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Fixed Income Investing in a Low Interest

Rate Environment

4Senior Secured Loans:

A Permanent and Tactical Allocation

8The Risks of

Investing in the Senior Secured Loan Market

12

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CONTENTS


he Federal Reserve is having its way. With the Fed’spledge to keep short-term interest rates near zero for theforeseeable future, most investors cannot meet their re-turn objectives by investing in short-term, high-qualityinvestments. And with inflation running in the 2 to 3%range, even investing in 10 year Treasury bonds and col-lecting the interest income is likely to generate a flat ornegative real return over time. As a logical consequenceof the Fed’s policy-making, the only way investors canmeet their objectives is to invest in risk assets.

The current generation of investment professionalshas only known one cyclical direction for interest rates:down. While there have been periodic incidents in thelast 30 years where rates have spiked higher, the long-term trend for the last three decades has been for rates todecline and for duration to contribute to positive fixed in-come performance. 2011 provides a perfect example ofthis, with 10 and 30 year Treasuries returning 17% and35%, respectively, for the year despite historically lowcurrent coupons.

But now, with interest rates at all-time lows and in-evitably poised to rise at some point in the future, howcan investors achieve the returns they will need going for-ward? Perhaps of equal importance, how can investorsavoid losses in their portfolios, and particularly in the“safe” fixed income portion of their portfolios? For manyinvestors, the senior secured loan market can help bothmeet their return objectives and, importantly, help themavoid losses when rates go up.

The Risks in Today’s Fixed Income MarketIn order to meet their return objectives, investors

have to take one or both of the two primary risks in fixedincome investing: interest rate risk and credit risk. De-pending upon the level of interest rates and creditspreads, investors at any given point may be taking moreof one risk than the other. And in the current low rate en-vironment, interest rate risk is very high.

The table below shows current yields for a range ofasset classes and compares them to historical levels and totheir lows prior to 2010. The notable and alarming conclu-sion from the table is that for many traditional fixed incomeasset classes, current yields are well below both their his-torical averages and their recent lows. For many high-qual-ity fixed income asset classes, if their spreads return tolevels seen recently, the asset class will generate negativenominal annual returns. When positive inflation is factoredin, these asset classes could easily end up generating neg-ative real returns for an extended period of time if interestrates revert to anything resembling historical levels.

The one asset class that stands out in the table belowis senior secured loans, whose yields are well above his-torical averages and recent levels. In addition to havingcurrent yields which are high on a relative and absolutebasis, senior secured loans also have an effective dura-tion of less than 3 months because their interest ratestypically reset every 90 days. In simple terms, senior se-cured loans have effectively zero interest rate risk, andinvestors are being paid a lot to assume credit risk.

4



Fixed Income Investing in a Low Interest Rate Environment

T

Yields of Senior Secured Loans vs. Other Asset Classes

29-Dec-11 7.93% 8.45% 4.30% 6.02% 0.27% 0.88% 1.90% 2.91%

Low prior to 2010 4.74% 6.95% 4.34% 6.36% 0.66% 1.55% 2.07% 3.88%

20-year median 6.94% 10.02% 6.45% 9.81% 4.67% 5.02% 5.32% 6.61%

% above/belowprior low 67.40% 21.58% -0.85% -5.36% -59.55% -43.23% -8.26% -25.08%

Senior Secured High Yield Inv. Grade Emerging 2-year 5-year 10-year FNMA Loans Bonds Bonds Markets Bond Treasury Treasury Treasury 30-year

Yield Mortgage


Senior Secured Loans:From “Bank Loans” to “Institutional Asset Class”

The senior secured loan market today is a large, liq-uid market with hundreds of participants. 2011 endedwith over $500 billion of outstanding institutional loans,over $230 billion of new issuance, and saw over $409 bil-lion of trading volume across 2,300 separate loans. Aswell, there are over 200 separate senior secured loan in-vestor groups involved in the loan asset class, with eachmanager typically managing multiple loan investmentvehicles. Gunther Stein, CIO and CEO of SymphonyAsset Management, observes that “The market, whichused to be considered a small, alternative, niche market,has developed into a mainstream, fixed income assetclass. There are dozens of retail mutual funds offeringdaily liquidity which focus on investing in loans, in addi-tion to hundreds of other vehicles including pooled insti-tutional funds, separately managed accounts, closed-endfunds, and CLOs.”

