"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 4^th 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.

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Back from the Dead: The CLO Revival

Last week it was reported that Symphony Asset Management is launching a $500M CLO. To give you some historical context of CLO issuance, please see the chart below from an 2009 LSTA conference:

This would be the second CLO launch of the year. Combined with the $525M CLO placed by Fraser Sullivan earlier in the year, and this $500M Symphony deal, CLO issuance will reach the $1 billion dollar mark, with more deals expected in the second half of the year. Compared to the chart above, that $1 billion dollars looks awfully minuscule.

According to various news reports, this CLO will purchase new deals, and given the current state of the primary market, will have a substantial amount of supply to choose from. The AAA tranche will be $317M in size, $113M to a Class B tranche (rated Ba2 from Moody's) and $70M in equity notes. In addition, it is reported that the AAA tranche will be held by one investor.

Given the $70M of equity versus the $430M of debt, this deal will be slightly more than 6.1x levered versus 2006 and 2007 structures which were 12-13x levered. While I have not heard hard data on the potential for equity returns in the structure, it is rumored that they will somewhere in the low-mid teens which is slightly less from what equity investors were told they would earn in the go-go years (2004-2007).

From looking at my runs, the Fraser Sullivan deal priced their AAA tranche at L + 190. Here is a chart of AAA and AA CLO liability spreads (again from LSTA)

If you were to show the most recent data, these levels would be even tighter. While investors have varying preferences for investing in legacy CLO liabilities or new CLO liabilities, it is readily apparent that the market is in far better shape than it was at this time last year.

Assuming investors can place the subordinated tranches of these structures, it seems likely that we will see more of these structures announced throughout the year. There has been substantial consolidation in CLO manager land which further bolsters the case that CLO liability investors will become comfortable with the less levered, more modest 2010 CLO vintages. And given that AAA liabilities are pricing near L+200 vs L+40 in 2007, investors are surely being paid a premium to play in these structures.

What this means for buy-side investors? More competition in the primary leveraged loan market where most deals today are already well oversubscribed. Also - more capital available for refinancing troubled borrowers or busted LBOs. The last thing this market needs is more capital - unfortunately, I think that is exactly what we are about to get.

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Finding Opportunities in Distressed Bank Debt

A few times each week, the various dealers, like Goldman Sachs or CSFB, will send out a list of all their bank debt names (including distressed bank debt paper). These names range from the very on the run - to the very off the run situation - in some case situations I have never even come across or seen.

Unfortunately, for most retail investors, it is difficult to gain exposure to bank debt unless you invest via a number of open end or closed end mutual funds. Complicating this, many times on a private deal, potential investors will be asked to sign a confidentiality agreement as to keep the debtors financial situation away from the prying eyes of competitors, suppliers and the likes.

But what if these structural issues create opportunities for investors? We all know the hordes of value investors out there that try to find companies uncovered and deserted by Wall Street to find diamonds in the rough...i.e. The number of analysts covering a particular stock is inversely proportion to the amount of mis-pricing in the security. 22 analysts covering Microsoft may mean very little inefficiency in the the stock price...But what about Bexil Corp (Symbol: BXLC)? No analysts covering the company, a market cap of $20M vs $37M of cash on the balance sheet...

The point I am trying to make - a lot of times in distressed debt land many people are looking at the same situation. Do you know how many calls / emails I got from other people on the buy side about Nakheel the last few weeks? Probably 30. (Note: Someone has written up Nakheel on the Distressed Debt Investors Club). Why not go looking for those uncovered gems?

There are few arguments against hunting for diamonds in the rough in the corporate debt world:

1. Many of the uncovered situations are so illiquid that only a fund with locked up capital / side cars would ever dream of taking a meaningful position because the mark-market is brutal.
2. In tandem with #1, if you want to be an activist in distressed debt land, you need to be able to source the paper - lots of paper is locked up in structure (CLOs, insurance companies) that do not mark to market and would rather not sell you the paper as to not take the mark.

For me, these two reasons are all the more reason to get excited about these sorts of situations. I forgot a third reason: You will not be the belle of the ball at every distressed debt holiday party / cocktail hour unless you are talking about First Data (FDC) or Harrah's (HET)...

What about Advancstar? Or Graceway's 1st or 2nd lien? Or Suburban Propane's Revolver? Who is pitching those at Houlihan's Distressed Holiday Party?

I could go on like this forever. I think the position a potential distressed debt investor has to take is why are these securities mispriced? Why was Spansion's Senior Secured Floating Rate note trading less than 10 a year ago and now is over par? (I will write a post on that a little later). Where are the mis-pricings? What does the market have WRONG...That is where you should spend your time, and then go out and exploit it.

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Bank Debt Returns

A reader was asking me about bank debt returns. I just received a message from one of my dealers:

The Leveraged Loan Index:

1992: +6.75%
1993: +11.17%
1994: +10.32%
1995: +8.91%
1996: +7.48%
1997: +8.30%
1998: +5.31%
1999: +4.69%
2000: +4.94%
2001: +2.65%
2002: +1.12%
2003: +11.01%
2004: +5.60%
2005: +5.69%
2006: +7.33%
2007: +1.88%
2008: -28.75%
YTD (as of April 8th): +9.61%

Please keep in mind, these are unlevered returns.

Now, the composition of leveraged loan buyers is substantially different than it was in 1992-2000 - i.e. the rampant presence of CLOs. Some reports indicate that CLOs represent 60% of the bank debt market right now. And CLOs are under some pressure as evidenced by this Moody's article. A reason the leveraged loan market was down so much last year was the unwinding of market value CLOs.

One of the things investors are seeing in the bank debt market right now is the "CLO Effect" - in short, a CLO does not like to buy assets below a price of 80 (85 in some deals) because they then have to market the asset to market for a number of their tests (CLOs are subject to a varity of tests including weight average spread tests, the amount of Triple-C assets they can hold, etc). If the CLO buys the asset above 80, you can mark it at par, and all is fine and dandy. So what you are seeing in the market, is deals getting a boost when they begin trading over 80. Does this make an economic sense? No. Is it something to consider? Absolutely. Is this what we are seeing now? Maybe.

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