A Post-Crisis Look at Bank Loans

A Post-Crisis Look at Bank Loans: Got Yield?

Modest improvements in the economy have sparked a renewed interest in the bank loan market, both from well-established institutional participants and new entrants such as individual investors and cross-over funds seeking high-quality spread with minimal interest rate risk, say PIMCO portfolio manager Eve Tournier and product manager Michael Brownell. In this Q&A, they explore these changing market dynamics and examine opportunities that have sprouted for investors.

Q: What does the bank loan market consist of, and what does the landscape look like today?Tournier: The bank loan market consists of loans made to businesses with credit ratings that are generally below investment grade. Bank loans are floating rate instruments tied to LIBOR or another base rate. They are usually secured by the assets of the company and ranked first in priority of payment in the capital structure ahead of unsecured bonds. The market is about $515 billion according to S&P LCD, which is about 35% of the total speculative grade market, so it is a substantial market. But the market has shrunk in the past two years because of repayments and lower new issue volume. On the other hand, over $12 billion in retail assets have flowed into bank loan mutual funds so far this year, which is roughly on par with flows into high yield bonds. The combination of improving fundaments across the corporate landscape and strong technicals, led by modest supply and high levels of investor demand, can make for a potentially attractive investment opportunity, especially in a very low interest rate level environment.

Q: Was it the 2008 financial crisis that precipitated the dip in new issuance?Tournier: Precisely. Collateralized loan obligations (CLOs) used to represent more than 70% of the new issue demand in the bank loan market. Today, with limited new CLO creation in the market and the conclusion of older CLO reinvestment periods, CLOs now make up just 40% of total new loan issue demand. Companies reacted to the decline in CLOs by finding other means of financing besides bank loans, such as within the high yield bond market where new issuance has been very active over the last 18 months. CLOs are only now beginning to re-emerge, with the senior part of the capital structure being successfully syndicated. But the issuing manager still has to retain a portion of the equity tranche and, in some cases, some of the mezzanine tranche as well. Nevertheless, the mere surfacing of activity in this space is a positive development for future bank loan demand. Prior to the 2008 crisis, pension plans, insurance companies and other institutional investors sought exposure to the bank loan market through CLOs because they offered a way to achieve levered returns. Today, growing participation in the bank loan market has been dominated by unlevered institutional investors, relative value investors, such as hedge funds, high yield funds and distressed investors, and individual investors who are looking outside of traditional fixed rate securities as a way to capture spread with minimal interest rate risk.

Q: Can you tell us more about PIMCO's outlook (both cyclical and secular) for this asset class? Tournier: In PIMCO's bumpy journey to the New Normal, interest rates in slow-growing developed countries will remain low for an extended period. In this environment of high uncertainty, we want to position for high-quality spread. The bank loan market is attractive because it is secured and it captures the top part of the capital structure, which has an average historical recovery rate of about 70 cents on the dollar according to Moody's Investors Services. Although recoveries slipped to as low as 45%-50% at the height of the credit crunch in 2008 and early 2009, they have experienced material improvement in the last 18 months and stand today just north of their long-term average of 70%. So on a loss-adjusted basis, we believe loans offer a high-quality spread for the right credits.

In addition, as I mentioned earlier, bank loans offer the potential advantage of no or very minimal interest rate risk. We know that, despite our outlook of low interest rates for an extended period of time, a number of investors are concerned about the possibility of rising interest rates. The bank loan market can provide an attractive hedge for this scenario. In addition, a number of loans have LIBOR floors. A typical new loan issue today includes a LIBOR floor of 1.5%-2.0% plus 350-450 basis points of spread premium. Therefore, we can essentially invest in a 5.0% to 6.5% minimum coupon with more upside if interest rates widen beyond the LIBOR floor. In addition, many new issues come with a call protection, which limits the issuer from calling back the security for at least one year should yields continue to decline.

Q: More specifically, how does PIMCO approach bank loan investing?Tournier: First, we have a high-quality bias and a strong track record of minimizing defaults. Our credit analysts conduct thorough and independent research on every company to build defensive portfolios. We look for stable industries that could fare well in the New Normal and have attractive secular growth characteristics. We favor, for example, industries benefiting from positive demographic trends or high exposure to emerging markets. We look at the company's competitive positioning within that industry, the track record of its management team and the company's financial policy "“ are they focused on increasing shareholder returns (a potential negative) or on decreasing financial leverage (a positive)? We then study the company's balance sheet and cash flows, both historically and on a forward-looking basis. And finally we review the specific security's covenants "“ the contractual restrictions that dictate how borrowers can operate and carry themselves financially "“ its position within the capital structure and asset coverage. Having thoroughly reviewed the fundamentals we also consider the relative value of that security versus other securities from the same issuer, competitors in the same industry, similarly rated credits, and other asset classes.