The senior secured loan market as we know it todaybegan its development into a large, liquid institutionalasset class starting in the late 1980s. Until that time,large corporate loans were traditionally provided bybanks, which assembled syndicates of other banks to holdloans that exceeded any one bank’s desired credit expo-sure to a single borrower. Hence the moniker “bankloans.” In the late 1980s and early 1990s, a handful ofmutual funds, or so-called “prime-rate” funds, werelaunched with a focus on investing in loans. This markedthe beginning of non-bank participation in senior securedloans, and led the way for the literally hundreds of loanmanagers and institutional and retail investment fundswhich exist today.

Senior secured loans, which are sometimes referredto as bank loans, leveraged loans, and floating rate loans,to name a few, are a distinctive and appealing asset class

in a number of important ways, many of which can bebeneficial to investors.• Senior – This means that loans are first in right of re-payment and are repaid before any other creditors andbefore shareholders.• Secured – In addition to being senior, senior loans aresecured and they have the first claim on the company'sassets. If a company performs well, this collateral pro-vides extra insurance that is never used. If a companydefaults, senior lenders have still gotten back around 80cents on the dollar, largely as a result of this secured po-sition. The table below shows how senior loan recoveryrates have far exceeded those of other debt and/or fixed

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continued on page 6


Moody's Ultimate Recovery Rates


6



income asset classes, including high-yield bonds.• Covenants - Most senior secured loans have financialmaintenance covenants which allow senior lenders to in-tervene and improve economics and terms if issuers arenot performing as projected. This is a critically impor-tant distinction of senior secured loans versus other assetclasses, particularly high-yield bonds, which typicallyonly have so-called incurrence covenants which preventthe incurrence of additional debt if certain financialthresholds are not being met. However, with high yield(or investment grade) bonds, there is no requirement tomaintain any specified level of performance other thanmaking scheduled principal and interest payments. Withsenior secured loans, if the borrower violates its mainte-nance covenants, senior lenders can intervene, which typ-ically involves increasing interest payments for thehigher risk, and also may involve speeding up the loan’srepayment and otherwise improving terms that reducethe risk to senior lenders.•Pre-payable - Senior secured loans are typically pre-payable at their par value. Consequently, despite typi-cally having stated maturities of 5 to 7 years, theiraverage life is usually much shorter. While the averagelife of loans has varied somewhat based on conditionsin financing markets, it has typically been around 2 to3 years, which is much less than the stated maturity.Other loan terms, like cash flow sweeps and periodicamortization, also distinguish senior secured loans frommany other corporate fixed income investments. “Thenaturally forced deleveraging at par which is typical ofsenior loans, which includes cash flow sweeps, repay-ments from asset sale proceeds, combined with scheduled

