misconceptions in the bank loan securitization market

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misconceptions in the bank loan securitization market Powered By Docstoc
Craig Sullivan, Taxable Fixed Income Analyst

With interest rates on the 10 year Treasury and other fixed income assets hovering near all-time
lows, investors are looking for ways to protect their portfolios from rising interest rates. For
many investors rising interest rates are a concern which they have never faced, since the overall
interest rate trend has been downward over the past 30 years, therefore greatly rewarding bond
investors. In preparation for rising interest rates and, to hedge against higher inflation, many
financial advisors and investors have moved into bank loan funds (also known as floating rate
loans, leveraged loans, high-yield loans or simply loan funds). However, a lot of investors don’t
truly understand how bank loans actually work. This lack of understanding could cause investors
to be disappointed by the returns they receive from these investments when interest rates

What are Bank Loans?
Bank loans are senior secured, floating- rate loans made to businesses which have below
investment grade credit ratings. The loan usually has a stated maturity range of five to nine years
however most loans can be paid off or refinanced at any time, usually without any sort of
prepayment penalty to the borrower. Due to the limited call protection, many sell-side models
build in an assumed four-year refinancing “maturity” for most leveraged loan valuations. Bank
loans are typically collateralized by accounts receivable, inventory, PP&E (property, plant and
equipment), or stock and are used to finance mergers and acquisitions, leveraged buyouts,
recapitalizations and other general corporate finance needs. The loans are packaged together and
sold to institutional investors.

How Bank Loans are Priced:
The coupon rate on a bank loan is the sum of two components – the reference rate and the quoted
margin or spread. The reference rate provides the floating rate component to the loan by resetting
periodically according to a ‘reference rate’. The most common reference rate is three month
Libor which resets every 90 days and thus provides the coupon on the loan a floating interest rate
as Libor changes. It is this change in coupon rate, as the reference rate (e.g. Libor) changes,
which gives the loan a low duration. However, this does not necessarily translate into protection
against interest rate increases which are not linked to the reference rate (i.e.Libor).

The second component of the coupon rate is fixed at issuance and is made up of the ‘quoted
margin’ which is the spread, typically expressed in basis points (bps), paid to the investor to
reflect the credit and liquidity risk of the loan and the issuer.

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Common Misconceptions:
The quarterly reset ‘floating’ reference rate component of loans is viewed by many investors as
providing protection against higher rates and inflation. However, the protection benefits of loans
against interest rate increases and higher inflation will depend on how the underlying curve
moves. Since bank loans typically have maturities between five and nine years they are priced
off that portion of the curve, however, the floating interest rate component is priced off Libor.
With the Fed’s forward guidance of low short term rates for an extended period of time, it is very
likely that the Treasury curve will get steeper in the 2-10 year part of the curve. If the curve
steepens significantly, a bank loan could begin to act and trade like a bond with a similar
maturity. The floating rate component of the loan will continue to be priced off Libor which
might not have moved. During the rapid increase in interest rates in May and June the 5 year and
10 year Treasury increase 100bp and 110bp respectively while 6 month Libor actually decreased
2bp. The price of the loan will trade off the increases in the 5 – 10 year part of the curve but the
yield of the loan fund will not have increased.

Normalized chart of the ten year Treasury versus three month Libor 05/01/13-10/17/13. As
interest rates have moved higher since May the Libor rate has actually decreased. Source:
US Treasury curve one year ago versus today. While long term rates have moved higher,
short term rates have actually decreased. Source: Bloomberg

