"A View from the Buyside"

Last week, the LSTA hosted its 16th Annual Conference. The LSTA does a fantastic job at these conferences, and in fact puts up every slide deck from the various presentations on their website. You can see them all here: LSTA's Annual Conference Slide Deck

One panel in particular I enjoyed and took detailed notes on was entitled: "A View from the Buyside." They have a similar panel every year and it gives an interesting and detailed look at some of the current trends in the leveraged loan market. The lineup of panelists, as usual, was a really great group of buyside practitioners that offered an inside look on what's going on in the market today.

The panelists included (with associated abbreviations for the notes below):

  • Beth McLean (BM) – Executive Vice President and bank loan portfolio manager at PIMCO

  • Leland Hart (LH) – Managing Director and Head of the Bank Loan Team at BlackRock

  • Greg Stover (GS) – Partner and Head of Fixed Income at Stone Tower

  • Dan Norman (DN) – Senior Vice President and Group Head of the ING Investment Management Senior Loan Group

Note: I've organized the below into a question / answer format, with the associated responder notes by the above abbreviations.

Question: What is the outlook and current situation in regards to retail funds flow (LH):

  • Relatively optimistic on flows, though earlier in the year when it became clear that rates wouldn't move up in any way you lost a lot of lows.
  • The amount of liquidity being provided by the dealer community is tremendously low so moves were fast to the downside.
  • Going forward as vol goes down, what's paying a lot in fixed income is high yield and loans and we will see flows coming back into the space

Question: We have seen a number ETFs focused on the bank loan / floating rate space. What is your outlook for these sorts of products (DN):

  • These ETFs are essentially income products that benefit towards the overall move of the global investment community towards income orientation
  • Typically these products come to market 6-12 months after positive total returns. Four closed end funds in first half of 2011 where very opportunistic at that time.
  • Year to date, 19 fund filings for additional CEF, ETF into the asset class. - but all were before the July / August volatility
  • A product like this will thrive when there is very little volatility in returns. Loans don't have the returns to weather another 4th quarter of 2008.
  • Fed Policy has not done any favors. Retail, who this product is really marketed to, doesn't understand LIBOR floors.

Question: What is the current situation in terms of capital raising on the institutional side (BC):

  • A saying at Pimco is “Practice safe spread.”
  • If you are looking for a sleeve of fixed income with strong fundamentals, maturity schedule pushed out, low default rates, recovery rates higher, seems like a good time to invest in asset place.
  • New issue premiums are attractive now to total return investors.

Question: Can you discuss the product innovation from sell side (GS):

  • This is really an evolution more than revolution. In other words, you have to ask yourself in the product better bought or better sold?
  • Amend-extend attractive to CLO b/c if vehicle is entering non reinvestment period can still extend duration of portfolio.
  • For example, the recent Kinectic Concept loan: Lead arranger Bofa went to a large audience (largest LBO since sell off), and one thing they did was carve out a 5 year tranche being sold into vehicles that couldn't invest in the longer piece due to indenture restraints.
  • Growing amount of reinvestment period CLOS – by end of 2012, ½ of CLOs will be passed reinvestment period. Lots of buying supply coming out of the market.
  • More market driven things: Some movements towards consolidation of loan and high yield (drive-by loan deals). Also seeing a shortening of launch to commit date.
  • Rolling incremental or add-on loans: makes loans look a lot more like high yield.

Question: What is your outlook for the amend extend. We saw a significant amount in the 4th quarter of last year running into the 1st quarter of this year (BM / DN):

  • You will see a lot of amend-extends coming down the market, especially those due 2014.
  • Beth told all corporate treasurers if they hadn't extended their loan, they should do it now
  • Hopeful that buyside will be disciplined in working with arrangers to get good terms - she mentioned specifically true call protection
  • The new pricing has to meet current levels of secondary market to play the amend-extend as well as trying to add in covenants.
  • One interesting technical issue companies have had to deal with is when only a small portion of loans extend. The non-extended piece knows the company has to roll that more recent maturity sometime in the near future, and are probably waiting for a bigger pick up in spread and / or terms...Community Health is a great example