principal pay-downs and voluntary prepayments beforestated maturity, materially shortens the average life,and consequently the principal risk, of senior loans,”notes Ross Smead, CIO and Managing Principal of Hal-cyon Loan Investors.•Floating Rate – Senior secured loans are floating-rateinstruments, with their coupons being determined as aspread over LIBOR. Historically, when LIBOR movedup, the interest rate which loans paid also went up. His-torically, the reverse was also true, and coupon levelswould go down as LIBOR went down. In recent years,however, so-called LIBOR floors have been introduced.LIBOR floors, which provide a minimum coupon for in-vestors if LIBOR is below a certain level, also allow yieldsto increase, or float, if LIBOR exceeds the floor level.These floors were introduced into loans in order to in-crease their overall coupon levels to appeal to a broadbase of investors, and also to enable senior loans to re-tain their floating rate upside. LIBOR floors are presentin nearly 50% of currently outstanding loans. Accordingto Eric Mollenhauer, Portfolio Manager for Fidelity In-vestments, “Investors today are getting the best of bothworlds, where they get the benefit of higher short termrates in their income today, but also don’t get hurtwhen rates rise like they would with fixed rate invest-ments.” Since the average LIBOR floor level exceedsthe current level of LIBOR by about 100 bps, loan in-vestors won’t see the benefit of any increase in shortterm rates for loans with LIBOR floors until short ratesgo up 100 bps and actual LIBOR exceeds the LIBORfloor. However, for the 50% of loans without LIBORfloors, they still will see any increase in short rates in

continued from page 5

S&P/LSTA Leveraged Loan Index: Annual Return




7

higher coupons. In either case, investors don’t havedownside yield risk and also benefit (with some lag) if andwhen short rates go up.•Liquidity - The large number of participants in the loanmarket and large size of the market has resulted in alarge, liquid market. While it is certainly smaller andless liquid than the treasury and investment grade bondmarkets, loan liquidity has held up well, including duringperiods of market stress. As Apollo’s Loan Product Man-ager and Portfolio Manager, Joe Moroney put it, "Duringthe period of extreme volatility in August of 2011, liquid-ity for loans held up relatively well as demonstrated byhealthy volumes of both buyers and sellers, unlike whatwas observed in many other assets classes, in particularhigh yield bonds."

A History of Stable ReturnsSenior secured loans have had positive returns every

year except 2008 (see chart on page 6). This history ofstable returns stands in stark contrast to fixed rate in-vestments, which frequently have negative total returnsin periods of rising rates. The seniority, security,covenant protection, prepayment terms and floating ratefeatures of senior loans have all contributed to the assetclass’s historically stable, low volatility returns.

2008’s negative index return of 29% was not only theasset class’s first year of negative returns, but the magnitude

of the loss interrupted the asset class’s history of positivereturns and low volatility, which had resulted in a 15 yearrecord of high risk-adjusted returns. 2008’s results,which were primarily driven by a liquidity crisis andwidespread forced selling, were followed by a strongbounce back in 2009, when loans rebounded to earn 52%,and 2010’s continuing improvement with a 10% return.For those who sat tight through the crisis, returns werepositive, albeit volatile, despite the highest default ratesin recorded loan market history. Many opportunistic buy-ers, who realized that loans’ precipitous price decline (theIndex hit a low of 62% in December 2008) had little to dowith their underlying performance or credit quality, ini-tiated or increased their loan holdings in late 2008 andearly 2009 and earned outstanding returns.

Despite widespread market volatility in 2011, loansgenerated a positive 1.5% return. Returns had gotten ashigh as 3.1% through April 2011, but declined in the wakeof the Japanese earthquake. In August, as a result of theEuropean crisis, the US debt ceiling turmoil, and the Fed-eral Reserve reiterating its commitment to keeping short-term rates low for years, retail investors pulled over $5.5billion from loan mutual funds, which resulted in loanprices declining over 5.5% within one week. With theIndex beginning 2012 at a price of 91.6%, loan prices haveroom to increase and the asset class is positioned to con-tinue its record of delivering positive returns. ▲


ixed income investors face challenges in the currentmarket. In any scenario, they have meaningful risks ofnot achieving their investment goals. If conditions re-main as they currently are with historically low rates, in-vestors will not yield enough on highly rated investmentsto meet their income needs and generate a positive realreturn. If economic conditions improve and rates go up insympathy, investors in high quality fixed rate invest-ments are going to take a hit. While the income compo-nent of these investments is likely safer in an improvingeconomy, the combination of rising real rates and lowerprices will result in negative real and nominal returns.