Right now, when we apply these criteria to new bank loan issues we find many attractive opportunities. We also look at the secondary market, where seasoned issuers have survived the financial crisis, resulting in more conservative balance sheets. Although these seasoned loans tend to have lower coupons, they generally trade at a discount to par. We are seeing rapid refinancing ahead of the 2013 and 2014 wall of maturities and anticipate repayment of those discounted secondary loans before their stated maturity date, providing the potential for extra returns.

Q: Why do institutions use asset management firms? Can't they access bank loans on their own?Brownell: Running a bank loan portfolio is operationally intense, due to the burdens associated with documentation, settlement and legal issues. For example, loan documents need to be updated whenever ownership changes. A lot of progress has been made in this area, but it remains a demanding business that requires extensive infrastructure. So, that's why investors generally tend to go through an asset manager like PIMCO, which has the capability to handle the legal and operational complications and free up portfolio managers and analysts to concentrate on the asset class. Having managed bank loans since 1996 PIMCO has vast experience investing in the asset class, and over this time we have developed the necessary infrastructure across our global platform.

Q: Does PIMCO provide other potential advantages in the bank loan market?Brownell: Absolutely. PIMCO has a significant presence in the capital markets and has strong relationships with both the broker/dealer community that underwrite leveraged loans and with the companies that are issuing bank loans. As a result of our considerable presence in the capital markets and strong relationships with broker dealers, we are often able to get attractive allocations to new issues and in some instances are able to negotiate pricing and covenants associated with bank loans.

Furthermore, we have bank loan portfolio managers located in the U.S. and Europe as well as a staff of 37 credit analysts who span the globe and are able tap into local markets. Our credit analysts, who are organized by region and industry, are charged with covering the full capital structure of each of the companies within their respective industries, which allows us to better evaluate relative value from the top to the bottom of the capital structure. Our credit analysts, who we consider to be industry experts, are focused on bottom-up, fundamental credit research and place a strong emphasis on limiting downside risks.

Q: We've talked a lot about opportunities. What are some of the risks you are monitoring?Tournier: Although recent bank debt issues provide some call protection, most existing bank loans are freely callable at par, so improving credits will refinance at limited cost or flex terms down "“ a transaction through which the issuer is able to lower the loan's coupon, and potentially change other terms, with the consent of lenders instead of refinancing the loan. We are very sensitive to this issue and systematically price the call option and incorporate it in our relative value analysis. Another more fundamental risk is the potential for a double dip in the economy, which could create a distressed environment and result in a drop in recovery rates. But if we muddle through the next few years with slow economic growth, as we expect, the weaker companies could avoid restructuring and might have an opportunity to gradually improve their operations. Also the liquidity provided by the Fed should continue to support financial markets and allow weaker companies to refinance themselves either in the equity or the debt markets.

Q: Finally, can you summarize the main reasons investors are attracted to bank loans?Brownell: There are a number of reasons why bank loans are an attractive asset class, both from a strategic and tactical perspective. First, the bank loan market has historically provided a competitive yield, while offering investors the security of investing at the higher end of the capital structure. As a result, bank loans have historically had lower defaults and significantly higher recoveries than similarly rated corporate bonds, according to data from Moody's Investor Services. Furthermore, bank loans generally offer better covenants than most bonds. In addition, bank loans have a low correlation to most other asset classes, especially to Treasuries where the correlation is negative, offering investors a hedge to rising interest rates. The bank loan market also provides access to some issuers who do not participate in the bond market, providing investors with yet another tool for diversification.

In today's market environment, there are also a number of reasons that bank loans are tactically attractive. Given today's low rate environment, in the long-run interest rates have almost nowhere to go but up. While bank loans tend to thrive in a rising rate environment, the last period of rising rates beginning in 2004 showed us that loans benefited long before rates actually increased. Bank loans have historically benefited, by way of stronger returns, when the Federal Reserve initiates a withdrawal of monetary stimulus, even before actually hiking interest rates. While we are not there yet from a Fed policy perspective, bank loans have been the recipient of strong inflows this year. Furthermore, with defaults falling materially month over month according to Moody's Investor Services, and given PIMCO's expectations for low defaults over the next year, bank loans should remain an attractive investment over the foreseeable future.

Thank you, Eve and Michael.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Bank loans are often less liquid than other types of debt instruments. Some debt instruments may include senior and subordinated and secured and unsecured debt obligations (including investments in the senior, subordinate, hybrid debt instruments, and Collateralized Debt Obligations or CDOs and Collateralized Loan Obligations or CLOs). General market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower's obligation, or that such collateral could be liquidated.

LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans.

The views and strategies described may not be suitable for all investors. This material is not intended to provide, and should not be relied on for, accounting, investment, legal or tax advice. You should consult your accountant, investment, tax or legal advisor regarding such matters. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.  No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.

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