The growing importance of leveraged loans

The leveraged loan market--the market for syndicated bank loans to non-investment-grade borrowers--holds surprises for investors, without the negative spin the word "surprise" usually implies. A growing market and growing array of players make for both an intriguing story and an intriguing opportunity.

Business lending was transformed during the 1990s. From the end of the recession in 1992, the amount of business lending that moved through a syndication process expanded very rapidly. This expansion was not simply in volume, nor was it confined to well-known names; rather, it was a broad-based redistribution of credit risk.

The significance of this market evolution may be underestimated. Certainly the fact that the three worst years of credit defaults (in dollar terms), between 1999 and 2002, has not produced at least one bank default is remarkable. Today in North America the capital markets and bank markets for debt are merging to produce assets that can be available to all investor types, from banks, to pension funds, to individual savings.

This article will focus on one element of this redistribution of risk, the market for syndicated bank loans to non-investment-grade borrowers, generally referred to as "leveraged loans." Relatively few investors realize that this market is now much bigger than the non-investment grade bond market. Even fewer appreciate it as an asset class with very low volatility--despite the nature of the underlying issuers.

It is a market with growing importance and growing opportunity for borrowers, intermediaries, and investors.

Dimensions of Market Growth

The expansion of the leveraged-loan market has been remarkable. As shown in Figure 1 the outstanding amount of such loans has increased sixfold, from $150 billion to $900 billion, over the last nine years, and the outstanding amounts now substantially exceed the amount outstanding in the non-investment-grade bond market.

One feature of this growth is the parallel development of institutional loans, which are most commonly a distinct tranche in a leveraged-loan syndication. Institutional loans are designed for nonbank investors, such as pension funds, loan mutual funds, and insurance companies. With such investors' needs in mind, institutional loans are generally fully drawn term loans, sometimes with prepayment penalties and other 'investor protections.

The importance of nonbank investors to the leveraged-loan market extends beyond the institutional tranches, as illustrated in Figure 2. In 1993, foreign banks took over 40% of the market. By 2001, that share had fallen below 20%, and the biggest investors were institutional pools, including pension funds, insurance companies, mutual funds, and firms assembling the assets for repackaging in wholesale and retail funds.

Other evidence can be presented to demonstrate how the market has grown and how the range of participants has expanded, but the key question to be addressed is why anyone would want to own these assets. After all, if non-investment-grade bonds are junk bonds, surely these must be "junk" loans.

Investing in Credit Risk

Credit risk portfolios that provide a reasonable return on capital over time must have three key characteristics over time: the risk is measurable, the price fully reflects the risk and volatility, and the portfolios are very diversified.

Unfortunately, large corporate lending has often failed in at least two of these criteria--pricing often fails to cover credit risk (particularly migration risk) and diversification needs are often overwhelmed by relationship pressures. It might also be added that Enron, WorldCom, and Conseco are just some of the more recent examples of how investment-grade risk is very difficult to measure.

Middle-market (and of course retail) lending generally meets these three conditions. First, pricing is usually well ahead of expected loss, especially when the prime rate is used as the base. Second, diversification is helped by the size of the individual loans and the lack of correlation between borrowers. Third, the risk of default in riskier companies may be as difficult to measure than investment grade or more so, but the structural protections in these loans have a meaningful impact on the outcomes. In sum, the conditions that should produce consistent returns through time without undue volatility are present more in middle-market-borrowing portfolios than in large corporate portfolios. The logic of this is powerful--the results are even more impressive.

Stability Is Remarkable

Figure 3 shows the performance of various asset classes over the period 1993-2000, including equities and debt. Observe the results of leveraged loans (for which we use the CSFB Leveraged Loan Index). It is the only asset class (other than three-month Treasury bills, of course) to never have a losing year. For many, this is a surprising and nonintuitive result.

As bankers have long appreciated, prepayment options and the nature of loans severely limit any upside potential. However, not only was the best year (at 11.17%) relatively unspectacular, but the median return of 7.48% in the period was also unexceptional.

The facts are clear:

Leveraged loans as an asset class are boringly predictable! They are (or should be) an important asset class for investors seeking income to alleviate concerns of capital preservation and willing to accept limited upside potential.

Why Should Banks Sell?

If the leveraged-loan asset class is so good for investors, then it seems reasonable to ask why a bank should sell its non-investment-grade loans or encourage its clients to use that market for their financing needs. One answer, of course, is that this is not a voluntary movement at all. The corporations seeking such financing generally have high borrowing needs and find that the cheapest financing with the most flexibility can be a bank loan. The best terms are often provided by banks that have highly developed distribution capabilities, and so this market, like that of large corporate lending, is now dominated by relatively few banks.

According to Loan Pricing Corporation, more than 30% of all leveraged-loan deals in 2002 were syndicated by three banks and more than 50% by the top seven banks. The syndicating banks are acting as distributors of debt rather than as bank lenders--for the most part they have no intention of holding more than the minimum necessary for service purposes.

