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Executive Summary

In 2010, we published an overview of what we described as opportunities
for investors in secured bank loans1. Since then, many of the trends we
highlighted have developed further, and a clearer view is now emerging of
the potential attractions of the loan market to investors. We have therefore
produced an update restating our case for the asset class, reviewing important
developments over the last year and providing our outlook for the market.
We believe an allocation to secured bank loans has the potential to provide:
• Absolute returns in high single digits
• Inflation protection through a floating interest rate (returns increase as
interest rates rise)
• Direct, secured exposure to corporate credit, an easily understood,
traditional asset class
• Low volatility of returns
• Access to assets via a deep pipeline of primary assets and an established
and regularly traded secondary market
• The opportunity to diversify exposure by issuer, industry and geography

Investing in Debt:
Opportunities in
Secured Bank Loans
By
Paul Hatfield,
Chief Investment Officer
Simon Perry,
Managing Director,
Business Development

• The highest new issue credit spreads and strongest deal structures that
have been available in over a decade
Since our original report, secondary market prices for loans have continued their recovery. However, we have not seen a return by investors to the
practice of investing in the loan market on a levered basis. Consequently, we
expect that the unprecedented drop in loan prices witnessed in 2008 and
2009 is unlikely to be repeated.
The new issue market for loans has re-opened. Loan issuance in Europe has
outpaced that of high yield bonds for the first time since the global financial
crisis. Companies seeking to manage their debt maturities are finding access
to the high yield bond market restricted due to heightened perceptions of
global risk and a desire to shorten duration, given the prospect of inflation
and higher interest rates. Instead we find those companies are again turning
to the loan market.
We consider terms for new deals to be exceptional with respect to potential
returns and the strength of lender protection through security, leverage and
covenant packages. In our view, the current vintage of loan origination is
likely to provide the greatest return for the lowest risk that has been seen in
the market for some time.
1 Paul Hatfield and Simon Perry, “Investing in Debt: Opportunities in Leveraged Loans,” BNY Mellon Asset
Management/Alcentra, June 2010. See Alcentra Group disclosures at back.

August 2011

BNY Mellon Asset Management

In addition, we believe Europe potentially offers better value than the US,
with higher spreads and more secure deal terms.
The concentration of loan maturities between 2012 and 2015 identified in
our last report has been reduced through loan refinancing, high yield bond
refinancing and amend-to-extend agreements with lenders; however a
significant “wall of maturities” remains. This will serve to keep new issue
spreads wide and leverage low. As the stronger credits are refinanced, the
average credit quality of the borrowers remaining in the “wall of refinancing”
may deteriorate. We believe this will likely provide a compelling universe of
opportunities for experienced distressed debt investors.

TABLE OF CONTENTS
Rethinking Asset Allocation Choices

3

Understanding Secured Bank Loans

4

Secured Bank Loans Versus High Yield Bonds

6

Evolution of the Secured Bank Loan Market

11

Market Outlook

17

Conclusion 26

bnymellonassetmanagement.com

INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS

2

other risks. Within fixed income there are a variety of segments to consider: government bonds. the investor must analyse the risk of default of the issuer and the expected loss following default.Rethinking Asset Allocation Choices Continued volatility in equity and bond markets has caused many institutional investors to review their asset allocation choices. Some have chosen to reduce their allocations to equity markets in favour of other asset classes that provide a more predictable return profile. 20% bnymellonassetmanagement.2 Each of these risks can be estimated through detailed credit analysis. 2011. 80% The well documented debt problems in peripheral Europe and questions over 70% US fiscal challenges have all contributed to uncharacteristic volatility in this asset 60% class. BofA Merrill Lynch. Exhibit 1 shows the yields on these different categories since 2003. June 23.com 10% INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 3 . particularly in the case of corporate credit where investors have access to detailed financial information on the borrower. Exhibit 1 – Yields on Global Fixed Income Asset Classes 25 Percentage (%) 20 15 10 5 BoA/ML Global High Yield Index Jan 2011 Jan 2010 Jan 2009 Jan 2008 Jan 2007 Jan 2006 Jan 2005 Jan 2004 Jan 2003 0 BoA/ML Global Large Cap Corporate Index BoA/ML Global Sovereign Broad Market Plus Index Source: Markit Hub. investment grade corporate bonds and sub-investment grade corporate bonds and loans. please see appendix for index definitions. which is very hard to do. Some have chosen to reduce their allocations to equity markets in favour of other asset classes that provide a more predictable return profile. Government bonds in particular have proven to be a challenging segment over 100% the 90%last year and are no longer regarded as the relatively risk-free asset they once were. presenting many more issues to consider before investing. The fixed income markets have been a major beneficiary of this shift. may be less important. trading liquidity and changes in interest rates. returns from fixed income are defined at the point of investment by the coupon and knowledge that the principal is to be returned by contract at maturity. Continued volatility in equity and bond markets has caused many institutional investors to review their asset allocation choices. 50% 40% 30% 2 In a hold-to-maturity approach. By contrast. Rather than take a view on equity market growth. Determining expected return in the equity markets requires forming a view of likely growth in earnings and profits over an investment horizon. such as market value fluctuation.

all of which command higher fees and which companies often source only from banks that agree to provide them with loan financing. certain parts of the bank loan market have attracted increasing attention from institutional investors. These are what are often referred to as “leveraged loans”. Corporate bond yields do not compete with those promised by the equity market. so by switching from equities to investment grade corporate bonds. The scale of institutional participation in the market for loans to sub-investment grade corporates in the US and Europe is comparable to that of the high yield bond market. The loan is a bilateral agreement between the lender and the borrower. However. In these deals margins are higher to reflect the greater leverage applied to the businesses through the buyout and the absence of the corporate banking dynamics that drive traditional corporate facilities tighter. or originally were. For these reasons.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 4 . they require a higher degree of administration than a corporate bond. bnymellonassetmanagement. The scale of institutional participation in the market for loans to sub-investment grade corporates in the US and Europe is comparable to that of the high yield bond market. However. the subject of private equity-sponsored leveraged buyouts (“LBOs”). In the US. At this point.Many have come to regard investment grade corporate bonds a new safe haven. so are easily accessible to large institutional investors and smaller asset managers. institutional investors. As a result. asset allocators face a yield deficit that needs to be made up. This is perhaps due to the fact that bonds can trade through a centralised clearing system. Lenders regularly have to respond to requests from borrowers for waivers to various terms of the loan documentation. as more money flows to this sector. have been slow to embrace loans as an asset class. In Europe. the majority of sub-investment grade borrowers are. many investors begin to consider the potential higher returns offered in the sub-investment grade market. The sub-investment grade market is very different. However. We believe this is indeed an asset class that provides transparency and liquidity. derivatives and advisory. They are based on a floating interest rate. When a company borrows from a bank. Most investors consider high yield bonds to be the only instrument available to them within the sub-investment grade corporate space. particularly in Europe. spreads are compressing. The banks aim to make up the difference by selling other services to the company like foreign exchange. private-equitybacked LBOs account for around half the market (Exhibit 2). loans settle through the physical execution of legal documents. so Euribor/Libor settings and terms need to be noted. Understanding Secured Bank Loans Unlike securities like corporate bonds. Banks are keen to lend to investment grade corporates and do so at interest rates typically lower than those available to the same company in the bond market. over the last 10 years the emergence of asset managers specialising in loan investment has made the asset class more accessible to less specialised investors. it typically does so via a loan.

