FT Mandate: What is a senior debt investment strategy and what impact is it designed to have on a fixed income portfolio?

Jeff Bakalar, senior vice president and co-head of the senior bank group, ING Investment Management:
We invest in the same companies as high yield bond investors, except our investments, senior loans, are floating rate and secured by assets. Within a fixed income strategy, there are two types of risk: credit and interest rate risk. Loans are floating rate instruments, so we have effectively removed the interest rate risk element, so there is a much lower volatility profile. We are left with just the credit risk, and that is the risk we manage daily.

The impact it has on a fixed income portfolio is that, if you put loans into a high-yield strategy, you see a significant decrease in overall volatility without giving up that much of the coupon.

FTM: Please describe the investment process.

JB: If you talked to five or six different loan managers in US, they may give you five or six different responses. Our approach is very credit-intensive and bank-like. The focus is on independent underwriting. The leveraged loan market is very big – more than $1200bn (€937.3bn) in the US – and we source our paper from the best underwriters in the business. Then we effectively re-underwrite every transaction. We do our own independent credit analysis with a focus on free cash flow generation.

Once an investment is approved by our Investment Committee, we go through the typical documentation process. We become a direct lender to the company. Once a transaction is allocated to the portfolio, it undergoes a rigorous monitoring process.

Given senior loans are private investments, companies have to provide financial statements and compliance certificates every 90 days. We have a team of 18 investment professionals who do nothing but underwrite the underlying credit risk and oversee the ongoing monitoring process. Our monitoring process effectively requires the investment committee is to make a fresh investment decision every 90 days.

FTM: How prevalent is the use of leverage and what level of gearing tends to be employed by portfolio managers?

JB: There are loan managers in the US who do not use any leverage; there are managers that use a high degree of leverage; and there are managers in between. Our strategy is to have different portfolios with different levels of gearing depending on the investment appetite of the clients. We have strategies with zero leverage, strategies with moderate leverage, which run three to four times, and strategies with higher leverage, which can run 10 to 12 times.

FTM: What are the key differences between a senior debt/floating rate income strategy and a high yield debt strategy?

JB: The biggest issue is that both are searching for incremental yield over investment grade, but the loan market has lower volatility as there is an insignificant amount of interest rate risk and we are investing in secured obligations. You see a lot of high-yield bond managers using loans as way of reducing volatility without materially reducing risk-adjusted yields. There are between 300 and 400 investors in the loan category in the US now, a much higher number than five to six years ago.

FTM: How can senior debt/floating rate income investment strategies protect bond portfolios from the negative impact of rising interest rates and the bursting of the ‘bond bubble’?

JB: What you are seeing in the market today is a heightened sense of concern that rates could be rising for quite a while yet. In that case, the value of fixed income instruments is at risk, regardless of credit quality. But with loans you typically see increasing yields because they are a floating rate asset class. They are structured to have their credit spreads reset over Libor every 60-90 days. In a rising rate environment you can have rising dividends and very stable net asset value. Compare that to bond investments, where you are going to see your coupon decline, relatively speaking, because rates are rising, and in most cases see the value of that bond fall. This floating rate nature provides an effective defensive mechanism when rates are rising.

FTM: How have floating rate income strategies performed in the last one and three years, and what factors have impacted on this performance?

JB: Returns have been Libor plus 200 basis points, on average, for the past three years, although they move with supply-demand conditions. The important thing is to note that it has been a very favourable credit environment, with no defaults. The net asset value of loan funds has generally been very stable. Those with bonds have seen more volatility.

FTM: What types of institutional investors are subscribing to floating rate income investment strategies in the US and how does US institutional demand compare with institutional demand in Europe?

JB: There are traditional loan investors like ourselves, investors who have seen the evolution of this market. We have recently seen a lot of new entrants, including CLO [collaterised loan obligation] managers, who account for probably 65 per cent of the market, insurance companies, pension funds, and hedge funds.

We just launched a European platform, with three individuals in Holland, because the market in Europe is blossoming like the market in US did about five years ago. It is currently about 25 per cent the size of the US market, but growing at a rate approximatelty three times faster. There has been a tremendous amount of growth, based largely on merger and acquisition activity, driven by private equity sponsors.

The European market currently has a different composition of investors than the US. There is not the same presence by traditional institutional loan managers; it is still mostly banks and a burgeoning CLO market. Today, it is more closed than the US market, but in three to five years we expect it to look substantially similar.

Demand in Europe is developing from insurance companies, pension funds and hedge funds. These types of inivestors at times will rely on traditional institutional loan managers to access this market. That was a primary reason we launched in The Hague.

FTM: What percentage of their total fixed income investment portfolio are institutional investors allocating to senior debt investment strategies?

JB: Asset allocation depends on risk appetite and investment objective more than anything else. Today it can reach as high as 25 to 35 per cent. There have been investors who have voiced interest in having their entire income portfolio in loans. We do not recommend that level of concentration, but it does showcase the attraction of the asset class.

FTM: What types of senior instruments do ING Investment Management’s own senior debt investment funds invest in and what level of return are these products targeting? What performance has been achieved since launch?

JB: We emphasise high risk-adjusted returns over credit cycles, rather than the highest total returns in a given period. We attempt to do this by staying in higher credit quality companies. The average credir rating in the US loan market is currently single B-plus; we try to keep half a notch higher, between single B-plus and double B. We also target the more liquid part of the market. Given that loans are not public securities, there are varying degrees of liquidity in the loan market. Of that $1200bn overall size, probably 25 to 30 per cent is inherently liquid, and that’s the type we like to keep in our portfolio.

Return-wise it is fair to say [that we target] the Libor plus 200 range. Performance will vary slightly, depending on gearing, but the best indicator of our performance is the ING Senior Income Fund (currently $2.9bn), which has posted one of the highest risk-adjusted returns in the US since inception (April 2001).

FTM: How does ING IM seek to control and mitigate the inherent investment risk?

JB: We have compiled a very experienced group of analysts. This is an asset class where you are still going to have credit risk, even though interest rate risk has been mitigated, and the best defence against broad-based credit risk is a high level of diversification and being very focused on the credit aspect of every underwriting.

FTM: Is borrowing an amount equal to 25 per cent of the senior bank loans’ investment fund’s net assets prudent in an environment of rising interest rates?

JB: We think it is. The potential negative with leverage is exacerbating credit risk. The bottom line is that, when we borrow, we do it at the same base rate that our assets float over. When borrowing costs rise, the rate we are earning on our assets rises more or less in step, so we typically cannot be in the nasty situation of interest costs outweighing what we are earning on assets. When we use leverage for investment purposes, we borrow at a spread that floats over Libor, typically 35 to 40 basis points. We take that leverage and invest in an asset that also floats over Libor, with a typical return of 200 basis points. So when interest rates rise, the interest rate mismatch or duration risk is almost non existent. This is probably the most beneficial asset class for the use of leverage.

FTM: What is the total volume of assets under management in ING IM's senior bank loans investment funds and who is investing in them?

JB: Roughly $6.7bn as at the end of June, comprised of seven different actively managed portfolios. We manage two of the largest US mutual funds where the end users are retail investors, accounting for approximately $5bn. Then we have a CLO platform with about $900m currently. Those investors are traditional institutional investors like hedge funds, life insurance companies and pension funds – investors looking for much more highly geared returns. Then are the two portfolios in the European market, which are sold to life companies, pension funds, and so on, who are looking for unleveraged returns.

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