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GSOContact: Daniel H. Smith, Jr.Senior Managing DirectorPhone: [email protected]

Guggenheim Investments330 Madison Avenue, 10th FloorNew York, NY 10017Contact: Kevin GundersenSenior Managing Director, Portfolio ManagerPhone: [email protected]://guggenheimpartners.com/

Highland Capital Management, LP300 Crescent Court Suite 700Dallas, TX, 75201Contact: Shannon WherryDirector of Corporate Communications Phone: [email protected] www.highlandcapital.com

KKR9 West 57 Street, Suite 4200New York, NY 10019Contact: Erik FalkMember & Co-Head of Leveraged CreditPhone: [email protected]: Lynette VanderwarkerManaging Director, Client & Partner GroupPhone: [email protected]

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The Loan Syndications and Trading Association - LSTA366 Madison Avenue, 15th FloorNew York, NY 10017Contact: Alicia SansoneExecutive Vice PresidentPhone: [email protected]

SPONSOR DIRECTORY CONTENTS

SPONSORS

The Loan Market Today

Regulatory Reform &the Loan Market

The Search for Yield

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The senior secured loan market has grown nearly40 percent over the past several years, reachinga record $731 billion in outstandings year todate, from a low of $510 billion in March 2011.With uncertainty around interest rates, investorsin the asset class like their short duration, highposition in the capital structure and their float-ing rate nature, which have resulted in better re-turns than other fixed-income instruments. LSTAExecutive Director Bram Smith sat down with fourleading loan market participants to discuss thecurrent state of the market, effects of new regu-lations, and how senior loans enhance an insti-tutional portfolio.

Bram Smith: What does the loan market look liketoday?

Erik Falk: The loan market has grown substantiallyover the past several years. There is currently morethan $700 billion outstanding in the institutionalbank loan market. The market has really been drivenby inflows over the past several years from the retailmarket, with more than 90 weeks of consecutive in-flows in the retail space before recent outflows.There’s been a tremendous amount of CLO (collat-eralized loan obligation) formulation in the market-place. Balancing this capital formation has beenpeak levels of new issue—much of which, about 70%,is being used for refinancing. Investors have ex-pressed an interest in participating in senior securedfloating-rate assets due to their short duration andtheir positioning high up in the capital structure, re-sulting in better returns—much better than what in-vestors are seeing in other fixed income markets withsimilar risk characteristics.

Kevin Gundersen: We look at the net rather thangross new supply in the market as a better factor tothink about from the supply-demand perspective.You’ve got CLO runoff, or CLOs hitting the end oftheir reinvestment period, so we think about net newcreation in the CLO world, not gross CLO issuance,

THE LOAN MARKET TODAY: Where Are We Now,

Bram SmithExecutive DirectorLoan Syndications and Trading Association

Moderator:

Dan McMul lenManaging DirectorGSO Capital Partners

Erik FalkCo-Head of Leveraged CreditKKR

Kevin GundersenSenior Managing Director,Portfolio ManagerGuggenheim Investments

Mark OkadaCo-Founder, Chief Investment OfficerHighland Capital Management


and then the same thing on the supply side.So the gross of more than $300 billion in2013 is a little misleading. It’s really just refi-nancing existing debt out there.

Smith: How has this affected prices in thenew-issue and secondary markets?

Dan McMullen: Strong demand for loans hasoutpaced the available supply, which hascaused secondary loan market prices to riseand spreads to compress over the last fewyears. Because loans are callable, issuersfrequently reprice or refinance their out-standing loans at lower spreads when theytrade above par. The Credit Suisse LeveragedLoan Index reached a post crisis peak at$98.93 on January 23rd and finished thefirst quarter of 2014 slightly lower at $98.72to yield 5.14%, assuming a three-year life.Refinancing transactions represented ap-proximately 39% of total loan issuance dur-ing the first quarter, and they contributed tothe lower secondary market prices, whileyields remained more stable.

Smith: Where are we in the credit cycle?

Mark Okada: We’re in the later stages of thecredit cycle. The loan market and the lever-aged capital markets have fully reflated andhealed from the great financial crisis. We areat that period where activity has been fairlyrobust, inflows have been fairly positive andleveraged multiples are rising.

Gundersen: We are certainly in the latter in-nings of the credit cycle. I think we used tospend all our time thinking about how longthe cycle can last, and certainly we acknowl-edge that it can last. We are probably in anovervaluation stage for high yield. It’s lessclear in the loan market, but there’s an ac-knowledgement that you can stay in an over-


Where Are We Going?

60%

50%

40%

30%

20%

10%

0%

-10%

-20%

-30%

-40%

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

YTD

TOTAL

EXHIBIT 1: Indexed Returns

CREDIT BETTER THAN EQUITY

R E P A I REconomy stops contracting, focus on balance sheet

repair, asset prices stabilize, equity to repay debt, cost reduction / survival

Steady but Low Interest Rates

L O W G R O W T H

D O W N T U R NEconomy contracting, profits fall, defaults

increase, asset prices decline, Central Banks implement stimulus.