Royal Bank of Scotland) example. 1200 bps in underwriting this sort of loan. TLC).” June 21. June 9. would in our opinion obtain sub-investment 6 ratings in the BB to B range.com Size ($bn) 1000 INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 800 5 . grade 4 June 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08 Dec 07 Jun 07 Dec 06 Jun 06 Dec 05 Jun 05 Dec 04 Borrowers represented in this market are generally substantial businesses with 2 annual earnings before interest. institutional investors usually will retain the loan as their investment.” June 30. chemicals. and bullet maturity term loans B and C (TLB. which are termed the “institutional tranches”. TLC). Generally banks participate across all the tranches while institutional investors focus on the TLB and TLC parts. broadcast media and manufacturing. an 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 amortising term loan A (TLA). A number of the larger banks (for 1600 bps 1400 bps JP Morgan. 2010. 0 bps typically consisting of a revolving credit facility. Cross-Border Bond Issue for Refi. Percentage (%) A public rating is generally not required to ensure a successful syndication of the 12 loan. 400 bps 200 bps 01/11 01/10 01/09 01/07 01/08 01/06 01/05 01/04 01/03 01/02 01/01 01/00 01/99 01/98 01/97 01/96 01/95 01/93 01/94 01/92 The loan is actually a collection of facilities ranking on an equal footing. However. Typically borrowers in this 8 market. Deutsche Bank. Whilst bank buyers may further syndicate 600 bps their position. In a typical deal. 2001. “Ineos Tagets Cov-Lite Loan. 2010.” November 3.BoA/ML Global High Yield Index BoA/ML Global Large Cap Corporate Index BoA/ML Global Sovereign Broad Market Plus Index Exhibit 2 – Sponsor Driven-Senior Loan Volume as Percentage of Total Volume 100% 90% 80% 70% 60% 50% The loan is actually a collection 40% 30% of facilities ranking on an equal 20% footing. cable. the loan may be publicly rated and and in many cases may have been privately rated. were they to be rated. the underwriting bank seeks to syndicate the loan to other 800 bps banks and to institutional investors. 3 1200 “J Crew Group Debt Weakens on 1Q Margin Compression.” Standard & Poor’s LCD News. bnymellonassetmanagement. Once the private equity firm wins the specialise 1000 bps bid for the company. Bank of America. typically consisting of 10% a revolving credit facility. telephony. then arrange an underwriting for a 1800 syndicated bank loan to finance the balance. taxation. Often they are substantially larger. 2011. Generally banks participate all the tranches while institutional investors HY Spreadacross to Worst Lev Loan Discount Margin (3-Year Life) focus on the TLB and TLC parts. Loan investors are comfortable forming their own view of the credit quality of the borrower through extensive due diligence. They are drawn from a diverse universe of industry sectors including healthcare. an amortising term loan A (TLA). and bullet maturity term loans B and C (TLB. depreciation and amortisation (“EBITDA”) in excess of US $50 million per annum and enterprise values of 0 over $200 million. in the US 10 in some cases in the European market. “Wrigley Plans High-Grade Bonds to Refi Bank Debt. European Market US Market Source: Standard & Poor’s LCD Leveraged Loan Review -US/Europe 1Q11. which are termed the “institutional tranches”. a private equity sponsor would put up between 30% and 2000 bps 70%bps of the purchase price of the business. retail. Well known examples ML Euro High (Total Return) S&P LSTA LLI (Total Return) of borrowers inYield this Index market would include Wrigley’s and J Crew in the US or 3 S&P ELLI (Total Return Excluding Currency) Alliance Boots and Ineos in Europe. “Alliance Boots Term Debt Holds Steady on 1H Results.

7%. between 1982 and 2010. which are generally unsecured and issued at the holding company level. This requires the borrower to be well known and have a business that is easily understood by a wide range of investors. each taking a larger slice of the loan. in contrast to bonds. Specifically.4 The higher recoveries and therefore lower risk in senior secured loans vs.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 6 . 4 “Corporate Defaults and Recovery Rates 1920–2010. if the borrower defaults. They will often be syndicated to a smaller group of investors. It also requires public disclosure of key financial information and typically a public rating. Typically this will be the case when a private equity sponsor is seeking financing for a new LBO.Secured Bank Loans Versus High Yield Bonds High yield bonds and leveraged loans are issued by very similar sorts of businesses. The more specialised nature of loan investors and the greater reliance on fundamental corporate analysis often means that in times of global market stress. Loans are different. bnymellonassetmanagement. there are some fundamental differences between the two forms of borrowing. We therefore look at the spread over the government yield curve for high yield bonds and the spread over Libor for loans. new issues can be more successfully placed in this market than in the high yield market. high yield bonds have traditionally been reflected in a differential between the credit spreads offered on loans when compared to that offered on bonds. The more specialised nature of loan investors and the greater reliance on fundamental corporate analysis often means that in times of global market stress. recoveries under the loan generally will be greater than recoveries under the high yield bond. The success of a high yield bond issue depends on the ability to build a large and diverse pool of investors. while recoveries on bonds have been between 30% and 50%. That is why leveraged loans are often referred to as “secured loans”. This gives lenders a much stronger claim on the assets of the business in the event of a default. new issues can be more successfully placed in this market than in the high yield market. Most high yield bond issuers will also have a bank loan in place.” Moody’s Investor Service. Higher recoveries As a direct consequence of their secured nature. but not all borrowers via bank loans will want to or be able to access the high yield bond market. Loan investors are used to performing more detailed due diligence on companies that are less well known and may have shorter operating track records. average global corporate debt recovery rates on first-lien bank loans were 65. which relies on building a much more diverse book of investors.8% while the comparable figure for senior unsecured bonds was 36. In order to compare credit spreads in the two asset classes it is necessary to adjust for the different duration of each instrument. Loans have the following characteristics that high yield bonds generally do not: Secured on the operating assets of the borrower Leveraged loans are secured on the assets of the operating company. February 2011. In addition to this. which relies on building a much more diverse book of investors. Typically loan recoveries have been between 50% and 100%.

this relationship has broken down and loans now offer a greater spread than bonds providing about 60bps more in credit spread.Market US Market Exhibit 3 – US High Yield and Leveraged Loan Spreads 2000 bps a greater effect on the price of the 1800 bps bond in the secondary market than 1400 bps they would on the loan. 50% since 40% the credit crisis. Credit Suisse. Part of 30% this 20%differential can perhaps be explained by a perception of lower liquidity in the loan 10% market than is achievable in the bond market but this does not fully explain the 0%yield gap. the differential can be much higher (Exhibit 3). The differen70% tial is volatile. Exhibit 4 illustrates the annual volatility of monthly 4 returns for the loan market and the high yield bond market. it follows that signs of potential stress will have Traditionally. June 30. but tends to be anything between 50 and 150 basis points (bps). 1000 bps 1600 bps 1200 bps 800 bps 600 bps 400 bps 200 bps HY Spread to Worst 01/11 01/10 01/09 01/07 01/08 01/05 01/06 01/04 01/03 01/02 01/01 01/99 01/00 01/98 01/97 01/96 01/95 01/94 01/93 01/92 0 bps Lev Loan Discount Margin (3-Year Life) Source: Markit Hub. Historical data suggest this is a powerful argument in favour of 1999 2000 2001attractive 2002 2003 2004 2005 2006 2007expected 2008 2009 2010 1Q11 loans offering a more return given their higher recovery rate when compared European to bonds. The loan of the market will therefore exhibit lower volatility in secondary market pricing than 6 the high yield bond market. bonds have offered higher credit spreads in compensation for the 80% greater risk of loss due to the unsecured nature of the instrument.com Market Size ($bn) 1000 800 600 INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 400 7 . 60% In specific periods. 2 ML Euro High Yield Index (Total Return) June 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08 Dec 07 Jun 07 Dec 06 Jun 06 Dec 05 Jun 05 Dec 04 0 S&P LSTA LLI (Total Return) S&P ELLI (Total Return Excluding Currency) 1200 bnymellonassetmanagement. 2011.100% 90% Since it is nearly always the case that a default results in a lower loss to the secured loan lender than will be experienced by the high yield bond investor. 10 it follows that signs of potential stress will have a greater effect on the price 8 bond in the secondary market than they would on the loan. Percentage (%) Lower secondary market price volatility 12 it is nearly always the case that a default results in a lower loss to the Since secured loan lender than will be experienced by the high yield bond investor. However.

bnymellonassetmanagement. Since they have a higher duration. with a possibility of eventual interest rate hikes in the US and Europe. 0 who is trying match2003 longer-dated liabilities. contributing to the greater volatility of bonds vs. We believe this feature of loans is of particular value in the current market where expectations of a rise in global inflation are high and the current level of interest rates low. 2011. so investors are restricted to trading on the basis of publicly available information and are denied unrestricted access to management and their projections. 200 The long duration of the bond is of value to an investor. 1200 Market Size ($bn) Floating rate asset class 1000 Loans typically pay a floating rate of interest made up of a Libor or Euribor 800 base rate. LCD Euro Secondary Report. If interest rates rise. The lender receives monthly management accounting from the borrower detailing current trading. The loan investor is also likely to benefit from a higher Libor/Euribor reset on the next coupon roll date. plus an additional margin to compensate for credit risk. the secondary market price of the bond generally will fall by much more than that of a loan in the same situation. Access to private. 2007 2008 1Q 2011 bonds over loans also makes them more price-sensitive to movements in the US Institutional Leveraged Loans US High Yield yield curve. June 16. like a pension fund. Bonds are public.01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ 01/ HY Spread to Worst Lev Loan Discount Margin (3-Year Life) Exhibit 4 – High Yield. bonds will generally pay a higher coupon than loans. revenues and expenses. Dec 06 2 Dec 04 Euribor base rate. monthly. 600 The credit spread is built into the fixed rate as a margin over a government bond 400of a similar maturity. US Loan And European Loan Volatility 12 6 ML Euro High Yield Index (Total Return) June 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08 Dec 07 0 Jun 07 margin to compensate for credit risk. Bonds. please see appendix for index definitions. loans are private instruments and in the US a large proportion of the market is private. management accounts In Europe.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 8 . the 2009 longer2010 duration of 2001 to2002 2004 2005 2006 However. plus an additional Jun 06 4 Dec 05 of interest made up of a Libor or 8 Jun 05 Loans typically pay a floating rate Percentage (%) 10 S&P LSTA LLI (Total Return) S&P ELLI (Total Return Excluding Currency) Source: Standard & Poor’s. loans as demonstrated in Exhibit 4. by contrast. are typically fixed rate instruments with a maturity of 7 to 10 years. when the yield curve is positive.

