A Case for Senior Secured Loans

8/4/2019 A Case for Senior Secured Loans

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Floating-Rate Loans

Poised to Perform

4

Floating-Rate Loans Seek

Greater Prominence in Portfolios

10

“Great De-Leveraging”

Raises Profile ofFloating Rate Loans

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CONTENTS

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10

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Floating-Rate Loans

Poised to Perform

lthough business lending may predate the rise of the bond and

equity markets by centuries, loans as a mainstream asset class

have only recently gained recognition among the institutional

investment community. Now many investment professionals

believe 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 rising

interest rates and inflation — may offer ideal investment conditions

for floating-rate corporate loans to perform well, especially compared

to other fixed-income alternatives.

Corporate loans, or more formally “senior secured floating-rate

debt instruments,” are the senior-most debt obligations of non-

investment grade corporate borrowers (the same cohort of companies

that issue high-yield bonds). Being the senior debt on the balance

sheet and secured by collateral means that loans provide a more

protected repayment stream to investors, with credit losses that

have historically averaged less than half those of high-yield bonds,

according to Standard & Poor’s default and recovery statistics.

A





5

At the same time, with floating interest rates that

are periodically reset at a spread over the London Inter-

Bank Offered Rate (LIBOR), loans actually benefit from

increases in interest rates, as opposed to traditional

bonds whose market value decreases when interest rates

rise. The floating-rate feature appeals to investors who

want 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 remaining

flat or dropping, which is the inherent interest rate bet in

any fixed rate bond.

Portfolio managers who recognize this have been

moving substantial amounts of new money into loan

assets in recent months. Retail investors alone were

reported by Lipper FMI to have moved almost $3 billion

into loan mutual funds during the month of December

2010. “Duration risk has become much more of a reality

to investors as long bond yields have moved up sharply in

recent months,” said Scott Page, vice president, portfolio

manager and director of Eaton Vance's Floating-Rate

Loan Group. “For investors who wish to reduce durationin their portfolios, floating-rate bank loans are the simplest

to understand, easiest to trade and most liquid of any

major fixed-income asset class.”

From “bank loan” to “asset class”The investor base for loans has been expanding beyond

traditional banks and specialized investment vehicles,

like collateralized loan obligations, which were the main-

stay of the market until recently. The new investors are

more likely to be oriented toward total returns, rather

than focused on a spread over LIBOR that they would

leverage multiple times. “We believe the institutional

loan 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 institutional

vehicles,” said David Frey, portfolio manager at Highbridge

Principal Strategies. “As a result, we are optimistic that

the favorable new issue pricing we have seen recently will

continue.”

Mr. Frey also thinks that loan demand – much of

which is driven by corporate mergers and acquisitions –

will continue to grow. “Some of the key drivers of M&A

activity are slow organic growth, low interest rates and

improving CEO confidence,” he said. “That seems to be

the situation today, so we are optimistic that M&A

activity 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 the

past, by ceding the better secured, floating-rate loan

assets to the commercial banks, investors left quite a bit

on the proverbial table in terms of attractive risk/reward

returns, cash-flow stability and portfolio diversification.

But they essentially had no choice. Until recently, there

were few investment vehicles providing large-scale

institutional access to the loan asset class.

The explosive growth of the syndicated loan market

over the past two decades has brought with it a substantial

increase in investment management firms focused on

serving institutional investors in the loan market. It has

spurred the development of loan tranches and other

investment vehicles designed specifically to meet the

distinct 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, distribution

and settlement protocols, and the greater transparency

and reliability of third-party pricing.

History of steady returnsReturns to loan investors have been mostly stable, positive

and consistent for the thirteen years since the S&P/LSTA

Leveraged Loan Index began. The two-year worldwide

liquidity crisis in 2008 and 2009 affected the loan market

as 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 their

loan portfolios through the crisis would have earned a netreturn of about 8% over the two years, despite the

resulting recession and some of the highest default levels

ever recorded. In 2010, the index returned about 10%, as

the credit environment improved and loan default rates

fell to below 2%.

Many loan professionals believe returns may not be

quite so high in 2011, but they could be close. “Loans havetraditionally offered stable, predictable returns to

investors,” said Dan Norman, senior vice president and

group head of ING's Senior Loan Group. “The liquidity

crisis a couple of years ago ended an eleven-year streak

of positive returns, but we have now had two successive

positive years. I think there is every reason to believe

loans are on their way to establishing a new streak of

attractive positive returns.”