If economic conditions remain weak or further dete-riorate, fixed rate investments may provide positive realand nominal returns. 2011’s Treasury rally highlightshow well fixed rate investors can do if they take durationrisk and rates decline, with 10 year Treasuries returning17% in 2011 despite offering historically low currentyields. However, given the currently low absolute level ofrates and the uncertainties surrounding the impact of theUS fiscal situation on interest rates, as well as the chanceof rates increasing alongside an economic recovery, this isa big bet for investors to make.

Enter senior secured loans. Because of their floatinglevels of income and historically low correlation to inter-est rates and other asset classes, they serve as an infla-tion hedge, provide diversification benefits and increasea portfolio’s efficiency across cycles. According to Fidelity

Investments' Portfolio Manager, Eric Mollenhauer,“Floating rate assets should have a permanent place ininvestors’ portfolios, and loans provide an ideal way forinvestors to get the inflation hedge and diversificationbenefits of floating rate assets.”

Low Correlation Increases Portfolio EfficiencyWith the exception of high yield bonds, senior se-

cured loans’ correlation to other fixed income assetclasses is low or negative. The table below highlightsloans’ correlation over the last 15 years with a number ofasset classes, and includes the higher correlations whichoccurred during the global financial crisis. As can beseen, the closest correlation which senior loans had to anyfixed income asset class was to high yield bonds at 0.80.On the other end of the spectrum, senior loans’ correla-tion to 10 year US Treasury bonds was a negative 0.39,reflecting the different returns characteristics of floatingrate, credit sensitive loans vs. fixed rate, ‘risk-free’ Treasurybonds. Also of note was loans’ 0.43 correlation to the S&P500. Senior secured loans have a clear and obvious place inportfolios as a result of their diversification benefits.

Looking ahead, correlations are likely to remainhigher than they were before the credit crisis as loans com-pete for investor dollars with other risk assets and asshort-term fund flows move markets. “When ‘risk-off’ sen-timent dominates market conditions, most risk assetstrade off, and senior loans, irrespective of the credit

F

8



Senior Secured Loans:A Permanent and

Tactical Allocation

continued on page 10

The Correlation Between Leveraged Loans + Other Asset Classes 5-year 10-year Aggregate High Grade High Yield S&P Emerging

Treasury Treasury Bonds Bonds Bonds 500 Market Bonds

10-year Treasury 0.93Aggregate Bonds 0.84 0.89High Grade Bonds 0.55 0.62 0.86High Yield Bonds -0.26 -0.22 0.16 0.46S&P 500 -0.29 -0.26 -0.03 0.21 0.62Emerging Market Bonds 0.03 0.08 0.29 0.46 0.59 0.57Leveraged Loans -0.39 -0.39 -0.05 0.24 0.80 0.43 0.30


FOR INSTITUTIONAL USE ONLY

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U.S. EQUITY

INTERNATIONAL EQUITY

GLOBAL EQUITY

FIXED INCOME

ASSET ALLOCATION

ALTERNATIVES


performance of the underlying assets, can sell off in sympa-thy. These widespread market sell-offs can create great op-portunities,” said Symphony's CIO, Gunther Stein. However,while the correlation of senior secured loans with other riskassets has likely permanently increased, it is still relativelylow. Additionally, the correlation with high-quality fixedrate assets remains very low or negative, and this is partic-ularly relevant to fixed income investors as they determinehow to protect their portfolios from interest rate risk.

“With the notable exception of 2008, which we think isunlikely to be repeated in normal credit cycles, senior loanshave been a stable and uncorrelated asset class which hasmade portfolios more efficient,” observes Joe Moroney, LoanProduct Manager and Portfolio Manager, Apollo. “Whethera fixed income portfolio has investment grade or high yieldbonds or both, adding loans makes the portfolio more effi-cient. And given where interest rates and loan spreads are

now and where they are potenially headed in the future,we really think investors need to consider allocating moreto senior secured loans.”