This has been used to great advantage over the last year by senior lenders to reset the lending margins from pre-crisis levels of 200 to 250bps to post-crisis levels of 400 to 500bps. senior lenders may decide to enforce their security and take control of the borrower. Investors need to review the intercreditor agreement in detail in each case to determine if the expected recovery on a senior secured bond will indeed be similar to that on a senior secured loan. senior secured bonds are a very different instrument as they typically do not incorporate maintenance covenants. amongst other things. Loan documents generally contain covenants that. However. Loan documents generally contain covenants that. These are covenant-lite loans. the high yield bond market sought to imitate the security advantage of secured loans and there have now been many instances of the issuance of senior secured bonds which share in the same security pool as the senior secured lenders. If a borrower knows that he risks breaching a covenant. and if they are breached. More protective covenants Both loan and bond documentation contains restrictive covenants. Covenant-lite loans Not all loans contain sufficiently tight covenants and some do not include maintenance covenants at all. There is also no standard wording for the intercreditor agreement which sets out how. Borrowers argue that defaults are less likely under a covenant lite loan. it is perhaps not surprising that hybrid instruments have evolved. limit the ratio of debt to earnings and require a minimum level of interest coverage to be maintained (“maintenance covenants”). the security pool is split between the senior lenders and the senior bond holders. mixing and matching various features of the two markets. Covenant-lite loans have never gained hold in the European markets. limit the ratio of debt to earnings and require a minimum level of interest coverage to be maintained (“maintenance covenants”). Bond covenants usually are not tested on a regular basis but instead are reviewed only when the borrower plans to take on new debt or pay an equity dividend.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 9 . Lenders argue that the presence of covenants allow them bnymellonassetmanagement. and they may have very similar recovery characteristics to senior secured high yield bonds. since defaults are often triggered by the breaching of a covenant. he must seek a waiver from the lenders and will most likely be asked for a fee or wider loan margin in return. Hybrid products Given the link between typical borrowers in the loan and high yield bond markets. Senior secured bonds and floating rate notes During 2010. These covenants are typically tested quarterly. amongst other things. senior lenders may decide to enforce their security and take control of the borrower. These covenants are typically tested quarterly. but have been issued extensively in the US. This key difference between bonds and loans allows loan investors a much greater ability to dictate the terms of their agreement on an ongoing basis.A loan investor typically has access to more detailed information on a more timely basis than a high yield bond investor and should therefore be able to make more informed investment decisions. in the event of default. and if they are breached.

bnymellonassetmanagement. senior lenders rarely seek to take control of the business through enforcing their security. They may not have access to the same level of information as the senior lender and may not enjoy as much influence over the final restructuring outcome. Once a potential covenant breach is identified. based again on access to material. Investors in distressed debt are an exception to this trend. forcing out the equity investors. They rank lower than the junior secured lenders when it comes to allocating residual value in the business following default and take whatever is left after secured lenders have been fully repaid. High levels of issuance of covenant lite loans are generally a signal that a market is becoming overheated with an excess of investor demand over new issue supply. Hopefully this prevents default. Nor do they have timely access to the information that would lead them to conclude that a senior debt covenant has been breached. So the rights of senior lenders are typically used to pressure the equity sponsors to address shortfalls in business performance. Bond holders are typically unsecured and do not have this right. Through the security package. but if default is inevitable the early action may well help to maximise recovery. With access to this information. The power the senior lender holds results from the ultimate sanctions they can use if a covenant is breached and remains unresolved. the senior lenders typically form a restructuring committee to communicate with the borrower and its equity sponsors. senior lenders may seize ownership of the operating assets of the company. They are likely to have a great deal of experience taking a company in and out of bankruptcy and may well exercise their rights specifically to take control of the business.to take action earlier upon evidence of a slowdown in trading. The value of private information The access a lender has to private information on the borrower is very important to the credit process. can assemble the senior lending group to approach the company and its private equity sponsors and require them to take action to address the situation. can submit its own plans for acceptance by the majority of senior lenders and can approach alternative providers of capital to the business if the existing owners show reluctance to propose a solution. Through the security package. the lender can monitor compliance with the loan covenants and if there is a risk that a covenant may be breached. They are unlikely to have the specialised skills required to run the business. non-public information. Restructuring process In practice. They can request an independent business review. senior lenders may seize ownership of the operating assets of the company. forcing out the equity investors. credit analysts can form a clearer view of how a company is trading. Perhaps more importantly. Ultimately the senior lenders vote on the approach to adopt. The power the senior lender holds results from the ultimate sanctions they can use if a covenant is breached and remains unresolved. The committee can hear plans for restructuring put forward by the business. This is in contrast to an investor in a high yield bond issued by the same company.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 10 .

the bond market is larger than the institutional loan market. 2009 and April 4.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 11 . but significant issuance during 2006 to 2008 brought loan market outstandings close to those of the bond market. The senior lenders formed a steering committee. but retaining the bulk of the equity in the business. Following a sharp decline in earnings. so avoiding the weaker recovery that would have resulted had they accepted the original offer from private equity. Dometic breached the debt/EBITDA covenant in its loan documentation in late 2008. the company was approached regarding the potential sale of the business. engaged a third party advisor to perform market and financial due diligence. Sale proceeds allowed the senior lending group to achieve a full recovery on their original amount lent to the company. so rejected the sponsors proposal and instead took control of the company themselves. taking a small write down. Figures for the loan market include only the institutional tranches. which are those held by nonbank investors and traded freely between holders in the secondary market.In the US. Following a competitive bidding process. Negotiations with the equity sponsors resulted in final proposals which required the senior lending group to take a substantial write down on their loans without sufficient compensation through residual equity ownership. then prepared three different strategies for restructuring the business. LCD News. Evolution of the Secured Bank Loan Market Exhibit 5 and Exhibit 6 show the evolution of the secured bank loan market and the high yield bond market since 2001 in the US and in Europe. but significant issuance during 2006 to 2008 brought loan market outstandings close to those of the bond market. The third required the senior lenders to take control of the business themselves through exercising their security and providing additional short term funding. 5 Standard & Poor’s. The group considered the company was experiencing a cyclical downturn in earnings and that there was a strong chance of recovery. bnymellonassetmanagement. either from the incumbent sponsor or from an alternative sponsor. Dometic. the company was sold. Two strategies involved additional equity injections. the bond market is larger than the institutional loan market. Restructuring case study: Dometic In 2008 senior lenders used the power offered to them through the presence of a strong covenant package to take control of the Swedish white goods manufacturer. Senior lenders then restructured their exposure. May 20. 2011. Earnings recovered through 2010 and early in 2011. In the US.5 This is a good example of the power of covenants and also an example of a situation in which the senior lenders ultimately exercised the rights conferred to them through the loan documentation to take control of the company.

high yield bonds In the immediate aftermath of the financial crisis.12 10 Percentage (%) In Europe. 2 ML Euro High Yield Index (Total Return) the US and Europe. which is that the bond market is deeper and more liquid 4 than the loan market. 2011 450 400 bnymellonassetmanagement. This contradicts conventional wisdom in Europe. Dec 04 In the immediate aftermath of the S&P LSTA LLI (Total Return) S&P ELLI (Total Return Excluding Currency) Exhibit 5 – Evolution of US High Yield and Loan Market 1200 Market Size ($bn) 1000 800 600 400 200 0 2001 US High Yield 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q 2011 US Institutional Leveraged Loans Source: Credit Suisse Leveraged Finance Strategy Update. June 1. June 11 Dec 10 Jun 10 Dec 09 Jun 09 Dec 08 Jun 08 Dec 07 Jun 07 Dec 06 Jun 06 Dec 05 dominated new issuance in both Jun 05 financial crisis. loan issuance during this same period took loan market outstandings 8 from a level well below that of the bond market between 2001 and 2004 to parity in 2005 and then to a point where loan outstandings substantially 6 exceeded those of the high yield bond market. In Europe this means that the two markets are now broadly similar in size.com suance ($bn) 350 300 250 INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 200 150 12 . and loan outstandings in the US are about 60% of those of the bond market. high yield bonds dominated 0 new issuance in both the US and Europe (as will be discussed later). 2011 Exhibit 6 – Evolution of European High Yield and Loan Market 250 200 Market Size (€bn) Jan 2011 Jan 2010 Jan 2009 Jan 2008 150 100 50 0 Global Large Cap Corporate Index 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q 2011 Western European High Yield Western European Leveraged Loans ex Source: Credit Suisse Leveraged Finance Strategy Update. June 1.

