Navigating Bank Loan Implementation
April 2012Sean Lynch
Head of Research Sutter Credit Strategies
CFA® and Chartered Financial Analyst® are trademarks owned by the CFA Institute.
Executive Summary
In our 2008 paper outlining the opportunity for diversification and risk reduction from an allocation to bank loans, we introduced basic vernacular, compared loans to high yield bonds, and discussed the benefits of allocating long-term to an institutional strategy, including fixed income diversification, superior credit protection via the senior secured status, lower volatility than other traditional asset classes, low correlation to common equity and fixed income styles, and an effective hedge against rising rates as a floating rate instrument. As a follow up, this paper offers reasons why it may be worth having an institutional credit specialist guide you through the nuances of implementing a senior secured bank loan allocation. We explore:
w The purpose of various bank loans, how secured status and superior credit protection work since legally a bank loan is not a bond or security w Trading with par or distressed loan documentation, and why distressed loans can be a rewarding part of the market with the right level
of credit research and due diligence
w Taking ownership of loans via assignment instead of participation, so that the new owner attains all the rights and powers of the original lender w Benefits of a robust operations and risk management infrastructure as it particularly pertains to bank loans
w Whether a high quality emphasis can aid in avoiding excessive idiosyncratic risk w Competitive risk-adjusted returns post-financial crisis
Recent volatility and market dynamics highlight the need for bank loan investors to utilize a robust credit research process and to take a long-term investment perspective. However, as is often the case in the wake of volatility, taking the time up front to dive in deeper can prove beneficial when preparing for the next volatile market or when building relationships one might need to fall back on for future negotiations for better terms. Understanding bank loans at a deeper level is critical to ensuring successful portfolio implementation and managing expectations, which collectively should provide a solid foundation for a new long-term investment.
What Is a Bank Loan, Really?
A bank loan (also known as a senior secured floating rate loan or leveraged loan) is considered private debt and originally was a privately negotiated, confidential transaction between a bank and a corporate issuer. Legally, a bank loan is not a security like a bond, which is a debt instrument, sold and traded in the public markets. Bank loans typically refer to loans made to less-than-investment grade companies, generally rated below BBB-/Baa3 and the same companies that issue high yield bonds. [See our 2008 paper for further comparison to high yield bonds.]
Purpose
The intent of a bank loan was originally to finance corporate cash needs such as acquisitions, debt refinancing, support organic growth, or pay dividends with a major portion of bank loans being granted to finance acquisitions. An issuer would share documents specifically written for the public domain one-on-one with potential non-bank investors. As the loans grew in size over time and as the market expanded with new types of investors, the loan market began to take on properties of the high yield bond market. For example, larger loan deals needed to be arranged and administered across several banks, akin to bond issuance procedures.
Secured
What gives a bank loan its secured status? Bank loans contain stronger, stricter covenants and credit agreements that have led to better recovery rates than high yield bonds. Final terms at issuance are outlined in credit and security agreements with attached collateral. Documentation can be amended from time to time with varying levels of required voter approvals but all documents and supporting data remain confi-dential until publicly filed after the deal is closed.
Covenants
As a form of risk management, covenants or financial tests require scheduled passage of certain hurdles to help ascertain an issuer’s ability to make future promised payments. There are different types of covenants, including cash flow, leverage, equity-related, and liquidity. These signed agreements clearly define the company’s use of cash flow and excess cash flow, reporting requirements, and help to preserve any underlying collateral.
Priority
During bankruptcy proceedings, the senior secured status affords bank loans priority over equity and other lower-ranked debt; however,
there are other types of claims that can still supersede the rights of bank loans. When breached, covenants and agreements can demand either repayment or loan restructuring on behalf of bank loan holders. Likewise, the issuer can also obtain a covenant waiver to launch a restructuring on their terms for financial flexibility. As an example, an issuer may restructure to maintain higher cash balances if there are concerns about its ongoing viability to make payments or restructure to match future expenses to an expected cash inflow.
Despite a few short periods where bank loan default rates were higher (Chart 1 and 2), bank loans which retain senior secured status have experienced generally lower default and higher recovery rates when historically compared to high yield bonds. During the recent financial crisis, which centered primarily on liquidity issues, bank loan defaults increased during 2009-2010 but still remained lower than high yield bonds. Previously during the 2000-2001 recession, bank loan and high yield defaults also rose when many companies that had borrowed heavily to finance expansion and capital expenditures (such as telecoms and utilities) experienced bankruptcies or restructurings.