Interest Rates Declining

L E V E R A G E F A L L I N G

L E V E R A G E R I S I N G

R E C O V E R YEconomy improves, M&A cycle starts gradual upswing, Asset prices increase, Central Banks begin to take back stimulus

Low and Rising Interest Rates

E X P A N S I O NEconomy growing, profit margins peak, asset prices continue to increase, leverage rising, M&A /LBOs more speculative.

Rising Interest Rates

THE CREDITCLOCK

CREDIT BETTER THAN EQUITY

BOTH CREDIT AND EQUITY DOWN BOTH CREDIT AND EQUITY UP

H I G H G R O W T H

1

3

2

4

continued on page 6

EXHIBIT 2: The Loan Opportunity: Current Credit Cycle

Source: S&P/LSTA Index

Source: Morgan Stanley Credit and Equity Strategy


valued stage longer than you think. With thatsaid, the investment thesis around loans isstill intact. We have a pretty constructive viewfor the U.S. economy with rates staying lowas long as they have. Borrowers are beingable to push out maturities. Their cost of cap-ital is low. There’s nothing on the horizon thatwe see increasing default rates meaningfullyuntil rates start to rise, and I think that’sprobably not until the end of 2015, maybeinto 2016.

McMullen: We think that now is a time forcaution. Average total leverage for new pri-mary loan transactions is at 4.9 times throughthe first quarter of 2014, according to S&PLeveraged Commentary & Data, which is thesame level as the previous peak in 2007. Onthe bright side, there is less subordinatedpayment-in-kind toggle debt than was issuedin 2007, and there is a higher amount of eq-uity contributions to LBO transactions, at38% of capital structures compared to 32%in 2007. The low interest-rate environmenthas also allowed companies to refinancetheir capital structures and extend maturi-ties. Interest coverage levels are currently at3.9 times EBITDA (or earnings before inter-est, taxes, depreciation and amortization),which is a full turn above levels experiencedin 2007. Finally, we have not yet seen thesame amount of M&A and LBO activity thatwe experienced during the previous peak,so we think the cycle still has room to run.

Falk: We agree we’re in one of the later in-nings of the credit cycle, as defaults peakedabout five years ago. The question iswhether it’s a nine-inning game, a 12-inninggame or longer. Overall, the economy andcompanies continue to recover. The markethas been strong, but compared to 2007, theeconomy still feels like it’s got some legs.We’re not pricing all these deals off of peakearnings and peak EBITDA. Deals are notbeing created with pro-forma EBITDA likethey were in 2007. Companies are still flushwith cash. Additionally, there is a tremen-dous amount of cash on the balance sheetsof investment-grade and other large con-glomerates, so there is takeout potential.And, everything is being done cov-lite, so thecatalyst to a real default wave is kicked fur-ther down the road.

Smith: Do you see a significant increase indefaults?

Falk: There are a few companies in the mar-ket that have a day of reckoning coming, andthere are a few large, identified defaults outthere. Other than that, it will be the rare sit-uation where liquidity or something in acompany’s particular business model be-comes an issue, and we don’t forecast wide-spread defaults.

Okada: Although we are later in the cycle,we do not see any significant increase in de-faults in the near term based on two promi-nent factors: number one, there are nonear-term maturities we see in the out-standing pool of loans at this point in thecycle, because so many loans have been ex-tended; and number two, the U.S. economyis improving, and the corporate health of is-suers is fairly healthy. That being said, wewould anticipate sometime in the next twoyears to see default rates revert back tosomething close to the long-term average asthe economy enters the latter part of thiscurrent expansion.

Smith: Cov-lite has received a lot of atten-tion in the press this year. Can you explainwhy cov-lite loans can actually be a positivefor the market and investors?

Gundersen: It’s positive because there isone less hammer in the capital structure tobring the whole thing to a default situation.It’s certainly good for the junior parts of thecapital structure. Comparing a high-yieldbond in a capital structure and cov-lite loan,the cov-lite loan is much more attractive. Forthe bank loan investor, it gives the private-equity sponsor or the equity managementteam an opportunity to work through any po-tentially unique circumstances that the busi-ness is facing rather than having to deal witha bank loan constituent that’s not willing tolet you work through that issue.

Falk: One difference to point out in thatanalysis is there are certain investors or cer-tain pools of capital for whom having acovenant may be hurtful because of thestructure of the mandate. You could includesome CLO vehicles in this category. With thestructure of the mandate, if there’s acovenant that’s tripped or if there’s a down-grade, which could be the result of thecovenant, or if there is a default, they be-come forced sellers when that may not havebeen the best way to realize long-term value.So, there are definitely instances where themandate informs how you want the loan tobe structured.

Smith: What have been the recovery ratesof cov-lite loans through the last cycle?

Okada: Cov-lites have two basic impacts onthe market during a cycle. From an issuer’sstandpoint, they allow the borrower to havemore flexible financing in order to deal withshort-term volatility in their cash flows,which, to the extent that those volatilitysources are short-term in nature, will actu-ally result in lower defaults through a cycle.On the other hand, from the lender's stand-point, cov-lites don't give the lenders the op-portunity to re-price their risk in a situation


continued from page 5

continued on page 8

“Investors have

expressed an interest

in participating in

senior secured

floating-rate assets

due to their short

duration and their

positioning high

up in the capital

structure, resulting

in better returns.”