The Senior Secured Loan Market is CheapIn addition to their inflation hedge and diversifica-

tion benefits, which make them a logical part of investors’permanent asset allocations, the current market envi-ronment also favors a tactical overweight to senior se-cured loans. The primary reasons for this are thehistorically low current level of interest rates combinedwith the historically high level of loan spreads and favor-able fundamental outlook. According to Halcyon's CIO,Ross Smead, “Senior secured loans are among the most ap-pealing investments to protect a portfolio against rising in-terest rates, and with a shortage of floating rateinvestment alternatives, we expect them to attract investor

10




What Today’s Loan Spread Implies for Future Defaults

Actual Spread Excess Spread Default Loss (1-Recovery Rate) Implied Default Rate

776bp - 285bp = 491bp / (100%-70%) = 16.4%

Leveraged Loan Spread Estimate Using 2% 2012 Default Forecast

(1-Recovery Rate) Default Forecast Default Loss Excess Spread Spread Estimate

(100%-70%) x 2.0% = 60bp / 285bp = 345bp

Fifteen Year Risk/Return Trade Off: Leveraged Loans Versus Investment-Grade Bonds




11

attention and continue to perform well. When you add thatto the high level of spreads and low expected default rates,the case for a tactical allocation to loans is very strong.”

Senior Secured Loan Spreads are Very HighIn order to understand how much investors are being

paid to take the credit risk in senior secured loans and toget some sense of what “fair-value” would be, it is useful tolook at historical spread levels, default rates and creditlosses to understand what the current level of spreads ispricing in. Just as equity investors typically look at earningsand P/E multiples and compare current market levels to his-torical levels to determine if the market is over or under val-ued, credit investors look at historical and projected creditlosses to determine fair value for credit spreads.

The table on the bottom of page 10 shows currentspreads and historical excess spreads to show what levelof defaults the market is “pricing” into current spread lev-els. At current spreads, the market is pricing in defaultrates of 16.4%. By comparison, the default rate was amere 0.2% in 2011, and default rates are generally ex-pected to remain at or below 2% through at least 2013.According to Apollo's Moroney, “The current level of loanspreads is pricing in a fairly dire default and economicenvironment, worse than what was experienced duringthe credit crisis in 2009. With the refinancing activity ofthe last three years, slow but steady economic growth andlimited near-term loan maturities, we believe that defaultrates will remain low for the next two years and currentloan spread levels offer a wide margin of safety. Even ina depressed economic environment, there is plenty ofspread cushion to absorb losses and generate positive realreturns.” By this measure, senior secured loans look veryattractive.

Default Rates to Remain LowSo what is the outlook for senior secured loan funda-

mentals and credit spreads? By most measures, corpo-rate fundamentals are solid and loan issuerfundamentals appear healthy even when considering therisks in Europe and the mixed economic data in the U.S.and abroad. Earnings growth, while slowing, has remainedpositive and corporate balance sheets are much healthiernow than they were a few years ago.

In addition to positive fundamentals, deleveragingand financing activity in the last three years has alsogreatly reduced the likelihood of near-term defaults.Many issuers took advantage of robust financing marketsto refinance and extend their upcoming maturities. Infact, there are less than $5 billion of loans maturing in2012 and only $30 billion maturing in 2013. Likewise,while there are still some outstanding pre-crisis loanswhich have not been refinanced and which mature in2014, these loans are by and large some of the more chal-lenged credits and are trading at prices which already re-flect the fact that they are likely to default.

Including the default spike of 2009, the long-term

average default rate for senior secured loans is 3.5%.This compares with 2011’s historically low default rateof 0.2%. Notwithstanding an uncertain economic envi-ronment, forecasters are generally expecting defaultrates to be around 2% for the next couple of years. Com-paring these levels to the table at the bottom of page 10highlights that, at current levels, loans have a lot of cushion.