Chart 1: 12-Month Trailing Historical Default Rates (%) 12 10 8 6 4 2 0 Jan-1999 Jan-2000 Jan-2001 Jan-2002 Jan-2003 Jan-2004 Jan-2005 Jan-2006 Jan-2007 Jan-2008 Jan-2009 Jan-2010 Jan-2011
Bond Issuers Loan Issuers
Source: S&P
Chart 2: 12-Month Trailing Historical Recovery Rates (%) 100 90 80 70 60 50 40 30 20 Jan-1999 Jan-2000 Jan-2001 Jan-2002 Jan-2003 Jan-2004 Jan-2005 Jan-2006 Jan-2007 Jan-2008 Jan-2009 Jan-2010 Jan-2011 High Yield Bonds
Loans
Trading Dynamics
Bank loans trade over-the-counter through a network of broker/dealers. During challenging market conditions, a number of loans will trade in the secondary market and on a separate, specialized side of the broker/dealer house. These issues are referred to as trading on distressed documentation (“distressed”) requiring special documenta-tion to trade (or “assign” the loan to a new investor). A loan is typically considered distressed at a market price of 70 or less. Under normal conditions, a buyer and seller can negotiate and settle a transaction using the par documentation (“par”) from an industry trade group, the Loan Syndication & Trading Association (LSTA). Hence, loan trading is often referred to as trading on par docs or on distressed docs. A majority of loans trade par (Chart 3).
Chart 3: Par vs. Distressed Trade Volume
4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 $96.4 $7.0 PAR DIS $125 $100 $75 $50 $25 $-Tr ade V olume ($ Billions) Source: LSTA
The LSTA promotes par bank loan trade settlement within seven days after trade date or T + 7 days. A distressed loan is entirely different. Not only is settlement time considerably longer for a distressed trade, LSTA promotes T + 20, but these transactions require the use of outside counsel, adding to transaction costs. The use of outside counsel in settling distressed trades is the accepted market convention in which the majority, if not all loan participants, abide.
Distressed loans can be a rewarding part of the market with the appropriate levels of credit research beforehand. One advantage to trading distressed is the additional protection that buyers and sellers require once a corporate lender becomes increasingly viewed as stressed or having the possibility of default or bankruptcy (if it has not happened already). Each counterparty to a distressed trade is required to provide an extensive set of representations and warranties, which
holds each counterparty to the terms of the contract well after the transaction is closed. Similar to the title clearing process for a house or auto, the chain of ownership from loan origination to current trans-action needs to be examined to make sure the chain of representations is complete with no damaging incidences. Distressed documentation also provides for the transfer of claims and other rights that may not be included in a par transaction. In contrast to the nuances of trading a distressed loan, a par settlement does not require opposing counter-parties to provide any representations or warranties.
Typical legal fees associated with the settlement of distressed loans cost several thousands of dollars per block trade. Total cost is split pro-rata among the client accounts on whose behalf the trade was executed. When evaluating potential purchases and sales for the portfolio, this additional transaction cost is taken into consideration and can be viewed akin to the widening of a bid-ask spread. A sophisticated institutional manager will be adept at investing in both par and distressed loans.