The percentile rankings are based on data self-reported by managers to eVestment Alliance (“EA”) and are based on monthly gross of fee returns since inception as of 12.31.2013. EA does not verify this data. The number of observations since inception for the universes are as follows: Core Fixed Income - 157, Multi Credit - 135, Opportunistic Credit - 3, U.S. Bank Loans - 16, and High Yield - 165. The strategies included herein are not representative of all strategies included in the EA database. The rankings may not be representative of any one client’s experience because the ranking reflects an average of all, or a sample of all, of the experiences of the adviser’s clients. Past performance does not guarantee future returns. Additional information regarding EA rankings for year to date and since inception performance of each composite is available on EA’s website. Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC.

For more information, contact us at 212.607.2547 or [email protected]

Our �xed income solutions address clients’ investment objectives, including requirements for total return, yield, duration, and risk. We invest across the capital structure in corporate credit, asset-backed securities, mortgages, and government debt, and have expertise originating securitizations and private �nancings. Our approach has enabled us to deliver strategies providing diversi�cation and attractive long-term results:

Guggenheim Investments Delivering innovative investment solutions and long-term results with excellence and integrity

Core Fixed IncomeInception: 01.01.1999

TOP

1%U.S. Bank Loans

Inception: 01.01.2003

TOP

7%

Multi CreditInception: 10.01.2007

TOP

1%High Yield

Inception: 05.01.2009

TOP

17%

Opportunistic CreditInception:09.01.2006

TOP

1%

Manager Universe Percentile RankingSource: eVestment Alliance



where maintenance covenants would allowthem to get an amendment and re-price thebank loan. You are giving up the option to po-tentially gain additional compensation whena stress situation occurs. However, if you lookat the overall data between the two perspec-tives, the borrower or the lender, the lendershould have the upper hand. If we look at his-tory, cov-lite loans have outperformed cov-heavy loans on a total return basis.

Smith: Where are leverage levels now fornew issues? Are we back to where we werein 2007?

Okada: The main risk at this point in thecycle is rising leveraged ratios with lowcoupons, meaning that you are creating anasset class that is potentially more sensitiveto either a GDP reduction or materially higherinterest rates, because borrowers wouldhave to pay much higher coupons. However,based on the performance of the U.S. econ-omy and the Federal Reserve's clear forwardguidance around interest rates, neither ofthose issues is something that market par-ticipants are or should be worried about inthe next year or so.

Smith: LIBOR, or the London Interbank Of-fered Rate, is around 25 today. What’s theimpact on the loan investor if it goes up 100points? What about LIBOR floors?

McMullen: The majority of loans in the sec-ondary market have LIBOR floors between

75 to 100 basis points. The loan investordoes not receive any of the benefit of the ris-ing rates until LIBOR exceeds the level of theLIBOR floors. However, we think it’s likely thatthe Fed will delay increasing rates until it iscertain of an economic recovery and willprobably be forced to increase rates at arapid pace to catch up to the acceleratinggrowth and inflation environment. We be-lieve that we are being compensated todayfor the Fed’s expected delay in raising rates.Given the lower duration risk, we think loanshave attractive yields, especially on a relativevalue basis if you compare them to high-yieldbonds.

Falk: The other impact of LIBOR floors andrising interest rates is that other assetclasses may appear to be more attractive forshort periods of time. So, looking at the first75 basis points where a loan accretes no in-cremental value, there will be some assetsthat accrete 75 basis points of incrementalvalue. In this case, the loan asset class maynot appear to be relatively attractive, eventhough it will benefit from further increasesin rates. However, we think bank loans pro-vide strong long-term good relative value, agood place to invest money for prolonged pe-riods of time.

Smith: How would you compare the volatilityin the loan market today versus a year ago?

McMullen: The increased size of the retailloan investor base and regulatory pressures


2,000

1,800

1,600

1,400

1,200

1000

800

600

400

200

0

Historical Average = L + 454 bps

Historical Tightest Level = L + 230 bps

3/31/14L + 473 bps

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Historical Average = T + 584 bps

Historical Tightest Level = T + 271 bps

10/31/02T + 1080 bps

3/31/14T + 409 bps

2,000

1,800

1,600

1,400

1,200

1000

800

600

400

200

0

Leveraged Loan Index (Spread to LIBOR) High Yield Index (Spread to Treasury)

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

EXHIBIT 3: Loan and High Yield Spreads

Source: Credit Suisse Leveraged Loan Index (3 year discount margin), Credit Suisse HighYield Index spread to worst, as of March 31, 2014.

The Search for yield_Layout 1 5/16/14 11:50 AM Page 6

at banks have increased volatility in the loanmarket today. We anticipate increased pricevolatility going forward given the recordamount of inflows into daily liquidity retail loanfunds in 2013. We are starting to see retailfund outflows because of two reasons: first,the market has extended the initiation dateof anticipated Fed funds rate increases andsecond, yields on loan funds have com-pressed due to increased demand for loansand associated spread compression. Com-pared to last year, it appears that increasedregulatory pressures at banks have some-what limited dealers' ability to provide trad-ing liquidity to the secondary loan market.As a result, we occasionally experience rel-atively bigger price movements when we tryto sell loans because the dealer can nolonger assume as much temporary tradingrisk compared to a year ago. Dealers morefrequently reduce the loan bids until buyersemerge at lower levels.