Lending Terms are Much TighterThere has been a dramatic tightening in lending

terms and improvement of economics in the senior securedloan market. While the pre-crisis credit bubble led to amaterial erosion in spreads and lending terms, the back-lash has been that lenders have tightened the terms underwhich they are willing to lend, and are also getting paid alot more to do so. As Fidelity’s Mollenhauer highlights,“Many loans which were created during the credit bubblehave either been repaid, refinanced, or defaulted. Conse-quently, the vast majority of loans which are currently out-standing were structured in this more favorable lendingenvironment. This is particularly important if investorsare concerned about the economic outlook, as these well-structured loans should perform relatively well.”

Volatility is Here to StaySo what can go wrong? As a result of the credit cri-

sis and changes in the base of loan buyers, the past maybe prologue. The fact that spreads and yields are widerthan they have historically been may reflect a permanentchange/increase in the market level of spreads. The in-crease in the importance of so-called cross-over/relativevalue investors has increased volatility in the loan mar-ket as loans compete for capital and as these investorsincrease or decrease their allocation to loans based onhow they compare to other asset yields. While investorsin loans today get the benefit of higher spreads in theirincome and also stand to benefit if rates rise, the marketis clearly more volatile than it was when it was domi-nated by a dedicated, non-redeemable buyer base of CLOswhich were more focused on spreads over LIBOR thanabsolute or comparative yield levels.

With new-issue CLO creation proceeding at a dramat-ically slower pace than before the credit crisis, and withmany CLOs completing or approaching the completion oftheir reinvestment periods, the importance of CLOs on de-mand for senior secured loans is declining. Likewise, rela-tive value investors are typically subject to redemptions,which also adds volatility to the loan market which hadbeen dominated by CLOs and their non-redeemable struc-tures. And finally, retail investors have become a largercomponent of the loan buyer base as mutual funds haveproliferated to offer retail investors a floating rate invest-ment alternative. While this has been a major source of in-flows in recent years, it has also added volatility, as retailinvestors can be notoriously fickle and reactive in their al-locations to products and asset classes. This came intostark relief last August. ▲


his time is different” is a common and overused expres-sion when trying to explain negative historical perform-ance and why it is not likely to be repeated. Whileconditions in today’s senior secured loan market are muchdifferent than they were prior to 2008, the Index’s 29%negative return in 2008 would previously have been con-sidered inconceivable given the asset class’s underlyingcharacteristics and history of stable returns. But 2008 didhappen, and investors need to understand how it hap-pened and, importantly, what could cause something likeit to happen again.

Underlying the senior secured loan market’s dra-matic growth in the mid-2000s was the global search foryield in a low interest rate environment. Because theloan market had a history of stable returns and had per-formed very well during the most recent recession (2001-2002), it was considered a suitable asset class to leveragein order to enhance returns.

There were multiple ways which leverage was ap-plied to loans. The most common leveraged structurewas the collateralized loan obligation, or CLO. In addi-tion to CLOs, a variety of investment products were cre-ated with the goal generally being to apply varyingranges of leverage to the historically stable asset class tomeet specific investors’ return objectives and risk con-straints.

CLOs, which were created to invest in loans andwere required to do so to meet their returns objectives,saw a dramatic increase in issuance in the early and mid-2000s. Concurrent with, and partly as a result of, theproliferation of CLO issuance and other loan-based in-vestment vehicles, there was also a dramatic increase inthe amount of senior secured loan issuance. Because of

the excessive demand which was created from the rapidgrowth of dedicated senior secured loan funds, the pric-ing and terms of the newly underwritten loans were atall-time issuer friendly levels with eroded terms and com-pressed credit spreads.