Growth in Market Liquidity
The investor base for bank loans grew dramatically and its composition changed with the introduction in the early 1990s of U.S. institutional investors beyond the original larger regional bank investors, and again more recently with non-U.S. investors. Since 2007, buyers such as Collateralized Loan Obligations (“CLOs”) have had a declining presence in purchasing bank loans, while institutional buyers including
pension plans and hedge funds maintain a growing presence (Chart 4). Chart 4: Investor Types
Primary Market for Institutional Loans (Excluding Banks)
2007 2008 2009 2010 1H11 3Q11
Hedge, Dis. & HY Funds CLO Mutual Fund Fin. & Insur. Co. 100% 75% 50% 25% 0% 27% 57% 8% 7% 32% 52% 6% 10% 32% 50% 9% 9% 33% 43% 14% 10% 28% 42% 20% 11% 40% 38% 12% 11% Source: LSTA
Chart 5: Pro Rata vs. Institutional Loans Chart 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q-3Q1 0 1Q-3Q1 1 $600B $400B $200B $0B
Institutional Pro Rata
220.2255.9 243.4 184.7 138.7 139.4165.6 265.2295.4 480.1 535.2 156.9 76.6 233.4 163.5 310.8 Source: S&P LCD
In order to facilitate this change in investors while taking on properties of the high yield bond market, loans were structured within specific groupings or tranches, either pro rata loans or institutional loans (Chart 5). Pro rata loans were initially packaged on a pro rata basis to banks and are usually revolving lines of credit. Institutional loans, on the other hand, are sold to institutional or other non-bank investors and are typically structured with bullet payments, such as first-lien term loans, second-lien term loans, and prefunded letters of credit. The changing investor base for loans was a key development since these dynamics helped the loan market with liquidity and loan pricing. Previously as a private transaction, the non-investment grade corporate loan issuer would meet with sales prospects to determine the potential market clearing price (yield) for a new loan in the primary market. Today, however, the markets are more liquid and investment banks have dedicated syndication desks that help parcel out the loans. Pricing for new institutional loans is generally based on credit quality and fixed income market dynamics, including liquidity on the open market. As a result, when issuers attempt to bring new loans to market, new issue loan yields will fluctuate for these various reasons (Chart 6).
Chart 6: Average First Lien Clearing Yield 10%
5%
0%
Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11
Source: S&P LCD
Traditionally, ownership of a bank loan was granted to a new investor either through an assignment or a participation in the loan. Today, institutional investors predominantly buy loans via assignment, which is important since this choice allows the new investor to become the legal lender of record with all the rights and powers stipulated in the credit agreement. When ownership is transferred as a participation, the original lender retains the lender’s rights and responsibilities and the new investor receives only the right to repayment, which is still common in middle market sized loans. Overall, participation loans have become a negligible part of the issuance market.
Available Investment Vehicles
A bank loan product can be implemented across various vehicle types for a broad range of investors. Managers can offer U.S. institutional investors a separate account or an on-shore, institutional commingled vehicle, such as an ERISA-qualified collective trust or an open-end mutual fund’s institutional share class.
Non-U.S. institutional investors also have access to bank loans through a separate account or a commingled vehicle. Since bank loans are not deemed to be a security and therefore not transferrable, they are not eligible for the majority allocation within a UCITS. However, bank loans are accessible via a UCITS Part I (structured as a SICAV for most regions or FCP for Japan) through investment in or exposure to a credit default swap, where a swap is based on an underlying bank loan model portfolio and this model portfolio is outside the UCITS structure. UCITS Part I requires a bi-monthly net asset value (“NAV”) at a minimum; however, for marketing purposes, most produce a daily NAV.
If a non-U.S. institutional investor does not want to invest in a swap with all the accompanying counterparty documentation that it entails, they could also access a bank loan product through a SIF or UCI Part II fund (structured as a SICAV or FCP). A SIF is available to institutional or “informed” investors and is subject to each country’s local distribution rules. A UCI Part II fund is available to institutional investors through a private placement with a monthly NAV minimum requirement. A SICAV or FCP for retail investors would have to be registered in the local jurisdictions of the underlying investors.
Infrastructure Considerations
In addition to a manager’s investment expertise, including the level of institutional quality, depth of credit research, and process discipline, an investor could consider evaluating the strengths and weaknesses of a manager’s infrastructure available to support U.S. and non-U.S. investors, including trading and back office. While the logistic and back office activities related to bank loans may seem cumbersome when compared to other types of portfolio implementation, in many cases the cost/benefit analysis fully justifies investing in a deep support staff. Since liquidity is important for fair value pricing, an opportunity exists for sophisticated bank loan specialists who can capitalize on over/under valued loans. Having a large group of dedicated credit analysts that are experienced with legal documentation, credit agreements, and covenants allows a manager to move quickly on any perceived inef-ficiencies. Additionally, a manager with a certain level of presence and specialist capabilities in trading bank loans enables better price negotiation, cost effective buying in the secondary market, and helps avoid size impact. A manager who is a recognized “player” in the bond and loan market can leverage its numerous relationships with all major bond dealers who provide current information on “fair” value of sectors. This information coupled with intimate knowledge at the
loan level can help lead to superior security selection in an inefficient market. Broad-based industry relationships with a variety of dealers can reduce dependence on any single dealer. Likewise, if the portfolio managers and traders understand historic trading levels of competing bids and offers for transactions and market technicals, one can achieve best trade execution.