but also retained large proportions of the deals they arranged.0x longest possible maturity date in the underlying portfolio. 1. LCD USD Leveraged Loan Review – US/Europe 1Q11 7. Following the introduction of the euro. but a number of banks emerged to dominate the leveraged finance scene. it became market practice for a US borrower to obtain a public rating when borrowing through the loan market. which allowed the CLO liabilities themselves to be pubWestern European Leveraged Loans Western European High Yield licly rated. making banks the dominant participants in the market. In their place. the concept of a “European loan market” is a fairly new one and was impossible to contemplate prior to the introduction of the euro in 1999. As 150 a by-product of this. the market was dominated by local banks lending in their local currencies to leveraged buy-outs (LBOs) in their region. Global Large Cap Corporate Index ex Market Size (€bn) While the US leveraged loan While the US leveraged loan market has been well established for several decades. Exhibit 7 – New Issue Volume in US and European CLO Market 450 400 Issuance ($bn) 350 300 250 200 150 100 50 0 5 2006 2007 2008 2009 2010 1Q11 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q 2011 European CLO Issuance European Loan Issuance US CLO Issuance US Loan Issuance Source: Standard &Poor’s. in this case private equity deal sponsors resisted the call for public ratings on loans.0x to CLOs because they provided cheap. the concept of a “European loan market” is a fairly new one and was impossible to contemplate prior to the Jan 2011 Jan 2010 Jan 2009 Jan 2008 introduction of the euro in 1999. predominantly insurance companies and mutual funds. However. avoiding refinancing risk 2. arranging deals.0x bnymellonassetmanagement. 100 In Europe. These banks made a business out of originating and syndicating leveraged loans.0x and locking in an attractive arbitrage. but then selling them on to 200 institutional investors.market has been well established for several decades. This 250 was in marked contrast to the US.0x CLOs are closed-end structures that match the term of the financing to the 3.0x 4.com Margin (3-Year Life) Europe 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 US INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 13 . CLOs obtained 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q 2011 private shadow ratings.0x Institutional investors in the leveraged loan market were increasingly drawn 6. non-recourse leverage with potential annual percentage returns in the high teens.0x 01/11 01/10 01/09 01/07 01/08 01/05 01/06 01/04 01/03 01/02 0. where banks had long since been disintermediated from the process. They require investors to commit to holding their investment to maturity (often up to 12 to 15 years). this situation persisted. while enabling the underlying loans to maintain their private status. Before. 5. institutional involvement in the loan market only started to become significant once the appetite for collateralised loan obligations (CLOs) grew 50 between 2003 and 2007 (Exhibit 7).

with an advance rate based on the mark-to-market value of the loans. seeking the high potential returns achievable via a leveraged investment in the asset class. p. buoyed up by 100resilient demand driven by investors who were relying on leverage to drive50their returns rather than relying on informed credit selection.0x 2.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 100 14 . Western European Leveraged Loans Western European High Yield banks account for an even smaller share of the primary loan market. financed largely European throughLoan shortterm retail andIssuance wholesaleUS funding. hedge funds Jan 2011 Jan 2010 Jan 2009 Jan 2008 entered the market. 4Q09. Issuance ($bn) Popularity of CLOs increased loan demand.5% of the demand 50 for primary syndication during 2007. as we will discuss later. In Europe.0x 01/11 01/10 01/09 01/08 01/07 01/05 01/06 01/03 01/04 01/02 0.0x 3.0x 6. The amount of debt senior lenders were prepared to 350 offer increased (Exhibit 8). 136. Issuance US CLO Loan Issuance European CLO Issuance Exhibit 8 – Average Debt/EBITDA in US & Europe Market 7. spreads narrowed from an average of 300 bps over 300 Libor to close to 200 bps and in some cases covenant protection was signifi250 cantly weakened. the demand for loans increased.0x 4. hedge funds entered the market. seeking the high potential returns achievable via a leveraged investment in the L Global Large Cap Corporate Index asset class. eventually accounting for 56. weakened terms As 450 more investor money flowed into CLOs and credit hedge funds. typically less than 10% of primary volume.4% (the difference accounted for by securities firms). 100 CLOs and institutional investors assumed an increasingly larger proportion of European loan new issuance.0x 5. ex Market Size (€bn) As loans gained acceptance among As loans gained acceptance among institutional investors.0x Margin (3-Year Life) Europe 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 US Source: Standard & Poor’s LCD Leveraged Loan Review – US/Europe 1Q11 6 Standard & Poors. 6 In the US. so instead they financed their investment in loans through mark-to-market financing 200 lines. LCD European Leveraged Loan Review.institutional investors. This resulted in a weakening of deal structures 400 between 2006 and 2007. reducing the banks’ share of the market to 36. the situation was exacerbated because Icelandic banks were aggressively 0 1999 2000 2001 sheets 2002 2003 2005significant 2006 2007exposure 2008 2009 2010loan 1Q 2011 expanding their balance and 2004 building to the market. 5 2006 2007 2008 2009 2010 1Q11 200 The150 quality of loans on offer was reduced. 110 bnymellonassetmanagement. where 0 2001 institutional 2002 2003 loan 2004 2005developed 2006 2007 2008 2009 2010 1Q 2011 the non-bank market much earlier than in Europe.0x 1. The150 consequences of this strategy were to have a significant impact on the market. the liquidity requirements of hedge 250 funds prevented them from participating in closed-end structures. However. but underwriting continued.

0x margin lines with their prime brokers. The collapse of ing one 6. When the sub-prime market collapsed. rapid unwinding of leverage and a precipitous price drop This100 was the situation as the credit crisis began in the middle of 2007. Both positions were financed through 4. but it also had a 5. so loans took a lot of the selling pressure. The fund had built up a very successful track record investing in US sub-prime mortgages. The meltdown in the sub-prime market and bank balance sheets bloated with 50 loans caused a significant sell-off in July and August 2007.0x triggering the unwinding of more leverage supporting other players in the turn 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 market. As this situ1. Loans were the more liquid and 2.0x sell whatever assets it could to raise liquidity. setting off an unprecedented fall in loan prices.0x valuable of their assets.com 06 2007 2008 2009 2010 1Q 2011 US (S&P LSTA Leveraged Loan Index) Sep-02 Dec 10 Jun 10 Dec 09 Jun 09 60 S&P LSTA LLI (Total Return) ns This sell-off persisted and was accelerated by banks that had provided financ7.0x ation was repeated around the market. collateral backing the margin lines was called in and the fund was forced to 3. These loans remained trapped on bank balance sheets. It was not directly related to E/L +1200 weakness in the underlying borrowers.0x significant portfolio of leveraged loans. in 0.0x particular hedge fund typified the problems. the price of loans fell precipitously. The closing of the 0 1999 2000 2001 2002the 2003 2004 2005 2006 2007 2008 2009 2010 1Q 2011 securitisation market halted issuance of new CLOs and instantly removed a European large part ofIssuance the anticipated demand for underwritten loans awaiting US CLO Issuance US LoansyndiIssuance European Loan Issuance CLO cation. These loans remained 01/11 01/10 01/09 01/08 01/07 01/06 01/05 01/03 trapped on bank balance sheets. Basis Points 01/02 5 2006 2007 2008 2009 2010 1Q11 300 15 . Finally the collapse of some smaller US banks and the Icelandic banks US Europe released more loans onto the market. as illustrated in Exhibit 9. please see appendix for index definitions E/L +1800 E/L +1600 Thus the collapse in loan prices during 2008 was triggered by an unwinding of E/L +1400 the excessive leverage applied to this asset class. Exhibit 9 – Secondary Loan Weighted Average Bids Dec 08 Jun 08 t Margin (3-Year Life) 250 200 Credit 150 crisis. 01/04 110 Price (%) 100 90 80 70 50 Dec02 Sep03 Jun04 Mar05 Dec05 Sep06 Jun07 Mar08 Dec08 Sep09 Jun10 Mar11 June 11 Europe (S&P European Leveraged Loan Index) Source: Standard & Poor’s. E/L +1000 E/L +800 E/L +600 E/L +400 E/L +200 Europe US Mar-11 Sep-10 Mar-10 Sep-09 Sep-08 INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS Mar-09 Mar-08 Sep-07 Sep-06 Mar-07 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 E/L +0 Mar-03 bnymellonassetmanagement.0xto hedge funds calling in margin as market values declined. LCD Leveraged Loan Review – US/Europe 1Q11.Issuance ($bn) 350 The closing of the securitisation market halted the issuance of new CLOs and instantly removed a large part of the anticipated demand for underwritten loans awaiting syndication.