Another important factor in the greater distribution of these assets is that many banks recognize that concentration risk remains one of the most substantial threats to their market value. They must therefore continue to reduce single-name exposures and manage their capital, be it calculated on an economic or a regulatory basis.

The Logic for Buyers

Figure 4 shows a list of institutional investors in the leveraged-loan market, where each of the names has participated in at least 20 primary allocations. The largest fund managers are represented as well as many of the largest insurance companies. This list is growing each year as more and more asset managers and investors find value in this market.

As already noted, this asset class can be a very conservative choice indeed. That said, other factors have caused these and other major investors to enter the market and take almost half the issue volume.

Liquidity. We estimate that there are 10 to 15 large and active loan trading desks in the leveraged-loan market, and so the ability of investors to both take and manage positions has improved immensely. Prior to 1993, minimum loan positions were high, with the lowest available level being $5 million. For institutional investors, many deals today are available for participation at the $1-million level. This means not only increased liquidity due to an increased number of buyers, but also an increased ability for investors to achieve adequate diversification.

Performance. Standard & Poor's Leveraged Commentary and Data (S&P LCD) and Loan Pricing Corporation (LPC) now supply a great deal of data and market intelligence. Pricing is open at issue and reported thereafter. In addition, leveraged-loan indexes are being maintained by such firms as S&P LCD, Bank of America, and CSFB. The individual prices and loan weights within these indexes are not published; thus, the index cannot be replicated at this point. Nonetheless, the appearance of a market benchmark is an important development in institutional investor participation.

Asset diversification. To obtain the stability demanded by fixed-income investors, credit risk portfolios must be highly diversified. That means adding names until the spread no longer covers the marginal risk contribution. With the minimum investment holding at $1 million, investment portfolios will have to be very large to derive the optimal diversification benefits; $75 million is probably a bare minimum. This is one reason why the amount of leveraged loans bought for the purpose of distribution in collateralized debt obligation (CDO) form has increased to become a dominant part of the institutional market (Figure 5).

International diversification. One important feature of leveraged loans is their lack of correlation with other major asset classes, in particular, equity and high-grade debt. For a bank or investor domiciled in Kuwait or Australia, this lack of correlation is magnified to the point where the diversification value is even more pronounced.

It would be comforting to note that this correlation measure was a significant force in the investment participation decisions by offshore entities, but that is probably not the case. A number of lending operations set up in the U.S. by non-U.S. banks continue to purchase leveraged loans and treat the acquisition as a relationship banking activity. In some cases, in fact, such activity has led to the worst effect of all--a deliberately acquired undiversified portfolio. Unfortunately, the credit losses often suffered by such activities are then often blamed on the asset class rather than the true culprits. This problem may well constrain the market over time, as it has the non-investment-grade bond market.

Balance Sheet Management

The evidence of the primary market league tables and the extension of the capital markets points to the fact that domestic bank growth has been constrained by a lack of new lending opportunities. A domestic commercial bank can react in a number of ways, but relatively few choose to reduce leverage or asset balances. Rather, they choose to increase the size of their investment portfolios; many do so in loans, because they are comfortable with floating-rate assets and have the back-office processing capability for these assets.

Again, while in some cases the motivation is leverage and revenue increases, the benefits may go beyond expectations. Consider that a bank in Boston or Houston can move beyond any natural concentration caused by geography to consciously add diversification while using the credit expertise already resident in the organization. That said, it should be understood that the principal reason why the domestic bank share of the leveraged-loan market has remained relatively constant is the pressure on both the originators and the local banks to retain exposure to clients and use that to lever sales of other revenue-producing banking products and services. Borrowers know this and frequently exercise their relative bargaining strength to reduce loan spreads, reduce onerous terms, or obtain pricing concessions.

Volatility

Figure 3 earlier showed the remarkable stability in the returns from leveraged loans through time. It must be acknowledged that part of that low volatility is artificial--the valuation of loans tends to change on trade activity, and trade volumes are relatively low in many names. Nevertheless, there is strong logic for a relatively narrow value range. On the down side, the security (collateral) and structure mitigate risk, so, even in default, leveraged loans seldom fall as precipitously as bonds. According to Bank of America, the asset volatility in its index over a three-year period ending December 31, 2002--a time of record default levels--has never exceeded 3%. The significance of this is more readily apparent when comparable numbers are cited from the "safer" asset classes. Even the 10-year Treasury has volatility through time of over 4%.

Summary

For many years, the stars in the lending firmament were the large corporate relationship managers. They dealt with the biggest corporations and had the power to lend tens or even hundreds of millions of dollars in loans. At the same time, the middle-market lenders toiled to negotiate complex agreements with smaller borrowers with far greater individual risk and lower exposures.