Okada: The market is now a bit more corre-lated to high-yield bond and equity markets.For active managers the volatility is actuallywelcomed, because it provides for betterentry points on down days for adding risk inthe space. When the equity markets sell off,and loans are down a half or a quarter point,better entry points are provided. Having themarket go straight up consistently over longperiods of time compresses spreads in boththe primary and the secondary markets, andvolatility actually helps to curtail spread tight-ening, which provides for a more robust in-vesting environment for long-term investors.

Gundersen: Over the long term, retail and ex-change-traded fund participation in the mar-ket will certainly increase volatility. Thatsaid, the bank loan market has a base ofstable assets unlike any other asset class.With at least 50% of the demand for loanscoming from CLO structures with permanentcapital not going anywhere, you have to in-vest in loans. You don’t have the luxury ofsitting in cash on the sidelines becauseyou’ve got liabilities. That creates a level ofstability that is unlike a lot of the other assetclasses we look at. Clearly the bank loanmarket, as it matures, with increased retailparticipation, there will be more volatility.You can use the high-yield market as a proxyfor this point; it’s a more volatile market,there are different factors, but retail partici-pation will likely make it more volatile.

Smith: Continuing on that theme, howwould you compare the volatility in the loanmarket today versus the high-yield market?

Falk: I think they both have more volatilitytoday than they did seven and 10 years ago.

We feel that the high-yield market is morevolatile than the loan market today in partbecause much more of the capital is formedwith potential for short-term bias, so whenyou look at the CLO capital and the stabilityof that capital, it provides an anchor for theloan market. There’s no real comparison inthe high-yield market to that very stablebase of capital. Also, looking out over theshort to medium term, there are more thingsthat are likely to spook a high-yield investorthan there are likely to spook a loan investor.Interest rates can spook a high-yield in-vestor. High-yield has been historically cor-related to equities and whether that will bethe case going forward or not, people thatrun correlation numbers realize that whenequity starts to look risky, you begin to de-risk and de-risking means selling high-yieldbefore loans. If people feel like there’s a de-fault cycle, regardless of what is causing it,they want to trade up in structure, thattradeup means selling high-yield. So we feel,on a relative basis, that high-yield is going tobe significantly more volatile than loans.

Smith: Has the investor base been evolving?What are the big changes over the pastthree years?

Gundersen: Fifty percent of the demandcomes from CLO structures, 30% from primefunds and the rest from various othersources. I would anticipate that over time, re-tail participation increases as a percentageof the overall market. Demand in the assetclass is being driven by interest rates andwhere we are in the cycle. Investors withlong-term stable bases of capital, such aspension funds, have recognized the benefitsof an allocation to the loan asset class withina broader portfolio. I don’t think that changesover time, so I think there’s going to be ahigher participation from both retail and fromother stable bases of capital like pensionfunds, institutions, etc.

Okada: There's a material increase in insti-tutional investors across the space thatwe're very pleased to see. Pensions, endow-ments, insurance companies and large in-stitutional investors who have significantfixed income exposures are rotating intobank loans as a way to avoid negative totalreturn in a rising interest rate environment.Long-term institutional investors are enter-ing the bank loan market as a way to turn anegative outlook from their fixed incomeportfolios into a very positive total return ex-perience in bank loans. Another shift wouldbe the resurgence of the CLO engine. We seta record in March of $10 billion of new is-suance in the asset class for new transac-tions. CLOs are 10-year vehicles that will

reinvest capital over the first three to fiveyears of their existence. New CLOs are com-ing to market at record volumes. So you'readding a very large amount of long-termsticky investors into the space, and certainlywe've seen the commensurate increase inmutual fund flows.

Smith: With outstandings at about $700 bil-lion today, do you foresee the loan assetclass growing over the next two to threeyears?

Gundersen: Absent the potential impact fromregulatory changes, such as leverage lend-ing guidelines, which could lead to morebond issuance, I can see the growth in theasset class. Bank loans’ relative stability,their floating-rate nature, returns and lowcorrelation to other asset classes will makeit more and more attractive to large basesof capital over time.

McMullen: We believe that the loan assetclass will increase in size for a number of rea-sons, including the attractive attributes thatKevin mentioned. We experienced continueddemand from CLO funds, the traditionalbuyer base, as well as an increase in retailinvestor interest, which has been well docu-mented. However, institutional demand ismore difficult to track, but anecdotally, wehave experienced strong loan demand fromnon-traditional investors including: globaland regional banks, insurance companies,large corporations and pension plans. Manyof these investors require more flexible, cus-tomized investment strategies depending ontheir unique regulatory or reporting require-ments and prefer to access the asset classvia separately managed accounts. We havealso experienced demand for global dynamicstrategies that enable managers to allocateacross U.S. loans, European loans, high-yieldbonds and CLO liabilities to maximize rela-tive value opportunities. Recent growth inbusiness development corporations (BDCs)have also contributed to increased demandfor the floating-rate asset class.