Question: What is the chance that new CLO's pick up the slack where older vintages are leaving the market because of reinvestment windows closing (LH):

  • Prospects change week to week because of the volatility and the arbitrage (both liability and asset side spread volatility are high.
  • Real drivers will be who can raise new equity. If you can find equity dollars, the structure (either CLO or TRS) will fall behind.
  • Market will exist but will be smaller. Until further equity comes into the asset class, it will be slow going
  • Liabilities haven't come back as fast as the asset side of the equation – makes arbitrage difficult.
  • The arb is very difficult, especially if you haven't been warehousing

Question: What about other products to pick up the power power (DN):

  • Asset and liability prices are changing on different variables.
  • June was a great time to close but if you waited 2 weeks it would have been impossible.
  • Who is the marginally buyer of loans? It was structured buyers. It was a rating arb.
  • Now, its institutional buyers and they are saying why not just own the outright asset. This leads the panelist to believe the market see simpler structures
  • At beginning of year, equity investors were more comfortable taking the first loss piece, since June and especially August very difficult to find first loss risk

Question: Another question on loan innovation and growing the base of institutional buyers: (BM)

  • Need to be paid for that volatility. The assets spreads need to stay up where they are today.
  • What is happening in Greece shouldn't affect the loan class but it does because it affects those making markets.
  • Call protection is good but soft call isn't really good enough (bond take out).
  • Need to also improve settlement funds (15% pf trades settling at T+30).
  • Structural changes, for example borrower approval of assignment. That just needs to be taken out of the market immediately

Question: Pension Funds have always been the holy grail of loan investment managers. What's the likelihood pension money flows into the asset class (DN):

  • They are the holy grail. If Pensions go from 0 to 2% or even 2-3%, it will be a massive number.
  • They want capital gains and income. Entry point today for loans: high yield like returns with senior securities.
  • Though, pensions are long term strategic allocators. They have many meetings and then will dip their toe in.
  • Allocations started to pick up in 2010, escalating in the first half of the year, but given the events of July/August, flows have been neutral (not not interested, but want the right price).
  • Will loan prices go down? Loans seem to be 100% correlated with risk assets meaning given everything going on, loan prices will go down.
  • Pensions like the investment thesis, and the panelist would love to see them pick up where the CLOs will drop off.
  • Though again structural changes are needed: CUSIPs on every loan. Automation. Improving trade price and market clearing clarity. Structure → call protection, want senior secured structure with price protections like HY bonds
  • Insurance companies, more-so than most, want covenants

Question: What is the future of the covenant light structure (GS):

  • Will get back to 20% on covenant lite.
  • Seeing reasonably better call protection that the past (NC structures).
  • When market heats up, that will go by way-side. Right now, there is a deal in market with 6 month call protection.
  • We will continue to see LIBOR floors in the market. Only way for this asset class to compete is LIBOR foors and high credit spreads.

Question: Outlook for returns in the marketplace relative to other asset classes (LH):

  • 80% of returns in fixed income in last 20 years has been duration driven.
  • What the panelists thinks you are going to see is not investors running from duration, but more questioning it.
  • You'll see high yield and loans become more fundamental driven by credit spreads versus investors guessing on duration.

Question: Outlook for default rates (all panelists):

  • (GS): Think 2011 will represent a trough in default rates, depending on economy, big worry is lower quality high yield and those from the 2007 LBO boom. As you get further out in 2013/2014, you will be subjecting default risk to the capital markets (i.e. can you kick the can down the road further)
  • (DN) Default rates being macro path dependent, 2-3% next year but with component of tail risk. Further out, completely path depending on economy, 3-4% default rates
  • (BM): 2-3% in 2012 and 2013, big jump in 2014 (TXU is 2% of index, people will start reporting defaults ex TXU): 2014 will be 6-8% in the big LBOs
  • (LH): In 2014, those that can't amend-extend, will hit a wall.



hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.