The auto manufacturing sector. This2001 had 2002 a knock-on effect2005 on all2006 of their and2010 related 1999 2000 2003 2004 2007suppliers 2008 2009 1Q11 industries. LCD Leveraged Loan Review – US/Europe 1Q11 bnymellonassetmanagement. was severely affected and dramatically 1. amongst others. amongst others.0x was restricted.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 16 . global demand was impacted by the credit crisis. As 60 investors sought to take advantage of this unprecedented yield opportunity for secured assets.0x reined back production as consumer access to finance for new car purchases 0. at their lows. was severely affected and dramatically reined back production as consumer access to finance for June 11 Dec 10 Jun 10 Dec 09 Jun 09 new car purchases was restricted.0x 01/04 01/02 5. 100 prices had far overshot the price level that fairly represented the level of stress 90 underlying borrowers and the likely recovery in any default. global demand was impacted by the credit crisis.0x During 2009. against this backdrop. Price (%) 01/11 01/10 01/09 01/08 01/07 01/06 01/05 01/03 3. and the number of leveraged borrowers forced back to the negotiating table with their senior lenders increased. providing evidence that the sell-off in 2008 and early 2009 had been driven by the unwinding of leverage and an indication that. Earnings in auto-related businesses started to show signs of weakUS Europe ness. in the S&P80data on yields achievable on flow names traded in the secondary market 70 show spread yields peaking in Europe at more than 16% over Euribor in February 2009 and in the US at more than 12% over Libor in March 2009.00% (Exhibit 10). Dec02 Sep03 Jun04 Mar05 Dec05 Sep06 Jun07 Mar08 Dec08 Sep09 Jun10 Mar11 US (S&P LSTA Leveraged Loan Index) Europe (S&P European Leveraged Loan Index) Exhibit 10 – Average Spread Yield for Flow Names E/L +1800 E/L +1600 Basis Points E/L +1400 E/L +1200 E/L +1000 E/L +800 E/L +600 E/L +400 E/L +200 ns Europe Mar-11 Sep-10 Mar-10 Sep-09 Sep-08 Mar-09 Mar-08 Sep-07 Sep-06 Mar-07 Mar-06 Sep-05 Mar-05 Sep-04 Mar-04 Sep-03 06 2007 2008 2009 2010 1Q 2011 Mar-03 E/L +0 Sep-02 Dec 08 Jun 08 t Margin (3-Year Life) 2.0x US Source: Standard & Poor’s. loan prices enjoyed the strongest rally ever 110 witnessed. This scenario played out in other troubled industry sectors such as building materials and chemicals.0x During 2009.4. The auto manufacturing sector. secondary pricing rallied and by the end of 2009 spread yields 50 in Europe and the US had fallen back to around 5. S&P LSTA LLI (Total Return) However.

the yields on offer to buyers of loans in the secondary market far exceeded the levels any but the most desperate of borrowers were willing to pay on new financing. 2Q02 004 2005 2006 2007 2008 2009 2010 1Q 2011 E/L +550 However. Development of the new issue market was hampered by two factors. the loan market has recently staged a significant recovery. LCD Leveraged Loan Review – US/Europe 1Q11 Market Outlook E/L +1600 Basis Points With leveraged investors removed from the system for all practical purE/Lthe +1400 poses. E/L +400 E/L +200 US CLO Issuance US Loan Issuance 4Q10 1Q11 2Q10 4Q09 2Q09 4Q08 2Q08 4Q07 2Q07 4Q06 2Q06 2Q05 4Q05 4Q04 2Q04 2Q03 4Q03 4Q02 Recovery in loan new issue volumes E/L +0 As a result of the removal of CLOs as purchasers of potential primary loan supply. This led to a sharp reduction in primary loan issuance during 2008 and 2009 (Exhibit 11). Exhibit 11 – Global Leveraged Loan Volume 600 responded much more slowly. the primary market responded much more slowly. Initially. Consequently. The highUS yield bond market does not New Issue Institutional Spread New Issue Institutional Spread rely on structured credit funds or levered investors as a source of capital. but with primary markets offering wide spreads and stronger deal structures. so European Flow Name Secondary Spread Yield US Flow Name Secondary Spread Yield arrangers were more confident that underwritten deals could be successfully placed in this market. 500 ($bn) 400 200 100 0 05 2006 2007 2008 2009 2010 1Q 2011 n European Leveraged Loans 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 US Market European Market Source: Standard & Poor’s. Three facE/L +500 torsE/L have contributed to the recovery in primary loan market volumes: +450 bnymellonassetmanagement. The gains in E/L +1000 secondary E/L +800market prices in 2009 are unlikely to be repeated.While secondary market prices recovered rapidly in 2009 as institutional investors took advantage of the opportunity to buy secured loans at unprecedented yields. a repeat of the precipitous fall in loan prices witnessed in 2008 and E/L +1200 2009 is very unlikely. because the loan market had become so dependent on CLOs and new issuance of these vehicles failed to restart. But more importantly. much of the natural investor base for loans had been removed from the market. we believe the E/L +600 loan market offers the potential for attractive opportunities.com Basis Points ssuance 300 E/L +400 E/L +350 INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS E/L +300 E/L +250 17 . highly levered companies and arranging banks switched to the high yieldEuropean bond market to raise new capital. high yield bonds initially dominated postcrisis issuance. the primary market Post-crisis recovery in new issuance While secondary market prices recovered rapidly in 2009 as institutional investors took advantage of the opportunity to buy secured loans at unprecedented yields. even if corporate earnings remain subdued.

tional investors who had been supporting the high yield bond market to consider the impact of higher interest rates on their fixed rate bond portfolios.” Standard & Poor’s LCD News. As discussed earlier. 2000 May 2001 Purchase.S. but from existing CLOs. 2010. which received high E/L +1000 2Q04 of new CLO issuance. October 21. further encouraging investors to switch out 25% of bonds into floating rate loans. LCD Leveraged Loan Review – US/Europe 1Q11 1Q11 1Q10 1Q09 1Q08 1Q07 1Q06 1Q05 1Q04 1Q03 1Q02 1Q01 1Q00 1Q99 1Q97 004 2005 2006 2007 2008 2009 2010 1Q11 1Q98 Basis Points E/L +550 the capital committed to the secondary market by CLO vehicles Interestingly. 2011. 20% 15% 10% Sep06 Jun07 Mar08 Dec08 Sep09 Jun10 Mar11 Europe (S&P European Leveraged Loan Index) bnymellonassetmanagement.” Standard & Poor’s LCD News. December 13. wasE/L available +500 not as a result of new CLO issuance. 4Q10 1Q11 2Q10 4Q09 2Q09 4Q08 2Q08 4Q07 2Q07 4Q06 2Q06 4Q05 their outstanding loan positions 004 2005 2006 2007 2008 2009 2010 1Q 2011 2Q05 2Q02 E/L +0 4Q04 existing CLOs. up secondary down US Market toEuropean levels atMarket which the primary market is again able to compete (Exhibit 12).pressures (LIBOR+) in Europe and the US have forced instituSecondly. but from Basis Points to the secondary market by CLO 4Q03 Interestingly. “Polymer 0% to Yule Catto.125%. “Takeda Completes Nycomed Latex Sold 1999 Times. Significant repayments during this period E/L +350 came from Virgin Media and Casema (Ziggo).” Financial 19. who refinanced their loans E/L +300 through the issuance of high yield bonds and from sales of highly levered E/L +250 sponsor owned businesses to trade buyers who financed the purchase on their E/L +200 own balance sheets at much lower levels of leverage (for example Polymer E/Land +150the more recent acquisition of Nycomed by Takeda). February 25. which received high levels of repayments from borrowers who had successE/L +450 fullyE/Lrefinanced their outstanding loan positions through the issuance of high +400 yield bonds or through trade sales. capital has been committed by opportunistic investors and CLOs to the 0 2001pushing 2002 2003 2004 2005prices 2006 and 2007dragging 2008 2009 2010yields 1Q11 secondary1999 loan2000 market.7 Latex Inflation pressure and relative value favours floating rate assets Europe growing (Euribor +)inflationary U. Some have now started to shift their attention to the floating rate. loans offer a higher level of 35% than high yield bonds. 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 European US INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 18 . European New Issue Institutional Spread US New Issue Institutional Spread European Flow Name Secondary Spread Yield US Flow Name Secondary Spread Yield Source: Standard & Poor’s. “Ziggo Notes Price at Par to Yield 6.com 7 “Virgin 5% Media to Pay Down More of TLB After Issue Upsized. 2010. yet also currently offer a greater credit spread security 30% premium (as illustrated in Exhibit 3). 50% Equity Percent of Total This45% trend has been supported by the higher relative value of loans when 40% compared to high yield bonds.” Standard & Poor’s LCD News. secured loan market. the capital committed Exhibit 12 – Yield Spreads of European & US Flow Names & New Issues 2Q03 n European Leveraged Loans 4Q02 05 2006 2007 2008 2009 2010 1Q 2011 Secondary yields fall to levels where primary can compete First.($b 300 200 100 E/L +1600 E/L +1400 vehicles was available not as a result E/L +1200 E/L +800 E/L +600 E/L +400 levels of repayments from borrowers E/L +200 who had successfully refinanced ssuance through the issuance of high yield US CLO Issuance US Loan Issuance bonds or through trade sales. 2002 2011.