Mr. Norman, like many loan managers, expects loan

returns could exceed historical averages in 2011, based on

a 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



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 most

challenging credit environment since the 1930s has con-

firmed to many observers and investors the durability of

senior, secured loan assets from a credit perspective. It

has also contributed to growing interest by institutional

investors in senior secured loans as a mainstream asset

class – one that deserves a permanent position in a fixed-

income allocation whether it be an individual, pension

fund, endowment or other long-term portfolio – rather

than 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 apparent

until the economy encounters a sustained period of ris-

ing interest rates. Just as bonds performed brilliantly

with the wind of falling interest rates at their back, many

loan investors expect their asset class to shine if and

when interest rates begin their climb, which has been

long anticipated by some. “Even if an investor is unsure

which 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 dictate

hedging one’s fixed income bet by holding both loans and

bonds.”

Risk-Reward ProfileThough both loans and bonds are considered fixed

income, they diverge in other ways.

Loans and bonds are typically regarded as “fixed-in-

come” investments. While this is true insofar as the

principal amount that an issuer contracts to repay at

maturity is fixed in both cases, the two asset classes

diverge in other respects, presenting distinct risk/reward

profiles.

Bond investments combine two main risks: credit

risk and interest-rate risk. The higher the credit quality

of 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 is

more complicated, partly because the credit risks vary

considerably between loans and bonds.

Also, the nature of the interest-rate bet inherent in

each instrument is different. Because loans are gener-

ally the senior-most debt of the issuer and are secured by

collateral and other protective features, they typically de-

fault less frequently than high-yield bonds. Moreover,

when they do default, loan investors generally recover at

a consistently higher rate than bond investors, as a

result of having collateral. Recoveries post-bankruptcy

average 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 more

markedly in terms of how each asset reacts to changes in

interest rates. With bonds, interest rates are fixed for the

term of the instrument. With loans, interest rates are

variable or floating, defined as a spread over a base rate

that changes periodically. Typically the base rate is the

three-month LIBOR. Recent loan contracts have included

a LIBOR floor, a minimum base rate that applies even if

the actual LIBOR rate is lower. This is intended to provide

investorswith a higherminimum returnduringabnormally

low interest-rate periods. Typical LIBOR floors have been

in the 1.5% to 1.75% range.With both bonds and loans, investors are taking a

position with respect to future interest rates. Some aspect

of the value of the investment — either its current market

value or its future income stream — will rise or fall with

changes in interest rates. But the impact on the investor’s

portfolio – in terms of valuation, accounting and future

income – differs greatly from bonds to loans. With bonds,

future cash flows, which include interest coupon payments

plus principal, are fixed (unless the issuer defaults). If in-

terest rates change so the fixed rate on the bond is out of

sync with current interest-rate levels, the market price

of 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 affected

since the loan is always paying a market rate. In a rising

interest rate environment, the economic value of the loan

increases, since the income it generates rises along with

interest rates. Fixed-interest instruments, like bonds,

decrease in both relative economic valueandactualmarket

price as interest rates rise. (Although generally immune

to interest-rate movements, loan prices may still vary in

the secondary market for non-interest-rate related

reasons like the overall supply and demand of loans, market

liquidity, risk appetite and issue-specific credit factors.)

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Liabilities and Equity

“Fixed

Income”

Loans Senior, secured, fixed principalreturn, 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



Driven by our ownbenchmarks.

Maintain a long-term perspectiveeven 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, deliveringconsultative, 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



Comparing returnsBonds have two primary elements of risk, which investors

want to be paid for: interest-rate or duration risk and

credit risk. Since floating-rate loans have no interest-

rate/duration risk, the entire coupon is available to

compensate the loan investor for credit risk. In effect,

comparing loan and bond returns requires netting out theportion of the bond return that compensates the holder

for taking the interest-rate bet embedded in the bond by

virtue of its fixed interest rate.

An investor gets paid almost 3.5% on a 10-year

Treasury bond and about 10 to 15 basis points for a

three-month T-bill. Although each has the same credit

risk, 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 loans

as pure credit instruments requires subtracting that

10-year/three-month Treasury differential (3.25%) from

the 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 the

premium for the interest-rate bet would be a range ap-

proximately between 4% to 7%. Meanwhile, the range

of 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 these

differences, based on the assumptions presented, which

may vary over time.)