Okada: One thing we try to emphasize to in-vestors is that loans have a different investorbase than high yield. There is no structuredproduct market for high yield. There's no CBO.There's no long-term buyer of high yield. Highyield’s investor base is largely mutual fundand total return investors, and that's why thatasset class has periods where it's doing verywell and periods where it's completely stalled.Comparatively, loans have had only one neg-ative year in their 21 years of recorded his-tory. A stable, long-term investor base and thesenior, secured, floating rate nature of loansresults in excellent, consistent yield. ~



REGULATORY REFORM


Smith: CLOs seem under attack by regula-tors—legacy ones by the Volcker Rule andnew ones by Risk Retention. Volcker mayforce banks to sell their $130 billion of CLOnotes by 2017. Will this be positive or nega-tive for the loan market, existing CLO note-holders and future CLOs?

McMullen: At this point, the impact seems un-clear. The CLO market had hoped that existingdeals would be grandfathered from the im-pact of the new regulations and that banks’existing holdings would not be affected. Afterthe announced Volcker rule, there is nowmore clarity, so there can be baseline expec-tations about the regulatory impact as banksevaluate existing and potential triple-A in-vestment opportunities. New investors intriple-A CLO bonds have emerged over thelast few months because they have foundthat CLOs can offer an attractive relativevalue opportunity compared to other triple-Aassets. As a result, you might see an increasein demand from these types of investors thatcould compress spreads.

Okada: Triple-A CLO loans have the widestand the most attractive spreads across theglobal capital markets. Part of that has beendriven by the regulatory uncertainty and thepotential that banks can no longer be hold-ers of CLO portfolios. The concern that bankswould be a forced seller, which would shutdown the CLO market, is unfounded. From ashort-term standpoint, it could be disruptive,but from a long-term standpoint, having es-tablished regulatory guidelines around CLOswould allow other entities to enter into themarket, and we would see the triple-A CLOprice actually tighten, which would encouragelong-term CLO formation.

Falk: There is also the human capital compo-nent to this equation. Banks that have in-vested in CLOs don’t have massive teams.They will have to take time to figure out whatto do with the assets within their portfolios.This will naturally slow down their desire toenter into other deals, which will likely reduceactivity for a while. Also, selling the notes isn’t

the only way to solve the issue. Some ofthese legacy deals may be called before thetwo-year extension period is over, and somecould be restructured, either into those thatcan incorporate bonds or into those thatdon’t, and those baskets are taken out. It’snot going to be a one-size-fits-all, and therewill be a lot of work to do that does not gen-erate incremental revenue for these firms.But a slowdown in CLO new issue could actu-ally be a good thing, and may even give themarket more pricing power.

Smith: Rules for Risk Retention should comeout this summer and will take effect twoyears later. If there is no change in the 5%retention of notional hold requirement, isthere an opportunity for the market?

Gundersen: Some CLO managers are goingto have a hard time in the new regime.They’ll be more apt to aggregate assets inthe near term, so there will be some pull for-ward and some higher activity right up untilthat rule takes effect. In the long term, onlythe larger asset managers with strong bal-ance sheets will be able to comply with the5% retention. They’ll be able to continue toexecute on CLOs and take advantage of theopportunity. Some of the smaller CLO is-suers, without strong balance sheets, aregoing to have a much harder time.

McMullen: Smaller CLO managers may findthe regulations challenging, and larger CLOmanagers may be less impacted from thenew risk retention rules. Larger CLO man-agers will benefit from larger balance sheetsas well as increased access to other poten-tial funding sources. To the extent that risk re-tention causes a decline in CLO creation, youmight see lower funding costs in CLO liabili-ties because of a scarcity of those bonds. Re-duced CLO creation could also result in widerspreads and more investor-friendly terms andstructures in the underlying loans them-selves, which would benefit all loan investors.

Okada: The effect will be negative because itwill reduce the number of managers that are

capable of issuing CLOs due to the capital re-quirements, and it certainly favors large man-agers over small ones. What’s interesting isthat CLOs have a fairly defined cost of capitalgiven that they borrow money in the capitalmarkets at a fixed spread basis, but today'sCLO debt cost is about LIBOR plus 210 basispoints. Any negative affect on the CLO mar-ket from a risk-retention standpoint wouldmean a lower supply of CLO securities, whichcould lead to spread compression acrossCLOs’ cost of capital, which would be a netpositive for equity investors in the asset class.Turning to CLO equity investors, the focus ison spread arbitrage. They're going to deter-mine whether the deal makes sense from themodeled equity return over the life of the dealas opposed to whether some regulatory re-quirement says that they can sell their equitydown the road.

Falk: Regulated financial institutions will feelthe impact of regulations. The beneficiary willlikely be investors, whether they’re currentlyin loans or high yield. That can be true if themanager is participating in a bridge or sta-ple financing in a particular transaction, asbanks will no longer be able to hold certaintypes of notes that have tight spreads, or be-cause banks aren’t allowed to hold as manyof the loans as before. Ultimately, it’s going toprovide opportunity. There’s still the need forthe underlying product, as the borrowerwants to have a loan in the capital structureand the borrower is willing to pay for that.Most borrowers today who are borrowing atLIBOR plus 300 believe that LIBOR plus 400was good a year ago, and markets find equi-librium over time. If I were an investor think-ing about the asset class, the thing thatwould concern me would be regulatoryscrutiny outside of regulated financial insti-tutions or restrictions that would disrupt howthe asset class works. So, I would considerregulations on what an asset manager canbuy, what a mutual fund can buy, interrup-tions of settlement—things that motivateborrowers to go to high-yield bonds as op-posed to bank loans—but none of those areon the table. ~

& THE LOAN MARKET


www.highlandcapital.com

A global pioneer in alternative investments since 1993.