9 “Sponsored Transactions Maintain Upward Trajectory. Strengthening in New Issue Terms Wider new issue spreads New issue loan spreads in the US and Europe have tightened from their 2010 levels during the first quarter of 2011. Private equity make new investments that require financing Thirdly.7bn of new institutional issuance. In the US the new-issue market saw the highest volume since the second quarter of 2007 at $103.9bn of issuance in the high yield bond market.10 We believe that demand for new financing will continue and that it will remain evenly split between the loan and bond markets. One example of a high yield deal that was recently pulled due to adverse conditions was Spotless.4bn worth of deals globally – an increase of more than half from the same period of 2010. but when initial sounding failed to get positive traction the deal was reattempted as a high yield bond. June 29. increasing the demand for new financing over and above that required for the refinancing of already outstanding debt.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 19 . In contrast. “Busy Year for Private Equity as Debt Markets Bounce Back. The Spotless financing was originally pitched to the loan market. June 29. arranging banks have become more confident that they will be able to successfully syndicate underwritten loan deals. private equity firms have begun to commit capital to new leveraged buyouts. 1Q11. However. 8 Daniel Schafer.9 That evens out the balance of loan issuance versus high yield bond issuance for the year at 47% market share for loans and 53% for bonds. an aggressively levered deal financing a dividend to the equity sponsor. but also by the weaker performance of recent new issues of high yield bonds in the light of heightened levels of global risk. bnymellonassetmanagement.With growth in the loan investor base. 2011. but remain significantly wider than the average spread prior to the financial crisis (Exhibit 13).” Financial Times. 10 LCD Global Loan Stats. According to a recent article in the Financial Times. recent increases in global perceptions of risk have slowed appetite for new issue high yield bonds and the deal was shelved. their confidence in fully placing underwritten bond deals has been shaken by the shift to loans. 2011.” LCD (EUR) Topical. quoting data from Mergermarket.” 8 The combined result of all these factors is that secured loan issuance to support LBOs in Europe in June 2011 reached €4bn against just €1. “the first six months of 2011 have been the busiest for private equity in three years with financial investors backing $131.

0x 0. level 4.0x US European 2. 35% 30% Equity Percent of Total Europe (S&P European Leveraged Loan Index) 50% 15% 45% 10% 40% 5% 35% 0% 30% 25% European 20% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 US 15% 10% 5% 6. just fractionally higher than was typical US New Issue Institutional Spread E/L +350 Equity contributed to new buyouts 004 2005 2006 2007 2008 2009 2010 1Q11 2Q03 E/L +500 European New Issue Institutional Spread E/L +450 European Flow Name Secondary Spread Yield E/L +400 1Q97 US CLO Issuance ssuance 4Q02 04 2005 2006 2007 2008 2009 2010 1Q 2011 2Q02 E/L +550 4Q09 E/L +200 Exhibit E/L13+0– Weighted Average New-Issue Institutional Spreads 0.9x versus 5.S. At the end of Q1 2011.0x was 3.2x in 2007 (Exhibit 15). E/L +350 1Q98 In Europe it has remained close to Basis Points in the boom years of 2006 to 2007. LCD Leveraged Loan Review – US/Europe 1Q11 Source: Standard 1Q97 04 2005 2006 2007 2008 2009 2010 1Q11 E/L +300(Euribor +) Europe 1Q99 historical highs at around 45%.0x peak of the market in 2007. average pro forma senior 2. 1Q98 E/L +300 E/L +550 E/L +250 E/L +500 E/L +200 E/L +450 E/L +150 E/L +400 has fallen to 35% in the US.0x Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 Sep-06 Mar-07 1.S. In Europe the Q1 2011 5.4x in 2007.0x Leverage as a function of EBITDA has also fallen from the levels seen at the 6. In Europe it has higher 40% (Euribor Europe U.0x debt/EBITDA in the US was 4.0x 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 European bnymellonassetmanagement. LCD Leveraged Loan Review – US/Europe 1Q11 Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 Mar-07 Sep-06 Mar-06 3.0x 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 Sep06 Jun07 Mar08 Dec08 Sep09 Jun10 Mar11 Europe (S&P European Leveraged Loan Index) 5. (LIBOR+) Exhibit 25%14 – Average Contributed Equity 20% Sep06 Jun07 Mar08 Dec08 Sep09 Jun10 Mar11 Sep-05 US Flow Name Secondary Spread Yield E/L +250& Poor’s. just fractionally Equity 45%than was typical in the boom years of 2006 to 2007.US Loan Issuance B US CLO Issuance ssuance European E/L +600 New Issue Institutional Spread US New Issue Institutional Spread European E/L +400 Flow Name Secondary Spread Yield US Flow Name Secondary Spread Yield Basis Points US Loan Issuance 4Q10 1Q11 2Q10 2Q09 4Q08 2Q08 2Q07 4Q07 4Q06 2Q06 4Q05 2Q05 4Q04 2Q04 4Q03 1Q11 1Q10 1Q09 1Q08 1Q07 1Q06 1Q05 1Q04 1Q03 1Q02 1Q01 1Q00 1Q99 E/L +200 Equity Percent of Total 1Q11 1Q10 1Q09 1Q08 1Q07 1Q06 1Q05 1Q04 1Q03 1Q02 1Q01 1Q00 Lower and larger equity contributions from sponsors E/L leverage +150 50%contributed to new buyouts has fallen to 35% in the US.com US INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 20 .0x 1.0x European US Source: 4.0x Mar-06 Sep-05 U.2x versus 4.0x 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 3.0x Standard & Poor’s. (LIBOR+) remained close to+)historical highs at around 45% (Exhibit 14).

April 14.0x 5.0x 3.13 11 Standard & Poor’s. 2. the leading players in the market have maintained more control. In Europe. 13 Standard & Poor’s. As a result the size of the European offering was reduced. 2011. bnymellonassetmanagement. retail funds do not represent such a significant force in the market. maintaining the yield differential between the US and European offerings. but many of the European lenders chose instead to redeem. June 13.0x 1. LCD News. One example of the better reception of more aggressive deals in the US vs. pushing back arranger proposals for tighter spreads and more aggressive deal structures.11 Having initially come to the market in late 2010 with a TLB priced at Libor+450 (Libor+475 for the European tranche). 2011.0x 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 European US Source: Standard & Poor’s.0x 0.0x The impact of higher inflows into Mar-11 Sep-10 Mar-10 Sep-09 Mar-09 Sep-08 Mar-08 Sep-07 significant in the US market where Mar-07 Sep-06 the loan market has been most Mar-06 Sep-05 Europe (S&P European Leveraged Loan Index) large retail inflows into loan mutual funds have boosted liquidity and increased competition for assets.0x 4.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 21 . LCD Leveraged Loan Review – US/Europe 1Q11 But Europe offers better relative value than the US The impact of higher inflows into the loan market has been most significant in the US market where large retail inflows into loan mutual funds have boosted liquidity and increased competition for assets. they returned to the market in 2011 tightening the spread to Libor+300 on the USD tranche. 12 Standard & Poor’s. This has encouraged arrangers to push spreads tighter and allowed some more aggressive deal structures to be successfully placed. earn the call premium and re-invest elsewhere rather than face the reduction in spread income. LCD News. LCD News. so while there have been significant inflows. May 11 and 14.12 European investors again demonstrated their ability to push back on more aggressive amendments from Elior. and Trader Media who did manage to get their amendment through. The European tranche was priced at Libor+325. The Spotless deal provides an example of a deal that was deemed too aggressive for the European loan market due to high leverage. 2011. This has encouraged arrangers to push spreads tighter and allowed some more aggressive deal structures to be successfully placed.European US Exhibit 15 – Average Pro Forma Senior Debt/EBITDA 6. who were looking to extend their existing facility without providing a sufficient margin increase – the amendment was withdrawn. Europe is the cross border deal for Burger King which was allocated earlier in the year. but only after revising the uplift in margin originally proposed.