The figures suggest that, with the interest-rate bet

premium 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 investors

typically receive when issuers default. Although default

rates vary through economic and credit cycles, typical de-

fault rates of 3% per annum would result in net credit

costs of about 2% for high-yield bonds (which are usually

unsecured or subordinated), but just below 1% for secured

loans.

Many professional loan managers believe they can

widen the differential even further through good credit

selection and active portfolio management. “A lot of

people have a perception that the credit loss on non-in-

vestment grade senior loans is fairly high, but history

seems to demonstrate otherwise, even during the recentcrisis,” said Highbridge’s Mr.Frey. “Moreover, a substantial

portion of the company-specific credit risk can be reduced

through a well diversified portfolio, and seasoned active

managers typically have default rates that are a fraction

of the overall market.” ◆

Weighing ReturnsLoans fare well compared to high-yield bonds.

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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 ofCoupon

Yields

InterestRate Bet

Premium

Return onCredit Risk (Net

of Interest Rate

Bet)

AnticipatedDefault Rate

(annual)

Loss GivenDefault

CreditCost

Net Returnto Investor

for Credit

Risk

continued fom page 6



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 moreabout how senior loanscan benefit 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 Rangeof Senior Loan Investments for Institutional Clients



Floating-Rate Loans

Seek Greater Prominence

in Portfolios

10



he financial press has been awash with articles about

possible “bond bubbles” and the risks of holding fixed-ratedebt as economic and fiscal forces come together to cause

interest rates to rise over the next few years. But most of

the articles focus on investment re-allocation from one

part of the bond market to another, such as from Treas-

ury bonds to corporates, or from investment-grade bonds

to high-yield ones. Others advocate moving out of bonds

and fixed income completely and into either stocks, with

their high volatility, or extremely short-duration assets,

which have no volatility, but no yield either.

Little attention has been devoted to the option of

moving out of bonds but remaining in fixed-income in-

struments that involve no interest-rate bet. “Loans are

one 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 group

head of ING's Senior Loan Group. “Floating-rate corpo-

rate loans generally allow investors to earn an attractive

current return in the range of 5% to 6% and still have up-

side potential in case interest rates rise due to economic

growth and/or renewed inflation.”

Other managers agree. “We think the case for put-

ting floating-rate loans in portfolios may now be the most

compelling in the 20-year history of the asset class,”

wrote Scott Page, vice president, portfolio manager and

director of Eaton Vance Floating Rate Loan Group, in a

recent research report.

Floating-rate loans – loans to non-investment gradecompanies – have been the purview of commercial banks

for hundreds of years. It is only over the past two decades

that loans have evolved from a “buy-and-hold” asset on

the books of banks to a full-fledged publicly underwrit-

ten and traded asset class. Most akin to public high-yield

bonds because of the type of companies being financed,

the volume of institutional term loan issuance actually

exceeded that of public high-yield bonds during the years

immediately before the crash.

Since the crash, high-yield bond volumes have ex-

ceeded floating-rate loan issuance, a development that is

not surprising. With interest rates hovering near their

lowest point in a generation, corporations have beeneager to issue fixed-rate bonds to lock in low borrowing

rates 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 of

having such a large portion of their fixed-income portfo-

lios allocated to bonds.

“With bond yields near historic lows, the risk of loss

attached to any upward move in interest rates is very

real,” said Greg Stoeckle, managing director and head of

global bank loans at Invesco. “Hence, sophisticated insti-

tutional investors have been looking for an asset class

that provides current income, like bonds, but protects,

T





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and actually supplements, current income in the event of

rising interest rates.”

Many investors still regard the term “fixed income”

as being synonymous with “bonds,” reflecting the wide

gulf that existed – legally, culturally and institutionally

– between public debt instruments (primarily bonds) and

private debt instruments (primarily loans) until just 10 to

15 years ago. Bonds were securities, underwritten and

sold to institutional and retail buyers by investment

bankers and distributed in a public market. Loans were

not securities, but were private financings arranged by

lending officers who worked for commercial banks that

held the loans on their books until maturity.