Experienced. Disciplined. Bold.


The Search forSmith: How do you go about recommendingan allocation to bank loans within a creditportfolio? Is there a magic number, and whatdo you advise for a traditional pension fund?

McMullen: Each investor is unique and theirallocation to bank loans will reflect their dif-ferent return requirements, liability structuresand regulatory parameters. For example,banks and insurance companies can be veryfocused on credit quality and regulatory cap-ital cost constraints. Pension plans have agreater focus on their current and future lia-bilities, which influences their return hurdles.We are working with pensions plans that areincreasing their allocations of loans and re-ducing that of investment-grade bonds be-cause of better risk-adjusted returns andloans’ floating-rate benefits. Many pensionsare also concerned about their high-yield ex-posure, given record low absolute yields andthe inherent duration risks. At this point inthe interest-rate cycle, and given the flatshape of credit and capital structure curves,pension plans should consider allocating be-tween 5% to 10% of their portfolio to loans toreduce their portfolio’s duration and maxi-mize risk-adjusted yields.

Falk: I wouldn’t have different advice for pen-sion funds. Some other types of investors areinfluenced by regulations, such as insurancecompanies or financial institutions. We workwith them to help optimize the strategy giventheir guidelines. When their guidelines maynaturally force them to go long on the inter-est-rate curve to stay in investment grade, werecommend moving into something wherethey can shorten the duration and still havean attractive return on capital. Going up to10%, 20% or even 25% can be somethingthat makes sense for them.

Okada: For many pension funds, the equity re-flation has been a joyless reality. The Fed’squantitative easing was meant to push institu-tional investors out of fixed income exposures

and into risk assets as a way to help the econ-omy grow. Public pension and endowment in-vestors, in general, have been hesitant togrow their equity exposure. Bank loans allowan institutional investor to take on some risk,but in a measured way. Within a pension fundallocation, bank loans are a hybrid of equityand debt that have the benefit of being cor-related with a positive economy, but not hav-ing the negative impact that the rate cycle willhave going forward. Historically, loans haveunderperformed fixed income instrumentsthat have the benefit of quantitative easingand falling interest rates. Given that interestrates will rise fairly dramatically at somepoint, and that loans will provide a defensiveallocation, we recommend a growing expo-sure to bank loans versus a fixed percentage.

Smith: There are a number of loan subcate-gories in the market: broadly syndicated, Eu-ropean corporates and the middle market.Where is the opportunity?

Gundersen: There were a lot of opportunitiesto put money to work as the U.S. came out ofthe recession. There is a lot of value in the Eu-ropean market right now. The inflection pointwas about 18 months ago. The European mar-ket is smaller and more of a middle market-focused bank loan market. Nonetheless, asthe structural protections, cov-lite and docu-mentation gradually deteriorated in the U.S.,those protections still exist in Europe. Lever-age levels on the whole are lower and health-ier, so while the secured leverage level in thecapital structure might be similar, you don’thave another tranche of that sitting behindyou. Plus, you can pick up yield—somewherebetween 50 and 100 basis points. We alsocontinue to find interesting opportunities inthe U.S. middle market, where better accessto information enables us to make better-in-formed decisions. Management teams andprivate-equity sponsors are accessible, whichlets us differentiate between good and badcredits.



YIELD


continued on page 14

McMullen: Global dynamic strategies thatallow managers to allocate across multipleasset categories including broadly syndicatedU.S. and European first- and second-lienloans, high-yield bonds, structured productsand originated loans currently offer the bestvalue. European loans are particularly at-tractive, with syndicated loan spreads 25 to50 basis points wider than U.S. spreads forsimilar or less risk. We believe this is due toless technical demand from European banks,CLOs and retail funds. Direct originatedloans, particularly in Europe, can providemanagers the ability to capture additionalstructuring fees and more attractive termsthan syndicated deals.

Falk: On a fundamental, asset-by-assetbasis, there are attractive opportunities in theEuropean syndicated market, and there isreal value there. While you can look at gen-eral levels of the market, it’s very much aboutthe specifics of a company, and there is moreopportunity in Europe today than in the U.S.When a company misses earnings, we’veseen loans drop 10 points over the course ofa couple days. If you know the credit and be-lieve in it, it actually creates a great opportu-nity, but it’s a horrible experience if you’reinvested and didn’t have your arms around it.Fundamentals really need to be the driver. Onthe middle-market side, we see privately ne-gotiated middle-market deals in both the U.S.and Europe as very attractive transactions ifyou can find a credit that you like. There areseveral hundred basis points of incrementalpremium that can be achieved, almost simi-lar to the dynamic for mezzanine versus highyield.

Smith: Second liens seem to be making aresurgence from last year. Do you thinkthere’s good value there?