In the second quarter of 2007, the music stopped.Banks and investment banks had large exposure to CLOwarehouses and also had an unprecedented amount ofloans which they had underwritten but which remainedunsold. As CLO issuance came to a halt, banks liqui-dated their CLO warehouses. Additionally, with the lossof new-issue CLOs as a buyer of loans, and a large over-hang of unsold loans, loan prices began to decline. In ad-dition to forced selling of CLO warehouses, investmentfunds which were structured using market-value basedleverage were forced to sell assets. The forced sellingwhich occurred in 2007 and the first eight months of 2008was dwarfed by the volume of selling which occurred inthe wake of the Lehman bankruptcy, and this drove pricesto levels which were heretofore considered inconceivable.

Can 2008, or something like it, happen again?To be clear, the senior secured loan market is more

volatile than it was when it was dominated by CLOs.With the waning importance of CLOs as loan buyers, rel-ative value investors in search of yield have taken centerstage, and these investors rotate in and out of assetclasses at a much faster pace than the loan market’s his-torical, dedicated buyer base.

Notwithstanding this increased volatility comparedto pre-crisis levels, conditions are much better than theywere in 2008. The table below shows the amount of CLOwarehouses, investor leverage, and committed but unsoldloans and bonds in the system in 2008 vs. now. Whilethe correlation of loans with risk assets and the depend-ence upon retail investors has certainly increased, thedramatic imbalances of 2008 are no longer there.Bankers are being more careful about structuring loanswith enough flexibility in pricing and terms to be certainthey can sell them, and they are also being much stricterproviding leverage to funds seeking to invest in senior se-cured loans. According to Fidelity’s Mollenhauer, “Whileit’s always different this time, and there can and may wellbe elevated volatility in loans, conditions are such that itis highly unlikely to be anything comparable to the spiralof forced selling that drove loan prices to their 2008 lows.”

Senior Secured Loans – Trading Interest Rate Risk forCredit Risk

Senior secured loans have virtually zero interest raterisk. On the other hand, most senior secured loans are

12



The Risks of Investingin the Senior Secured Loan Market

“T

continued on page 14

Credit Markets in a Better Position than 2008

Bridge risk is 90% lowerBridge risk Total loans & bonds2008 $330bn2012 (est.) $20bn

CLO warehouses are negligibleCLO warehouses Total2008 $40-50bn2012 (est.) $1-2bn

Less investor leverage in loan marketTotal Percent accounted for by hedge funds Leverage$250bn 75% 8-10x$50-100bn 60-65% -3x


Partnering with our investors for over 30 years

A leading $10 billion global asset management firm

This information is for informational purposes only and does not constitute an offer to purchase or sell, or a solicitation of an offer to purchase or sell any interests in the Halcyon funds.

For more information, please contact Joseph W. Hill at [email protected] or 212.303.9484


14




rated below investment grade, which reflects the fact thatthey contain credit risk. While there are certainly miti-gants to this risk by way of their senior and secured po-sition in issuers’ capital structures, investors shouldexpect there to be credit losses in a broadly diversifiedportfolio of senior secured loans.

Credit risk can be impacted by a number of factors.The most obvious factors are company-specific and per-tain to an issuer’s ability to meet its principal and inter-est obligations. The specific factors which influence acompany’s financial performance are myriad, and it istypically the job of the portfolio management team toevaluate these factors and determine if they think a com-pany is creditworthy. For the investor, choosing an ex-perienced and stable asset manager is crucial.

The other major determinant of credit risk, which islargely outside the control of investment managers, isoverall market conditions and their impact on creditterms and economics. The chart below provides a visualdescription of how market forces can erode credit terms.It shows the leverage multiples (debt/EBITDA) of seniorloan issuers across time, with higher leverage multiplesbeing reflective of looser lending standards, and viceversa. As can be seen, the period leading up to 2007 wit-nessed a dramatic increase in the amount of debt beingput on companies. What is not visible in this chart, butwas occurring alongside the larger debt loads, was an ero-sion of contractual terms which made the overall struc-ture of the loans weaker.

