
are effective hedges against rising rates. Credit analysis, however,
is vital to properly navigating the market, and in periods of
volatility, successful portfolios will be those that best identify
strong credits that can withstand market downturns and provide
the appropriate risk/reward for current pricing levels, covenant
structure and asset coverage. There are few actively-managed
portfolios dedicated to leveraged loans, and a distinct tactical
advantage exists for those investment portfolios managed by
experienced analysts with a long-term track record in the analysis
of leveraged credits. Dislocation in the overall credit markets can
lead to further investment opportunities and will be examined in a
future companion piece.
Sutter Credit Strategies
w Leveraged loan investors since 1998
w Over $1B currently invested in leveraged loans
w Top decile leveraged loan manager*
w Deep credit team, established infrastructure and strong access to loan market issuance
*Source: eVestment Alliance Bank Loan Universe­—YTD, 1-year, 2-years and since inception (April 2006) ended September 30, 2008
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