The gap between loans and bonds first began to erode

as loans and the deals they were financing became so

large that individual banks had to “syndicate” them to

larger groups of other banks, with the role of syndicator

increasingly coming to resemble that of an underwriter in

the bond market. The erosion accelerated as non-bank in-

stitutional investors, such as insurance companies, mu-

tual funds and securitized vehicles, started to buy into

loan syndications. Eventually bankers began to structure

dedicated term-loan tranches with features, such as

longer terms, fully funded and non-amortizing balloon

payments, specifically oriented toward the needs of these

institutional 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 its

two component parts: the credit bet and the interest-rate

bet. Previously, when bonds were the only game in town

for fixed-income investors, buying debt without some

amount of interest-rate bet attached to it was virtually

impossible. 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 a

greater credit risk component into the fixed income world.

Leveraged Finance Volume

continued on page 12

Fixed Income Instruments

Credit Risk/Interest Rate Risk Matrix

HighCredit Risk

LowCredit Risk

Low InterestRate Risk

High InterestRate Risk

High YieldCorporate Bonds

Long-term

Corporate Bonds

Long-termTreasury Bonds

Floating-rateCorporate Loans

Short-termTreasury Bills

Leveraged Finance Volume Returning to Pre-crash LevelsUS Volume



12



Of course, not all debt is created equal with respect

to the mix of credit risk and interest-rate risk from one

fixed-income asset class to another. Three-month Treas-

ury bills, for example, have recently been yielding 10 to

15 basis points, making them the proxy for the actual

credit risk of the U.S. government (i.e., the risk of not

being paid back in U.S. dollars). Ten-year Treasury bonds

carry a yield of almost 3.5%. Since the credit risk is vir-tually the same (i.e., the U.S. government’s ability to

print out new U.S. dollars to repay its debts won’t change

over ten years), the difference of just over 3.25% between

the three-month T-bill yield and the 10-year T-bond yield

represents the interest-rate risk premium investors are

being paid for tying up their money for 10 years rather

than three months.

A 10-year, single-A-rated corporate bond yields about

4.35%. Since 3.25% of that covers the premium on the 10-

year interest rate bet, then the remainder – 4.35% minus

3.25%, or 1.1% – is what the investor is being paid for

taking 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 the

next 10 years, or 1.1% for a corporate credit risk – albeit

a 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 the

heightened risk of non-payment. Typical high-yield bonds

yielding in a range of 7% to 10%, depending on the is-

suer’s credit rating, pay an investor approximately 4% to

7% for credit risk, after deducting the 3.25% interest-

rate-bet premium. Corporate loans have recently yielded

in a range of about 6% to 7%, with the entire coupon pay-

ing for credit risk, since there is minimal interest-rate

risk with the continually re-setting floating rate.Further, corporate loan investors typically get to keep

more 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 that

are less than half those experienced by the unsecured or

often subordinated high-yield bond holders.

The various types of fixed-income instruments allow

investors to pick their risk profile (see chart). An investor

who is primarily interested in making an interest-rate

bet 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 an

interest-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%, depending

on credit quality) compensating the investor for taking

credit risk, but with still a sizable remainder (33% to

46%) allocated toward interest-rate risk. Corporate loans,

with their adjustable interest rates, remain the only

major 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 feel

that rates are likely to remain stable or move up should

look to lighten their allocation to instruments that carry

an embedded bet that rates will fall, if an alternative is

available 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 syndicated

corporate loan market has certainly changed all that,”

said Craig Russ, vice president and portfolio manager at

Eaton Vance's Floating-Rate Loan Group. “Now institu-

tional and retail investors can enjoy the advantages of buying corporate debt without making a bet on interest

rates that they may not really want to make.” ◆

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

Single-A

Coporate 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

Interest

Rate Bet Premium

Return on Credit Risk

(Net Interest Rate Bet)

Percent of Coupon

Allocated to Interest

Rate Bet

Percent of Coupon

Allocated to

Credit Risk

Interest Rate Risk/ Credit Risk Return Allocation

continued fom page 11

Divvying Up RiskInvestors can choose where to place their bets.



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 Worldwide

Achieve Their Financial Objectives

Experience Builds Trust

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



or years, bankers, loan portfolio managers and investors

have been singing the praises of floating-rate loans to a

larger investment community that was indifferent.