An additional factor in today’s loan market is the Libor floor. Currently, Libor is very low and
has been since the 2008 financial crisis when the Federal Reserve cut interest rates to record low
levels. As a result, banks have structured most loans issued since that time with Libor “floors”.
As the name implies, a Libor floor ensures that investors in loans receive some minimum base
level of compensation in addition to the credit spread the loan pays. Today, about 70% of bank
loans have LIBOR floors with the most common floor level being around 150bps. While the
floor provides a higher base level, it also means that the yield on a bank loan fund will not
increase until Libor has increase through that floor level. 3 month Libor today is 26bp and Libor
would therefore have to increase 125bp before the yield on loans would increase assuming the
credit spread component of the loan didn’t tighten. As a point of reference, three month Libor
has not been above 1.5% since December 2008 and the forward yield curve current suggests
Libor will not increase above 1.5% until sometime in 2016. While there is no certainty in this,
we do know that the Fed has been very successful in controlling short-term interest rates. In
addition, Bernanke’s likely successor, Janet Yellen, has generally erred on the side of preferring
more accommodation. It’s likely, given Yellen’s economic philosophy, she will lean towards
keeping rates low for longer than necessary, meaning that the economy might be approaching the
point of overheating by the time the Fed decides to increase short term rates. If this is the case,
then credit spreads will have likely tightened farther and the loans will have been called away at
par without ever having broken through the Libor floors. Loans will not trade above par because
this would mean that the company could, and most likely will, refinance their debt at a lower
rate. In this scenario, the loan investor will not see any benefit from the floating rate component
of the loan.

Historical five year chart of the three month Libor rate. Source: Bloomberg.

The second major component in the pricing of loans is the required credit spread. A bank loan is
simply a loan made to a below investment grade company for five to nine years in which the
credit spread remains the same for the entirety of the loan. If the company does well and its
financial condition improves then the CFO will refinance the loan to a new loan with a smaller
spread over Libor, lowering the company’s interest costs. For example, if the original 8 year loan
was based on a 3month Libor, with a 150bps Libor floor, plus a 350bps quoted margin the total
yield on that loan today would be 5%. If the company’s credit fundamentals improve the
company might be able to finance a new loan with a 150bps Libor floor plus 300bps spread over
Libor for a total yield of 4.50%. Since loans have very little if any call protection the CFO will
call the original loan and refinance. The company will continue that process until they can no
longer refinance their debt at a lower rate. This phenomenon is very similar to a US residential
mortgage and gives loans a negative convexity profile.

However, if the economy or company performs poorly or worse than expected, the credit spread
investors will require to make a loan to that company will increase. Suppose the real interest rate
for that company or industry in one year’s time is 650bp. This means that the yield on a new
issued loan to this company would require that the lender gets a yield of 8% (150bps Libor floor
+ 650bps credit spread; 8% is the average yield for loans since January 2007). The value of the
original 5% loan, which now has 7 years to maturity, will trade with a modified duration of about
5.65 and the price of the loan will decrease to a value around $80. At maturity in 7 years time it’s
likely that the investor will still receive $100 (par value), however, if they need to sell the loan
for any reason prior they may need to accept less than par. The CFO will never refinance the
original loan in this case because the new loan would have a higher interest rate.

Liquidity is an aspect of the loan market which is often overlooked. Loans are not as liquid as
Treasuries or investment grade corporate bonds, yet loans have seen the most inflows this year.
Through the first week in October, loan funds reported inflows of $54.8 billion year to date –
more than three times greater than the previous annual record of $17.9 billion in 2010. The assets
under management in the retail portion of the loan market have grown by more than 80% in 2013
and the asset class has not had a single weekly outflow since June 2012.These record inflows
into an ill understood, more illiquid, asset class present a danger to the value of loans if investors
begin to reverse course and withdraw assets. What could cause large outflows? Some of the
common misconceptions discussed in this paper, such as, investors realizing that short term rates
are not increasing in the near future and all the interest rate volatility is in the 5 year part of the
curve and longer, therefore their interest rate and inflation views aren’t being recognized in bank
loan funds.

In todays market environment it is tough to find bank loans appealing. In a growing economy
with rising interest rates, bank loans will perform better than most traditional core fixed income
assets. However, the risk profile of loans is most similar to high yield as opposed to traditional
core fixed income products, and in general should not be used as a core fixed income substitute.
When comparing bank loans against high yield, it is likely that high yield will outperform. While
the price movements of loans and high yield are quite similar, loans today have lower yields - in
many cases the advantageous carry of high yield over loans from the same issuer can be 300-
400bps – and loans offer no call protection. Loans will also face more liquidity pressure if they
begin to sell off as it’s a smaller market than the high yield market place. Through the first week
in October, the high yield index returns are outperforming the loan index by 140bp year to date.
This is a trend we believe will continue as loan performance will likely be unable to keep pace in
a growing economy with high yield due to loans’ lower carry and lack of call protection.

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