In addition. they would be of less value in Europe in any case.com 40 bps INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 20 bps 22 . Taking all of this into 6 account. This is offset to some degree by the availability of Libor floors in the US. is significantly higher than the historical average level of closer to 50bps (Exhibit 17). is significantly higher than the historical average level of closer to 50bps. 005 2006 2007 2008 2009 2010 1Q11 Percentage (%) marginally higher in Europe as 4 3 2 16 – Libor 3-Month Forward Rates & Implied All-In Coupons Exhibit Percentage (%) Risks adjusted returns are also Higher Libor and forward curve in Europe US new issue spreads are now slightly below 400bps. However. 2011 US New Issue Institutional Spread US Flow Name Secondary Spread Yield Risks adjusted returns are also marginally higher in Europe as indicated by the spread per unit of leverage. floating interest rates and the forward Libor curve are higher in Europe vs. but given the higher level of interest 7 rates. However. the main trend that emerges from analysis of this parameter is that spread per unit of leverage in both the US and Europe at about 90 bps per turn of leverage. LCD Leveraged Loan Review – US/Europe 1Q11 80 bps 60 bps bnymellonassetmanagement. 4Q10 1Q11 2Q10 4Q09 2Q09 4Q08 2Q08 4Q07 2Q07 160 bps 140 bps US New Issue Institutional Spread 120 bps US Flow Name Secondary Spread Yield 100 bps 80 bps 1Q11 1Q10 1Q09 1Q08 1Q07 1Q06 60 bps 1Q05 1Q04 4Q06 Exhibit 17 – Spread Per Unit of Leverage 180 bps 40 bps 180 bps 20 bps 160 bps 0 bps 140 bps 4Q98 120 bps European 100 bps 3Q00 2Q02 1Q04 4Q05 3Q07 2Q09 1Q11 US Source: Standard & Poor’s. the main trend that emerges from analysis of this parameter is that spread per unit 005 2006 2007 2008 2009 2010 1Q11 of leverage in both the US and Europe at about 90 bps per turn of leverage. August 4. 1 8 0 7 08/04/11 6 5 4 3 08/06/12 08/05/13 08/04/14 08/04/15 3 Month EURIBOR Forward Rate Euro Implied All-in Coupon 3 Month GBP LIBOR Forward Rate Sterling Implied All-In Coupon 3 Month USD LIBOR Forward Rate US Dollar Implied All-in Coupon 08/04/16 2 1 0 08/04/11 08/06/12 08/05/13 08/04/14 08/04/15 3 Month EURIBOR Forward Rate Euro Implied All-in Coupon 3 Month GBP LIBOR Forward Rate Sterling Implied All-In Coupon 3 Month USD LIBOR Forward Rate US Dollar Implied All-in Coupon 08/04/16 4Q10 1Q11 2Q10 4Q09 2Q09 4Q08 2Q08 4Q07 2Q07 4Q06 Source: Bloomberg LLC.indicated by the spread per unit of leverage. These are not as 8 commonly seen in the European market. we believe higher absolute returns are more likely achievable on Euro5 pean loans than on US loans (Exhibit 16). while in Europe margins on new deals remain between 425 and 450bps. 3 Month Forward Inter-Bank Lending Rates. the US.

5bps 100. significant progress has already been made to address this issue. Exhibit 18 provides summary details of some recent European new issues and highlights the difference in terms between the European borrowers and the US names (Burger King and IMS Health). However.00 3.00 3.64x Retail Mivisa Mar-11 Spain 425bps.78x Insurance Takko Mar -11 Germany 500bps.50% Libor Floor Repricing with no fee 4.2x Chemicals IMS Health Mar-11 US 350bps.The rapid growth in loan issuance between 2005 and 2008 has resulted in an unprecedented volume of loans outstanding in the market. Ultimately these loans will approach maturity and need to be repaid or refinanced. 2013 to 2015 dwarfed the annual issuance capacity of the new issue market at that time. the peak in maturities occurred slightly later. In mid-2010. Leveraged loans have typically been structured with a maturity of 7 to 9 years. The greatest concentration of maturities was between 2013 and 2014 in the US. between 2014 and 2015.4x Food & Beverage approach maturity and need to be repaid or refinanced.4x Computers & Electronics Burger King Apr-11 (Euro) US 325bps.50 3.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 23 . 1.00 4.75x Cable Iglo Birds Eye May-11 UK 462. 1. Exhibit 19 shows how the concentration of maturities has been reduced in the US loan market.8x Chemicals R-Cable May-11 Spain 450bps 99. We favour the opportunity in the European market. Ultimately these loans will It is for this reason that we believe the current vintage of loan origination is likely to provide the greatest return for the lowest risk that has been seen in the market for some time.5% Euribor Floor 100.7x Metals and Mining Novacap Mar-11 France 450bps 99. Source: Standard &Poor’s.5% Euribor Floor 100.00 3. 1. since the amount of debt that needed to be refinanced in the peak years. spreading out the required refinancing over a much longer period between 2013 and 2017 and reducing the volume of refinancing bnymellonassetmanagement. 1.00 3. In Europe.50% Libor Floor 99. LCD News US/Europe. Exhibit 18 – Recent New Issue Loans Borrower Allocation Country of Issuance Senior Loan Margin Issue Price Senior Industry Leverage Towergate Feb-11 UK 500bps. so the loans raised between 2005 and 2008 were originally due to be refinanced between 2012 and 2017. 1.00 3.00 4. this was highlighted as a major risk for the market. May 2011 Progress reducing the wall of refinancing The rapid growth in loan issuance between 2005 and 2008 has resulted in an unprecedented volume of loans outstanding in the market.5% Libor Floor 99.0x Restaurants CABB May-11 Germany 450bps 100. which has held onto the stronger deal structures established in the immediate aftermath of the financial crisis.

US New Issue Institutional Spread US Flow Name Secondary Spread Yield 180 bps 160 bps in the peak years of 2013 and 2014. 2011. May 3. This has been achieved by required 140 bps 180 bps refinancing loans through the issuance of longer-dated high yield bonds. LCD Leveraged Loan Review – US/Europe & 1Q11 2010 2011 2012 2013 1Q10 2014 5 2006 2007 2008 2009 2010 1Q11 A similar trend can be observed in Europe (Exhibit 20). extending their maturities by 2 years in return for a 200 bps uplift in margins.14 Luxembourg-base Flint Group achieved a similar result. So the threat of refinancing has actually proven a virtue 80 bps for 20 the bps 60 bps market. 40 bps 4Q98 3Q00 2Q02 1Q04 4Q05 3Q07 2Q09 1Q11 20 bps A European recent exampleUSof a successful “amend and extend” is that of the Dutch 0 bps waste-management firm. There is still a significant concentration 14 “AVR A-to-E Nets Close to 100% Lender Approval. All of these solutions have required the consent of senior 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 60 bps lenders 100 bps and the request for consent is generally accompanied by a margin uplift 40 bpsand consent fee.” Standard & Poor’s LCD News. AVR to4Q05 achieve 100% approval 4Q98 3Q00 2Q02who managed 1Q04 3Q07 lender 2Q09 1Q11 toEuropean extend their maturity by 12 months in return for an increase in margins US on the outstanding TLB/C from Euribor + 225/250 to Euribor + 375/400.15 250 $ Bn $ Bn Exhibit 19 – US Maturity Wall Then and Now 200 005 2006 2007 2008 2009 2010 1Q11 250 150 200 100 150 50 100 0 50 Mar-10 0 005 2006 2007 2008 2009 2010 1Q11 2010 2011 2012 2013 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018 2015 2016 2017 2018 2015 2016 2017 2018 Mar-11 2010 2011 Mar-11 Mar-10 Source: Standard & Poor’s. allowing the margins on loans from earlier vintages to be reset 0current bps to higher market levels.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 24 . although the scale of reduction is less than in the US. LCD Leveraged Loan Review – US/Europe 1Q10 & 1Q11 Exhibit 20 – European Maturity Wall Then and Now 70 60 50 70 € Bn 40 60 30 50 € Bn 20 40 10 30 0 20 5 2006 2007 2008 2009 2010 1Q11 2010 2011 10 Mar-10 0 Mar-11 Mar-10 Mar-11 2012 2013 2014 Source: Standard & Poor’s.” February 14. taking 120 bps 160 bps advantage of high levels of liquidity in the bond market and by “amend-and100 bps extend” 140 bps agreements with existing lenders to extend the maturity of loans 80 bps already 120 bps in place. bnymellonassetmanagement. 15 “Flint Group Holds Investor Meeting for Giant A-to-E Request. 2011.