Decades of falling interest rates and a steadily growing

economyprovideda fairly benignenvironmentfortraditional

fixed-income investors who felt no particular need to

push the definition of fixed income beyond bonds. But

there is nothing like a market crash and de-leveraging to

raise the profile of an asset class. The last three years

certainly did that for floating-rate loans.

Respectable PerformanceThough volatile, the S&P/LSTA Leveraged Loan Index

returned 19% over the three years from 2008 to 2010.

An investor who held the S&P/LSTA loan index through

the three-year period from 2008 to 2010 would have lost

29% the first year, gained 52% the following year, and

madeanadditional10% in2010, for a respectable 19% gain

over 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 the

previous high-default period of 1999 to 2003, when loan

default rates reached almost 8% (see chart on right).

“Loans are hardly a new asset class,” points out Scott

Page, vice president, portfolio manager & director of

Eaton 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 wider

investment community,” he said.

What enabled the loan market to bounce back so

quickly from the worst credit crunch since the Great

Depression? More than anything, it was credit structure

and asset protection. While floating-rate loans represent

debt of the same cohort of non-investment grade compa-

nies that issue high yield bonds, the comparison stops

there. Loans are senior obligations, secured by collateral

– usually the key earning assets of the issuer – and they

have covenants that allow the lenders to take protective

steps if thecompany’s financialhealth begins to deteriorate.

As a result, loans generally do not default as readily

as high-yield bonds, whose holders have minimal

covenants and control, and often must sit on the sidelines

as the issuer’s creditworthiness declines. Moreover, when

borrowers do default, loan investors, as a result of their

collateral security and senior position, recover at a

consistently higher rate than bond investors. Recoveries

post-bankruptcy typically average 70% for loans versus

40% 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.



many years. This translates into a substantial “credit

expense” differential for a diversified portfolio of loans

compared to a similar portfolio of bonds. Over time, loans

incur 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 losses

to corporate-loan credit losses tends to hold throughout

credit cycles, the absolute advantage increases as the

economy worsens and defaults increase. Conversely, theabsolute advantage decreases as defaults drop. A current

example of how this structural advantage works in practice

is the recent Burger King loan. Craig Russ, vice president

and portfolio manager in the Eaton Vance Floating Rate

Loan Group, views Burger King as a prototypical example

of the loan asset class. “The secured loan is at the top of

the capital structure, with junior capital – equity and the

high-yield bond – providing a good cushion. And it’s got

an attractive spread.” (See sidebar for details.)

The structural seniority of loans, combined with their

floating interest rates, is a powerful combination in terms

of being able to perform well in various types of economic

scenarios. “Loans are the fixed-income asset class for allseasons,” said Dan Norman, senior vice president and

group head of ING's Senior Loan Group. “While the

floating rate advantages are clear and apparent in an

expansive, rising interest-rate environment, loans have

also significantly outperformed not only traditional

fixed-income instruments such as Treasuries, investment

grade and non-investment grade corporate bonds, but

also equities in prior recessionary cycles. Therefore,

loans are attractive long-term investments for institutional

investors.” ◆



15

Burger King Financing

The recent Burger King buyout financing shows how

companies utilize both loans and bonds to complete

major 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 owner

providing $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 its

foreign 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% in

Europe). 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 the

loans in the event of default. With a fixed rate of

9.875%, they were sold at par. We look to the 8-year

point on the Treasury yield curve – 3% – minus the

3-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 B

and B2 respectively by S&P and Moody’s. The loan

and bond were notched up (the loan) and notched

down (the bond) from the corporate ratings to differ-

entiate the starkly different risks, as follows:

• Loans were notched up two notches, to BB-and

Ba3, 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 more

for taking the additional risk. Typical default costs

on high yield bond portfolios could run 1-2% yearly,

versus less than half that on loan portfolios, which

more than offsets the gross coupon differential.

Portfolio Credit Costs: Doing the Math

Assume 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 cash

will default on its unsecured (or subordinated) bond, but continue to make payments on its senior secured

loan. That will count as a bond default, but not a loan default, in compiling the statistics. So the default rate

for loans is actually a bit lower than it is for bonds, even for an identical cohort of issuers.

Loan Financing

Revolving credit facil ity – 5 years $150 mil lion

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

A Case for Senior Secured Loans

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