Robust operations and risk management infrastructure is key to successfully handling complex transactions day in and day out. Daily third-party loan pricing services are available, such as Markit Partners, Loan Pricing Corp, IDC, or Bloomberg. Additionally, formalized compliance and trade settlement procedures aid in handling complex instruments like bank loans, including automatic data feeds to accounting and performance, and compliance checks throughout the entire trade process. A compliance department with a separate reporting line can handle all loan documentation and ensure a compliant private information/public information firewall. Third-party loan administrators and systems, such as Wall Street Office (WSO), are available to aid in tracking interest and principle payments and reconcile positions and ultimately allow the bank loan operation staff to focus on handling issues.
Putting the Float in a Floating-Rate
To create a floating rate, bank loans pay a fixed spread over a specified variable index rate, typically the three-month London Inter-Bank Offered Rate or LIBOR. As a global market rate, LIBOR exposes investors to fixed income supply demand, and global market dynamics. Currently, bank loans are pricing relative to LIBOR at approximately L+ 350 to L+450. The interest rate is then reset periodically to reflect changes in LIBOR. Generally speaking, bank loans trade close to par at $0.90 to $1.02. However, they did trade as low as $0.60 to $0.70 during the financial crisis of 2007-2009 (Chart 7). Some contracts will even stipulate a minimum base rate if the actual LIBOR rate declines too far. Because of the continually low LIBOR levels currently, most loan deals now include a floor of 100-150 plus the marketed spread.
Chart 7: CS Leveraged Loan Index Average Price 110 100 90 80 70 60 50 Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11 Source: Bloomberg
Unlike many floating rate securities, loans have a mechanism to shorten the “lock-out” period (the time between the rate reset and payment), which reduces interest rate volatility risk. This is accomplished by break-ing down a loan into multiple “contracts” in a laddered maturity schedule. The sum of the contracts is equal to the total outstanding amount of loan. When the near-term contract expires, the interest payment is made and a new contract is set reflecting the current index rate.
The use of contracts provides for a smoother rate-reset and truer floating rate investment. Some loans have been known to have as many as 15 active contracts, highlighting another reason to have a sophisticated loan manager with the resources and systems to handle the complicated accounting behind loans.
High Quality Emphasis
Given the additional complexities surrounding bank loans by way of examples outlined above, should one favor investing and implementing a bank loan product with a high quality emphasis? Higher quality can in this way behave like a negative selection screen and aid the team in avoiding particular loans.
w Some bank loan strategies favor a high quality emphasis as a by-product of solid credit analysis where loans have met certain credit standards. In some cases, the investment decision may be contrary to all other market indicators, such as rating, leverage, etc. or even the overall market consensus. Indeed, “high quality” may simply refer to the quality of the assets being secured and the perceived lack of downside risk in the event of default or bankruptcy.
w Having the ability to evaluate an issuer’s entire capital structure helps with the decision on whether to participate in a bank loan and more importantly, when not to participate in a bank loan. w With some legal expertise, the manager could take the time to
understand more complex covenants and be even more selective about investing in certain types of bank loans or in certain industries. w Since bank loan performance is largely a function of credit quality
and company-specific events, an allocation provides diversification benefits by having the potential to not add idiosyncratic risk or market risk to the overall pension plan or endowment. Less idio-syncratic risk can lead to lower volatility and higher risk-adjusted performance relative to other fixed income sub-asset classes.
Performance Post Financial Crisis
Short-term market volatility stemming from 2008 and 2009 events was partially driven by fundamentals such as weakening credit quality in a recessionary environment but, in our opinion, more impacted by forced selling by leveraged investment prices. Despite the recent market crisis, bank loans have recovered long-term returns and prices. Using the Credit Suisse Leveraged Loan Index as a reference point, bank loans have garnered 19 positive absolute returns in the last 20 calendar years (Chart 8), recovered on a three-year rolling-return basis (Chart 9), and also recovered on an invested capital basis (Chart 10).