Okada: Second liens have come at very at-tractive spreads, but they are a very smallportion of the calendar. We think of second

liens as an alternative to high-yield bonds, butthey are much more attractive than high-yieldbonds. They are secured on a second-lienbasis and floating rate.

Gundersen: Second liens are picking up yield,but you’re taking on more risk to be in thatpart of the capital structure, so it’s going tobe more volatile, and there isn’t any upside.You’re clipping a coupon. You need to becareful about when and where you’re playing,and we prefer to give up yield to be higher upin the capital structure. With that said, it re-ally does come down to the fundamentals ofthe underlying issuer.

Falk: This part of the cycle is not materiallydifferent than any other part of the cycle, sowhen we consider first lien versus secondlien and where we are in the capital struc-ture, we always think about the fundamen-tals of the business first. We aim to reallyresearch through KKR’s broad reach andunderstand each business, so that we knowthe risks and are confident that we’ll be ableto monitor the business and anticipate whatis coming. That can lead to opportunitiesacross the board, but in general, we feel youcreate alpha from not being in the main-stream, run-of-the-mill double-B, senior-se-cured credit. It may be a second lien whereyou can create that opportunity, but it hasto be driven from understanding the funda-mentals of the business. We assess therange of outcomes that we can quantify withsome level of conviction, track our liquidityposition and make sure we get paid fairly forthe components. There are some second-lien deals today that come out at 575 over,and some at even 1,300 over. Some mayhave value, others may not, and the chal-lenge—and the fun—in all of this business isfinding those that you think really do havevalue.

Smith: Could you compare and contrastloans vs. high-yield and the broader fixed in-

come market in terms of price, yield, riskand volatility?

McMullen: We constantly compare the rela-tive value of loans to high-yield bonds in boththe U.S. and Europe—and to other assetclasses for investors in our global strategies.At the end of March, the U.S. Credit SuisseLeveraged Loan Index spread was about 473basis points, and that’s still wide—about 20basis points wide of its historical average of454 basis points since 1992, so loans arestill cheap to their historical average. High-yield spreads were at 409 basis points—in-side of the 473 basis points for loans—as wellas the high-yield historical average of 584basis points since 1992. So, high-yieldspreads are tighter than their historical aver-ages, tighter than loan spreads, junior toloans in the capital structure, generally un-secured and—importantly—they are fixed andtherefore carry duration risk. For those rea-sons, loans are much more attractive, andthere’s a similar analysis to be made for in-vestment-grade bonds. The Barclays U.S. Cor-porate Investment Grade Index is close to 3%now, and the spread is inside 110 basispoints, so the duration of six to seven-plusyears doesn’t compensate investors for therisk of rising rates in investment grade either.

Gundersen: One point to add: It’s construc-tive to compare bank loan and high-yieldspreads versus their average yields excludingthe recession. The bank loan ex-recession av-erage is around 356 basis points, whichmakes today’s average look relatively attrac-tive. We’re well under the ex-recession high-yield average of around 540 basis points.

Okada: Everyone talks about interest-rate riskin here, and so the focus is on duration. Ahigh-yield bond may have a five-year duration,a loan has a three-month duration, and thatbecomes the whole focus. Credit duration,which is a measure of price sensitivity to acredit event, is more important. Today, the




nominal yield of a high-yield bond vs. a loanis about the same. In a credit event, the loanor the bond is going to have to reprice to ayield that would pay the incremental investorfor the increased credit risk. And here'swhere the concept of credit duration kicks in,and creates a very different reality for high-yield bonds and loans. Unfortunately, be-cause the coupons are about the same, theprice action in the bond is going to be muchmore dramatic on the negative movementversus the loan. The loan may be down 10points in that environment, and the bondmight be down 30 or 35 points. Because oflow nominal coupons, high-yield today has ahigh credit duration versus loans. Given thefact that we’re later in the credit cycle, thefocus shouldn't be on interest-rate risk pri-marily, it should be on credit duration andcredit risk when comparing and contrastinghigh-yield bonds and loans.

Falk: Another good exercise is to loss-adjustthe numbers. The loan market seems to havea default rate of less than 1%—aside from afew large identifiable credits. With a recoveryrate of 68 to 70 cents, you’re talking about30 to 32 basis points of reduction. Going withthe same default assumption of 1% in thehigh-yield market, recovery is in the 35%range, so you’re going to have to take off 65to 70 basis points. So there is more relativevalue in loans.

Smith: Why should investors be consideringallocations in the loan market today? Whatare the risks and the rewards?

Gundersen: We’re positive on the economy.Default rates will stay low. Historically, peri-ods of low default rates typically follow peri-ods of low short-term rates. Companies areable to push out maturities, and there arefew maturities in the near term. They areable to borrow money at low cost, and cov-erage ratios are healthy. There’s nothing onthe horizon that we see to derail that envi-ronment. With floating rates, you’re clearlyprotected from a rising rate environment. Wealso acknowledge where we are in the re-covery. We’ve come a long way, but it’s pru-dent to be a little defensive and perhapsmove higher up the capital structure. Thereis some degradation in the marketplace—notevery deal is alike, and you really need topick your spots and be thoughtful. So giventhe environment today as a whole, bankloans sit pretty well in the equation.

