FTMandate: What is a senior debt investment strategy and what impact is it designed to have on a fixed income portfolio?
Jeff Bakalar: Senior loans are large corporate loans made to non-investment grade companies. We invest in the same companies that a traditional high-yield bond investor would invest. However, there are two main structural differences between loans and bonds. First, we are investing on a floating rate basis – loans float over Libor, they are not fixed rate – and they are very short in duration. Second, we have collateral backing our position. These two factors combine to make loans less volatile than bonds. The senior debt market in the US is over $1000bn in size, much larger than the high-yield bond market.
Our strategy is to focus on the highest quality non-investment grade loans and stay in the most liquid part of the market. The highest quality typically provides the lowest default rate and highest recovery rate. Liquidity enables you to manage the portfolio more effectively in difficult credit environments. Many of our competitors don’t employ specific strategies. They gather assets regardless of credit quality.
FTM: How can senior debt/floating rate income investment strategies protect bond portfolios from the negative impact of rising interest rates?
JB: Loans provide a hedge against rising rates. This is because when rates rise you get an increasing dividend, whereas the coupon of a fixed-rate portfolio will be static. And, importantly, the asset value, the value of the loan against which it will be credited, will be typically more stable.
FTM: Please describe the investment process, giving an indication of the credit quality of the targeted securities.
JB: The average credit quality in the leveraged loan market has historically changed from B+ to BB-. It has moved down a little over the last two years because credit conditions have been so good – to a mid- to low single B market. Our strategy is to stay a little higher quality than that.
We focus on sector selection and individual credit analysis. We independently analyse every transaction. It is very important because the way to outperform in this market over a full credit cycle is to avoid defaults.
FTM: How much leveraging do portfolio managers tend to use?
JB: When we leverage we borrow at Libor and use the proceeds to buy loans that float over Libor. As a result we’re naturally insulated against the negative impact of rising borrowing costs. The level of gearing in the market goes from zero to 15 times levered, depending on the particular portfolio structure.
FTM: What are the main differences between a senior debt/floating rate income strategy and a high yield debt strategy?
JB: That is difficult to answer unless you are comparing strategies directly. Our strategy is to minimise asset price volatility and avoid default. Some US managers take incremental credit risk and reach for total return. The same thing happens in the fixed income, high yield bond market. Some managers are conservative and some are aggressive. Strategies vary, but the most distinct difference is whether you manage loans or bonds.
FTM: How have floating rate income strategies performed in the last one and three years? What factors have affected this performance?
JB: Over the last year or two, there hasn’t been much capital appreciation in the loan market, but dividends have been steadily rising in step with short-term interest rates in the US. NAV performance has been very stable due to a strong credit environment. So, overall performance has been very good.
FTM: What types of institutional investors use floating rate income investment strategies in the US? How does institutional demand in the US compare with Europe?
JB: Over the last five years, the number of loan managers of any size in the US has grown from approximately 25 to nearly 200. Traditionally it was the banks and independent asset managers providing institutional tranches. Over the past two or three years insurance companies and pension funds, and hedge funds, have come into the market. Banks have also come back searching for yield. It’s very crowded at this point in the credit cycle.
The European market is about three years behind and one third of the size of the US market. But it is growing faster than the US. Leveraged buy out (LBO) and merger and acquisition (M&A) activities drive the issuance of new loans. The catalyst behind those activities are the private equity groups - the sponsor groups that commit equity to buy the companies and divisions. They use loans as a major part of the capital structure.
FTM: What percentage of their total fixed income portfolio are institutional investors allocating to senior debt investment strategies?
JB: If you believe that interest rates will continue to rise, then you will want a sizeable portion in loans as long as credit conditions remain favourable. Allocations have been increasing steadily as knowledge about the asset class increases. Depending on the institution, it can range as high as 50 per cent.