giving cash back to investors early which then must be re-invested at the lower spread levels of the primary market. 2011 bnymellonassetmanagement. as it allows them to commit new money to the loan market at attractive spread levels. This is positive for loan investors. since they are looking to spread compression to generate a capital gain on their investments.0% and 2. Bond market investors would regard this stability in spreads to be a negative feature of the market. We believe that eventually we will see defaults pick up as a result. then fall into a range of 1. No finance director wants to be relying on the capital markets to raise new debt in 2014 and 2015 if he can avoid it. We believe the opportunities to profit from these distressed opportunities will grow significantly over the next three years. June 7. This means there is little to be gained from spread tightening as it generally results in a higher level of pre-payments. over the next 12 months the rating agencies expect that default rates will remain modest as corporate fundamentals remain good. Distressed debt opportunities to increase The second impact of the maturity wall on the market will likely be an increase in the volume of distressed debt opportunities. Loan investors are less focused on this effect since loans are generally pre-payable at par.16 There is still a significant concentration of debt coming due between 2014 and 2016.5% to 1. In our view. and original investors without the stomach for uncertainty often look to sell out of the situation. or those that are likely to go through a more distressed restructuring process where the objective is to end up with equity sourced at a discount to intrinsic value. That means that the companies that have the easiest access to the capital markets today. those who are performing well and those with the least leverage. we believe the maturity wall will prevent significant tightening in new issue loan spreads.3% until October 2011. 16 Moody’s Investors Service May Default Report. It also means that cash from early pre-payments on loans over the next few years will be able to be re-invested at similarly attractive levels. We believe the remaining debt maturity wall is likely to influence the loan market in a number of ways: New issue spreads to remain wide First. This provides an opportunity for informed investors to build positions cheaply in the companies they believe offer the prospect of recovery. Moody’s estimate the global speculative-grade default rate will remain between 2. However. but for many we believe the problem is too much leverage.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 25 . We believe that eventually we will see defaults pick up as a result. some of these businesses may be operating under fundamentally challenged business plans. over the next 12 months the rating agencies expect that default rates will remain modest as corporate fundamentals remain good. Debt in these businesses will be volatile in the secondary market as their maturity approaches.of debt coming due between 2014 and 2016.7% from November 2011 to May 2012. will already be doing all they can to manage their maturities. However. These situations provide fertile ground for distressed investors. since any reduction in spreads will quickly attract new supply to the market from those companies keen to reduce their demands on the capital markets during 2014 and 2015. We believe this process of natural selection will result in a gradual reduction in credit quality of the universe of credits still needing to refinance in these years.

which has shown itself to be better able to hold on to the stronger deal structures established in the immediate aftermath of the financial crisis. we believe investors can more effectively access the opportunities in this market. In addition to this. we have seen this trend developing and expect it to continue.. i. In the ensuing year. bnymellonassetmanagement. By allocating capital to specialised managers. We favour the opportunity in the European market.Conclusions In 2010 we predicted that unlevered institutional funds would gradually replace CLOs as the dominant non-bank participants in the loan market. experienced in dealing with the operational complexities of the loan market. experienced in dealing • Low volatility of returns due to the secured nature of the asset class with the operational complexities of the loan market. and with established credit expertise in the field. • A  ttractive risk-to-return opportunities. and with established credit expertise in the field. supported by what we perceive are the key strengths exhibited by the secured loan market: By allocating capital to specialised • High absolute returns that will improve as interest rates rise managers. we see potential opportunities for distressed investors to profit from the restructuring of balance sheets of those companies that have to date struggled to access the capital markets to manage their maturities. high lending margins for lower levels of leverage and stronger capital structures Primary market volumes appear to be returning to healthy levels on the back of a return of private equity sponsored leveraged buyout activity and as a result of arrangers’ perception of greater appetite for the loan asset class.e. particularly as the high yield bond market slows amid heightened global risk perceptions.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 26 . we believe investors can more effectively access the opportunities in this market.

sterling and euro-denominated fixed rate debt of corporate issuers domiciled in an investment grade rated country (i. CAD 500 million.e.e. Managing Director. S&P LSTA LLI (Standard & Poor’s Loan Syndications and Trading Association Leveraged Loan Index) is a daily total return index that uses LSTA/LPC (Loan Pricing Corp. The Group refers to these affiliated companies: Alcentra. Chief Investment Officer. Only Alcentra NY. or 50 million euros. including dollar-denominated loans to overseas issuers. Qualifying securities must have a below investment grade rating (based on an average of Moody’s. The foregoing index licensers do no sponsor. S&P and Fitch). Global Broad Market Corporate Index. Simon was also part of the cross-asset class derivatives marketing team at CSFB. The Bank of America/Merrill Lynch Euro High Yield Index: tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Prior to joining Alcentra in 2009.S. JPY 60 billion. Simon was involved in the development of the European CLO market. Deutsche (Morgan Grenfell) were the leading underwriter of European LBOs. and they make no representation regarding the advisability of investing in the products or strategies described herein. BNY Mellon holds over 90% of the parent holding company of The Alcentra Group. bnymellonassetmanagement. Qualifying securities must have an investment grade rating (based on an average of Moody’s. heading the European CLO business at UBS Investment Bank. the LLI tracks the current outstanding balance and spread over LIBOR for fully funded term loans. and USD 500 million. Global Broad Market Non-Sovereign Index. BB or lower based on a composite of Moody’s and S&P) but not in default. Paul has 22 years’ experience in leveraged finance and prior to joining Alcentra. and Global Broad Market Collateralized Index. Qualifying currencies and their respective minimum size requirements (in local currency terms) are: AUD 500 million. The facilities included in the LLI represent a broad cross section of leveraged loans syndicated in the United States.) mark-to-market pricing to calculate market value change. The S&P European Leveraged Loan Index (ELLI) is a multi-currency index that covers the European leveraged loan market back to 2003 and currently calculates on a weekly basis. must have at least one year remaining term to maturity. was a senior analyst for the CDO operations of Intermediate Capital Group. LLC offers services in the U. S&P and Fitch foreign currency long term sovereign debt ratings). originally in London for the Leveraged Finance Team. The indexes are trademarks of the foregoing licensers and are used herein solely for comparative purposes. Paul graduated from Cambridge University with an MA in Economics. Ltd and Alcentra NY. he held similar roles at CIBC and Natixis. Individual bonds must be rated below investment grade (i. The Bank of America/Merrill Lynch Global Large Cap Corporate Index: tracks the performance of large capitalization investment grade corporate debt publicly issued in the major domestic and eurobond markets. He is a graduate in mechanical engineering from Bath University. Alcentra.. GBP 250 million. The Bank of America/Merrill Lynch Global High Yield Index: U. LLC. Global Broad Market Quasi-Government Index. 50 million pounds silver. S&P and Fitch) and an investment grade rated country of risk (based on an average of Moody’s. Ltd Simon is a Managing Director at Alcentra. EUR 500 million. Sub-indices include Global Government Index. a minimum face value outstanding of $100 million.. a fixed coupon schedule and a minimum amount outstanding of EUR 100 million. endorse. Paul worked at Deutsche Bank. At this time. C$50 million. The Alcentra Group Paul joined Alcentra in May 2003 as a portfolio manager and is now global Chief Investment Officer. Simon Perry. dollar. sell or promote the investment strategies or products mentioned in this paper. qualifying securities must have at least one year remaining term to maturity.Paul Hatfield. including Global bonds. and have available price quotations. responsible for the Business Development Team for EMEA ex Japan. Between 1995 and 2001.com INVESTING IN DEBT: OPPORTUNITIES IN SECURED BANK LOANS 27 . On a real-time basis. In addition. Index Definitions The Bank of America/Merrill Lynch Global Sovereign Broad Market Plus Index: The Global Broad Market Index tracks the performance of investment-grade public debt issued in the major domestic and Eurobond markets.S.Canadian dollar. BBB or higher foreign currency long-term debt rating).

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