Okada: Rotating out of high-yield bond expo-sure into bank loans is something that werecommend today. This would provide a de-fensive return at this point in the credit cycle.However, investors need to be prepared formore correlation and volatility. The punchline is that selecting the type of manager to

execute exposure into the asset class is ameaningful decision at this stage in thecycle. We would propose that active, total re-turn managers are probably better suited todeal with the volatility than buy-and-holdloan managers.

McMullen: History demonstrates that long-term loan investors have been rewarded forinvesting during periods of technical weak-ness. In recent client meetings, we have sug-gested that investors prepare for increasedvolatility and consider adding loan exposureshould loan prices decline. We are starting tosee some softness in the secondary marketas a result of outflows from retail mutualfunds for the first time after an impressive95 weeks of consecutive inflows. The out-flows are largely technical in nature, as theyare not a result of declining fundamental bor-rower credit conditions. This is actually a pos-itive for loan investors as we are seeing areduction in spread compression caused byrepricing activity, and there has been someinvestor pushback against a number of newprimary transactions in favor of more lender-friendly pricing and terms. This is healthy forthe loan market in general, and we recom-mend to our clients that now is a particularlyattractive time to selectively buy loans at at-tractive prices.

Smith: What would you say in conclusion?

Falk: We’re getting to the point where peopleforget about what happened in the financialcrisis. Both the loan and the CLO markets aregood data points. The loan market sold offfrom a mark-to-market perspective substan-tially, with 30 points of price declines. One-year defaults rose to high-single, low-doubledigits in the loan space, peaking in late2009. CLOs also had their perceived difficul-ties with mark-to-market. Rolling the clockforward, equity returns in CLOs were actuallypretty good across deals—in the double digitsfor the most part, and sometimes 20-pluspercent. All CLO creditors have recoveredtheir capital and have received the couponthey were expecting to get. So, the contractwas met through one of the worst criseswe’ve seen. In the loan market, there weresome defaults, but a buyer in the marketfrom 2007, staying all the way through, wouldhave achieved a very attractive total return.We can conclude that loans are a very stableasset class, and one that can weather differ-ent scenarios. We expect that we will be ableto weather the interest-rate volatility scenar-ios that are likely to come, and loans shouldbe a core part of investors’ portfolios goingforward.

Gundersen: A lot of people think about howfar we’ve come in the recovery, and theyworry if we are back to 2007. Are leverage lev-

els and structures back to where we were in2007? So we think a lot about the marketwe’re in today and try to compare that to2007. We discussed supply-demand dy-namics. On the supply side, you had anenormous amount of inventory largelybased on leveraged buyout activity—some-thing like $650 billion in 2006 and 2007. Abig portion was financed with bank loans,and a big portion of that needed to come tomarket. You also had an enormous amountof mark-to-market leverage in the system.The combination of those two factorscaused a large technical sell-off. Today, thedeal fundamentals in general are muchhealthier. Not every deal is the same, andthere is going to be the poster child thatpeople point to and say, “Oh, we’re back to2007.” But on the whole, the market ismuch more rational. In addition, therearen’t the same technical factors that couldcause a large sell-off. We just don’t have thesame underlying characteristics as in 2007.

McMullen: We have suggested to our clientsthat now is a time for caution, given recentaccommodative central bank polices thathave successfully resulted in an artificially lowinterest-rate environment, lower yields forriskier credit assets and higher valuations inequity markets. We continue to find the loanasset class attractive relative to historicalspreads and other asset classes. Direct orig-ination loan strategies, particularly in Europe,represent attractive risk and return opportu-nities for a number of reasons. We also rec-ommend that clients consider flexiblemandates that allow managers to allocate dy-namically and selectively to first- and second-lien loans, high-yield bonds and structuredproducts across multiple geographies andcurrencies. Such strategies enable managersto create alpha by maximizing relative valueopportunities through different environmentswith a more diversified portfolio that can pro-duce higher, more stable returns. However,markets can move quickly, so you have tohave the people and resources in place toperform the required detailed fundamentalcredit analysis and effectively allocate portfo-lios across those different geographies andasset categories.

Okada: Over the long term, the time whenbank loans actually add the most value toportfolios is when short-term rates are ris-ing, and we haven't gotten to that period inthis cycle yet. So when investors ask if theyare late to the party, I tell them they're ac-tually early. Loans will, on a Sharpe ratio,add the most value to portfolios in periodslike 1994, when rates are rising across therate curve. We're not going to see that untilsometime in 2015. The best relative valuethat loans will provide in asset allocation areahead of us, as opposed to behind us. ~


KKR is a leading global investment firm that manages investments across multiple asset classes including private equity, energy, infrastructure, real estate, credit, and hedge funds. KKR aims to generate attractive investment returns by following a patient and disciplined investment approach, employing world-class people, and driving growth and value creation at the asset level.

KKR’s Credit business was launched in 2004 and invests on behalf of its managed funds, clients, and accounts across the corporate credit spectrum, including secured credit, bank loans and high yield securities, and alternative assets such as long/short credit, senior secured lending, mezzanine financing, special situations investing, and structured finance.

With more than 80 investment professionals, KKR’s credit investment teams are closely aligned with KKR’s wealth of private equity investment and industry resources.

To learn more, visit www.kkr.com.

THE POWER OF PARTNERSHIP


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