Working hard for the money

Last year large institutional investors in the US, including the State of Massachusetts Pension Fund and CalPERS, dedicated money to senior bank loans. Amanda White examines the outlook for the sector and talks to group head of ING’s senior loan group, Jeff Bakalar, about whether institutional allocations to the sector have been tactical or strategic.

Senior bank loans are loans to non-investment grade corporate borrowers that, because of their average B rating, generate excess yield. Traditionally a conservative market, the sector faced a unique environment in 2008, that like
other sectors presented challenges, but also opportunities for those positioned to exploit them.

According to group head of ING’s senior loan group, Jeff Bakalar, the growth of the market and the adoption of mark to market pricing introduced volatility into the sector.

“The market has grown exponentially in the past couple of years due to the entrance of more aggressive investors such as hedge funds. These players took a stable asset class and used derivatives to deliver equity-like returns. This combined with the mark to market methodology has introduced volatility,” he says. “But the events of 2008 have taken most of the leverage out of the market. It has been a natural self correcting.”

At the end of last year the S&P/LSTA Leverage Loan Index reached an all time low of 60.33 per cent of par, down from 94.39 per cent at the beginning of the year.

But already in the first quarter of this year, the index is up 15.57 per cent.

The outlook for the next 18 months then, is an environment of sporadic supply, improving demand and increasing defaults. But unlike other assets, the loan asset class market can also do well in a period with rising defaults.

“With a senior, secured position in a borrower’s capital structure, first lien, secured senior loans have historically experienced superior recovery rates in the event of a default,” he says.

According to Bakalar there are three major differences between these loans and high yield bonds which make the sector attractive for institutions.

“These loans are senior and secured, the entire collateral of the company is behind the claim; they have a floating rate versus a fixed rate; and there is a maintenance covenant, which don’t exist in bonds. In more challenging credit cycles this is very important,” he says.

Pension funds with defined liability hurdles have not historically been huge investors in the sector, with retail investors and insurance companies the traditional investors. However when the market dislocated, institutional investors saw the opportunities.

ING received its first pension fund mandate in June 2008 with the State of Massachusetts Retirement System allocating $540 million to the sector between two managers; followed by CalPERS at the end of 2008, with an as yet unfunded allocation.

While for now it seems the decision to invest in such an asset class has been tactical, or opportunistic, Bakalar believes the exposure is more all-weather than investors believe.

“Is it a tactical purchase? It may be, but it will become strategic. In two years if loans return to par it will be in a period of stronger economic growth and rising interest rates, so it will be a good time,” he says. “It is however still a difficult credit market, defaults are rising. We won’t return to the lows of 2008 because demand and supply is healthier than it was then, and there are still very attractive opportunities.”

While there may be some near-term volatility, according to Bakalar there will be a long-term return to the basics with lower leverage, wider spreads, and high transparency characterising the sector.

“Continued improvements in loan prices will depend on the strengthening of market technicalities and fundamental credit experience, not outside of market expectations.”