Chart 8: Calendar Year Return
As of December 011 50% 40% 30% 20% 10% 0% -10% -20% -30% 2001 2002
CS Leveraged Loan Index
2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Zephyr StyleAdvisor
Chart 9: Rolling 3-Year Returns
January 00 – December 011 (6-Month Moving Windows, Computed Montly)
20 15 10 5 0 -5 -10
CS Leveraged Loan Index
Dec 2004 Dec 2005 Dec 2007 Dec 2009 Dec 2011
Return
Source: Zephyr StyleAdvisor Chart 10: Cumulative Return (%)
January 00 – December 011 (Single Computation)
70 60 50 40 30 20 10 0 -10
CS Leveraged Loan Index
Dec 2001 Dec 2002 Dec 2003 Dec 2004 Dec 200 5
Dec 200 6
Dec 200 7
Dec 2008 Dec 2009 Dec 2010 Dec 201 1 Source: Zephyr StyleAdvisor
Additionally, loans continue to reflect institutional, competitive risk-adjusted returns (Chart 11, next page) as defined by the Sharpe ratio. Most managers in the eVestment Floating Rate Bank Loan peer group have a positive long-term Sharpe ratio better than the index. Even the median manager in the eVestment peer group has a competitive Sharpe ratio.
Chart 11: Sharpe Ratio
December 011
3Yr %Rk 5Yr %Rk 7Yr %Rk 10Yr %Rk Universe: Floating-Rate Bank Loan
th Percentile . 0. 0. 0.
Median . 0. 0. 0. th Percentile . 0. 0. 0.
# of Observations 6 6 19 CS Leveraged Loan Index . 0. 9 0. 89 0. 90
Source: eVestment
Conclusion
Combining a deeper understanding of what is important to each party in a bank loan transaction with experience and knowledge of the specific bank loans and interested parties, makes it easier over time to negotiate successful terms, avoid disagreements with other creditors, and successfully handle changes over the life of the loan. It may prove beneficial to investors to understand how the nuances of investing and trading loans differ with bonds, which types of tranches are available, how loans retain their secured status, and how a robust infrastructure can help keep costs to a minimum yet preserve a quality allocation experience overall.
The decision to allocate to bank loans comes first as investors con -sider all the numerous benefits including diversifying fixed income exposure, diversifying credit exposure through corporate loans with company-specific risk, as well as helping reduce a plan’s interest rate exposure in a rising rate environment. Given their private transaction nature, bank loans are not available to an individual on the open market. So, while there are a few peculiarities surrounding the implementation of a bank loan product, a manager specializing in bank loans and credit research would be willing to help an investor with implementation. Additionally, a specialized fixed income manager or a plan consultant would also be capable of offloading an investor’s allocation decision and actively managing a dynamic allocation between bank loans and high yield bonds within one portfolio. The on-boarding process for a bank loan product should appear seamless and yet worth the extra effort in the long run.
For further reading, see “Understanding Bank Loans: Opportunities for Diversification and Risk Reduction,” Wells Capital Management, December 2008
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.
Wells Capital Management | 525 Market Street, 10th Floor, San Francisco, California 94105 | www.wellscap.com
Authors
Niklas Nordenfelt, CFA
Managing Director, Senior Portfolio Manager Sutter Credit Strategies
Niklas Nordenfelt is currently managing director, senior portfolio manager with the Sutter Credit Strategies team at Wells Capital Management. Niklas joined the team in February 2003 as investment strategist. Niklas began his investment career in 1991 and has managed portfolios ranging from quantitative-based and tactical asset allocation strategies to credit driven portfolios. Previous to joining Sutter, Niklas was at Barclays Global Investors (BGI) from 1996-2002 where he was a principal. At BGI, he worked on their international and emerging markets equity strategies after having managed their asset allocation products. Prior to this, Niklas was a quantitative analyst at Fidelity and a portfolio manager and group leader at Mellon Capital Management. He earned a bachelor’s degree in economics from the University of California, Berkeley, and has earned the right to use the CFA designation.
Sean Lynch
Managing Director, Head of Research Sutter Credit Strategies
Sean Lynch is managing director, head of research with the Sutter Credit Strategies team at Wells Capital Management. Sean rejoined the team in 2005 as a senior research analyst with coverage of the services, homebuilding, autos, paper, metals/mining, and steel sectors. He left Sutter in 2004 to join KKR Financial as a director and senior high yield analyst, specializing in high yield and leveraged loan research for the services sectors. Sean was previously with the Sutter team from 1996 through 2004, first as a research analyst and then becoming the co-head of research. Prior to joining Wells Fargo and Sutter, Sean worked at First Interstate Bank and within the California State Assembly. He is a graduate of the Wells Fargo Credit Training Program and earned a bachelor’s degree in political science from the University of California, Davis.