Through those years, we have witnessed the LDC crisis, multiple real estate crises, the oil and gas crisis, the telecom crisis; soon, perhaps, another crisis will come to pass. In the meantime, diversified pools of well-structured and well-priced loans have performed quietly and efficiently. While equity markets were booming and interest rates were high, investors had little interest in such assets. Now that the search is on for stable income sources that add value to large portfolios, however, these assets are much more in demand.

There is every reason to believe that demand for loan assets will continue to grow, and there is every reason for the banks that originate the loans to continue to supply the market. It has taken around nine years for the market to reach almost $1 trillion, My prediction is that it will double in less than half that time.

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Figure 3

Summary Statistics of Various Assets (1992-2001)

                            Geometric  Arithmetic
                              Mean        Mean
Asset                        Annual      Annual       Annual     Return/
1992 - 3Q01                  Return      Return    Volatility *   Risk

U.S. 30 Day T-Bill            4.62%      4.62%        0.31%      15.01
U.S. Intermediate Treasury    6.99%      7.09%        4.58%       1.53
U.S. Long-Term Treasury       9.20%      9.54%        8.66%       1.06
ML Mortgage                   7.38%      7.43%        3.20%       2.31
LB AAA Corp.                  7.73%      7.85%        4.93%       1.57
ML Corp. Master               7.93%      8.04%        4.85%       1.63
High-Yield Bonds              7.48%      7.68%        6.51%       1.15
Leveraged Loans               7.10%      7.12%        2.17%       3.27
S&P 500                      12.11%     13.21%       15.79%       0.77
Wilshire 5000                11.27%     12.43%       16.10%       0.70
MSCI EAFE                     4.16%      5.36%       16.07%       0.26
Gold                         -1.83%     -1.15%       11.80%      -0.15
U.S. Inflation                2.61%      2.61%        0.66%       3.94


                            Highest   Lowest  Annual
Asset                       Annual    Annual  Median
1992 - 3Q01                 Return    Return  Return

U.S. 30 Day T-Bill           5.89%     2.90%   4.77%
U.S. Intermediate Treasury  16.80%    -5.14%   9.29%
U.S. Long-Term Treasury     31.67%    -8.96%  10.56%
ML Mortgage                 16.99%    -1.56%   7.31%
LB AAA Corp.                21.41%    -3.64%  10.55%
ML Corp. Master             21.23%    -3.34%   9.13%
High-Yield Bonds            19.68%    -5.66%   7.90%
Leveraged Loans             11.17%     2.15%   7.12%
S&P 500                     37.43%   -26.22%  15.52%
Wilshire 5000               36.45%   -26.69%  16.25%
MSCI EAFE                   32.95%   -33.48%   7.21%
Gold                        17.68%   -21.68%  -1.33%
U.S. Inflation               3.39%     1.61%   2.68%

* Monthly returns

Source: CSFB

Figure 4

The Importance of Nonbank Investors Grows

Institutional Investors in the Leveraged-Loan Market


           Aladdin Capital                   Eaton Vance Group
            Allstate Life                    Fidelity Advisors
          American Express                    First Union 1DM
           Angelo, Gordon                      Franklin Funds
      Ares Mgmt/Apollo Advisors               Highland Capital
            Black Diamond                     Indosuez Capital
              Blackrock                     ING Capital Advisors
             BMO Monegy                         ING Pilgrim
            Carlyle Group                         INVESCO
           Centre Pacific                        JH Whitney
                Cigna                           Liberty View
              Citi AIS                           MassMutual
               Conseco                 Merrill Lynch Asset Management
   Credit Suisse Asset Management                 MetLife
CypressTree Investment Management Co.    Morgan Stanley Dean Witter
     Deerfield Asset Management


           Aladdin Capital                     Nomura Holdings
            Allstate Life                    Oak Hill Securities
          American Express                Octagon Credit Investors
           Angelo, Gordon                     Oppenheimer & Co.
      Ares Mgmt/Apollo Advisors        Pacific Investment Mgmt (PIMCO)
            Black Diamond                            PPM
              Blackrock                         Sankaty/Bain
             BMO Monegy                  Scudder Kemper Investments
            Carlyle Group                     Seaboard Partners
           Centre Pacific                Stanfield Capital Partners
                Cigna                             Stein Roe
              Citi AIS                     SunAmerica Investments
               Conseco                       Travelers Insurance
   Credit Suisse Asset Management         Trust Company of the West
CypressTree Investment Management Co.        Van Kampen America
     Deerfield Asset Management

Source: S&P LCD, Banc of America Securities LLC.

[C] 2003 by RMA. Brian Ranson is executive managing director at BMO Monegy, a division of Bank of Montreal. He was the cover story interview in the July/August 1999 issue of The RMA Journal, then known as The Journal of Lending & Credit Risk Management.

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