A Case For Senior Secured Loans

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Eaton Vance Management
2 International Place
Boston, MA 02110
Contact: Scott Ruddick
Head of Institutional, North America
Tel. 617-672-8300
sruddick@eatonvance.com
www.eatonvance.com
Highbridge Principal Strategies, LLC
40 West 57th Street
New York, NY 10019
Contact: Faith Rosenfeld
Tel. 212-287-6747
faith.rosenfeld@highbridge.com
www.highbridge.com
ING Investment Management
230 Park Avenue, 14th Floor
New York, NY 10169
Contact: Erica Evans
Head of Institutional Sales and Service
Tel. 212-309-6552
Erica.Evans@inginvestment.com
www.inginvestment.com
Invesco
1166 Avenue of the Americas
New York, New York 10036
Contact: Kevin Petrovcik
Managing Director
Tel. 212-278-9611
kevin_petrovcik@invesco.com
www.invesco.com
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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 of
Floating Rate Loans
14
CONTENTS
4
10
14
4
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 weakness
at 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 & Poors 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 an
opportune 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 duration
in 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 like
CLOs 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-investment
opportunities.
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 returns
Returns 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 net
return 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 have
traditionally 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 markets new normal returns may actu-
ally be somewhat higher than their pre-crash old nor-
mal.
The loan markets 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, many
loan 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 ones fixed income bet by holding both loans and
bonds.
Risk-Reward Profile
Though 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 direction
of 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 minimumbase rate that applies even if
the actual LIBOR rate is lower. This is intended to provide
investors with a higher minimumreturn during abnormally
lowinterest-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 streamwill rise or fall with
changes in interest rates. But the impact on the investors
portfolio in terms of valuation, accounting and future
income differs greatly frombonds 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 value and actual market
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.)
6
Liabilities and Equity
Fixed
Income
Loans Senior, secured, fixed principal
return, floating-rate interest
Bonds Unsecured or subordinated,
fixed principal return, fixed-rate
interest
Equity Lowest claim on assets, no fixed
return, unlimited upside potential
}
continued on page 8
11pi0028.pdf RunDate:02/07/11 LSTA Suppl Page:07 Color: 4/C
Driven by our own
benchmarks.
Maintain a long-term perspective
even in the most complex markets.
At Eaton Vance, we build on the knowledge weve 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 Vances dedicated institutional team expands on these strengths, delivering
consultative, hands-on service to our clients. Their exceptional insight into our equity,
xed-inccme, Ncating-rate, structured and alternative strategies 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
2011 Eatcn vance nvestment Managers. nvesting entails risk and there can be nc assurance that Eatcn vance (and its afliates) will achieve prcts cr avcid
incurring losses. Past performance does not predict future results.
Client
Centric
Performance
Excellence
Risk
Management
Comparing returns
Bonds 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 the
portion 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-
kets 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
premiumremoved, 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 when
one 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 below1%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 recent
crisis, said Highbridges 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 Returns
Loans fare well compared to high-yield bonds.
8
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 of
Coupon
Yields
Interest
Rate Bet
Premium
Return on
Credit Risk (Net
of Interest Rate
Bet)
Anticipated
Default Rate
(annual)
Loss Given
Default
Credit
Cost
Net Return
to 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. INGs 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.
INGs 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
I NVESTMENT MANAGEMENT
Dan Norman Jeff Bakalar
Call us now to learn more
about how senior loans
can benet 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 Range
of 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-rate
debt 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 grade
companies 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 been
eager 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
11
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 Matrix
The 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
High
Credit Risk
Low
Credit Risk
Low Interest
Rate Risk
High Interest
Rate Risk
High Yield
Corporate Bonds
Long-term
Corporate Bonds
Long-term
Treasury Bonds
Floating-rate
Corporate Loans
Short-term
Treasury Bills
Leveraged Finance Volume Returning to Pre-crash Levels
US 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. governments ability to
print out new U.S. dollars to repay its debts wont 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 the
risk 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-
suers 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 Risk
Investors 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 across
retail 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.com
or contact Senior Client Portfolio Manager Kevin Petrovcik,
212 278 9611, kevin_petrovcik@invesco.com.
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
economy provideda fairly benignenvironment for traditional
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 Performance
Though 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 from2008 to 2010 would have lost
29% the first year, gained 52% the following year, and
made anadditional 10%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 newasset 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 thema 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 the companys financial health 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 issuers 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 Defaults
Loan 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, the
absolute advantage decreases as defaults drop. A current
example of howthis 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 its 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 performwell in various types of economic
scenarios. Loans are the fixed-income asset class for all
seasons, 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-terminvestments 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 was
raised as debt (loans and bonds) with the new owner
providing $1.3 billion in equity.
Deal features, risk and reward
The loans are secured by all of Burger Kings 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 Moodys. 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 on
average) and the other of senior secured loans (70% recoveries on
average).
HY bond portfolio: 4% defaults, with 40% recovery/60% loss
Results in an annual 4% X 60% = 2.4% portfolio loss
credit expense of:
Senior secured 4% defaults, with 70% recovery/30% loss
loan portfolio:
Results in an annual 4% X 30% = 1.2% portfolio loss
credit expense of:
The loan portfolio credit expense is only half that of the bond portfolio, at
any level of default, because the secured loans consistently recover at a
higher rate than the unsecured and sometimes subordinated high-yield
bonds. In absolute terms, of course, the difference becomes greater at
higher default rates. For example, at a 5% default rate bonds suffer a
portfolio 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 facility 5 years $150 million
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
Incc 199, T!c TA !as !ccn
t!c !cadIng advocatc oI t!c scnIov
sccuvcd !oan assct c!ass
1Ic !oan ynuIcaIons
anu 1vauIng AssocIaIon
vonocs a faIv, ovucvIy,
cfIcIcn anu gvowIng
covovac Ioan navIc
anu vovIucs IcaucvsII
In auvancIng anu
IaIancIng Ic Incvcss
of aII navIc avIcIans.
For More lnformation on the LSTA
Please Contact:
Alicia Sansone l asansone@lsta.org
212.880.3002 l www.LSTA.org

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