In addition to the weakening in lending standardswas a compression in spreads. While investors in belowinvestment grade credit expect credit losses to occur, themitigant to this is higher gross credit spreads to providecushion to offset these losses as they occur. In the2006/2007 period, not only were terms eroding, butspreads were also compressing. In stark contrast totoday’s tighter terms and wider spreads, investors at thetime were not being adequately compensated for their el-evated credit risk. “Having seen the imbalances whichoccurred leading up to the credit crisis,” observes Sym-phony's CIO, Gunther Stein, “it is important for investorsto pay attention to where they are in the credit cycle.”

Liquidity – The Good and the Not So GoodLiquidity in the senior secured loan market has dra-

matically improved in recent years. There are literallyhundreds of managers and funds dedicated to investingin senior secured loans, and all of the major banks havededicated primary and secondary loan businesses. How-ever, investors need to understand that liquidity in thesenior secured loan market, while much improved, is notcomparable to certain larger capital markets like USTreasuries, sovereign debt, large-cap US equities, cur-rencies, and many large-cap investment grade bonds.

There are a number of factors which can influencean individual senior secured loan’s liquidity, primarilythe size of issuance, number of holders, and originatingbank(s). Large, multi-billion dollar tranches with multiple

dealers and a large investor base will typically see goodliquidity in all market conditions, albeit at a price. How-ever, there are certain loans for which liquidity can belimited, and the reasons for this can vary. The most com-mon challenge to liquidity is if an issuer is small and hasa narrow investor base. While this challenge is also fre-quently seen in the high yield market, investors need tobe aware that their manager’s ability to quickly rotate inand out of positions may be constrained, and should dis-cuss how their managers approach and seek to mitigatethis potential risk.

In addition to imperfect, albeit much improved, liq-uidity, bid-ask spreads in the senior secured loan marketare fairly wide. While the levels have varied based onmarket conditions, seeing a spread of approximately 50bps for a performing, highly liquid loan is fairly typical.Unlike other asset classes, where it is common for port-folio managers to rapidly rotate in and out of industrysectors based on relative value, the relatively high bid-ask spreads in loans makes this much more difficult toeffectively implement.

Dealers Reduce Their Risk TakingThe recent round of quarterly earnings from the

leading US banks highlights the reduced level of activity,risk taking and profitability which they are seeing in theirfixed income businesses. In the senior secured loan market,there has been a meaningful reduction in dealer inventoriesand their willingness to take principal risk. “While seniorsecured loan liquidity is still relatively solid, particularlyin larger credits," notes Halcyon's Smead, "we have cer-tainly seen a reduction in the banks' risk taking.”

To be sure, senior secured loans have many appeal-ing, all-weather investment attributes. Additionally, cur-rent conditions in the senior secured loan market inparticular and fixed income markets in general makethem look particularly appealing at this time. However,investors should spend time with their managers dis-cussing and understanding the risks in the market andhow their managers address these risks. ▲

Average Debt Multiples of Highly Leveraged Loans


For more information on how we can provide broad credit solutions to your portfolio, contact Anne Popkin at 415-676-4000 or [email protected].

www.symphonyasset.com

Symphony Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen Investments, Inc.

Experts Across the Capital Structure

Symphony Asset Management is a leading boutique investment firm specializing in leveraged finance.

Access to an Industry Leader

For more than 15 years, Symphony has distinguished itself as a manager of long-only senior loans, structured products, and alternative strategies throughout various market cycles.

Expertise in Corporate Credit

Symphony’s robust credit platform looks across the entire capital structure to identify the most favorable risk-adjusted opportunities.

Institutional Infrastructure

Symphony supports its investment results with an institutional infrastructure focused on excellence in client service and independent risk management.

WHY INVEST WITH SYMPHONY?

Research Driven Dynamic Portfolio Management Performance Excellence



Visit · 2019. 5. 6. · San Francisco, CA 94109 Contact: Anne Popkin President Tel: 415-676-4000 [email protected] Fixed Income Investing in a Low Interest Rate Environment

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