A Discussion with David Ardini, CFA,
and Tyler Chan, CFA
Franklin Templeton Floating Rate Debt Group
"We are focused on credits that have good asset coverage and sufficient liquidity to weather the current credit storm."
Please describe the Franklin Templeton Floating Rate Debt Group's structure and its investment approach.
David Ardini (DA): We're structured differently from some of our competitors in that our portfolio management group is separate from credit research and trading, as well as from our operations group. Further, our portfolio management team is separated into two different focuses—institutional portfolio management, which I lead, and retail portfolio management, led by Richard Hsu. This separation between the portfolio management groups is a result of the different investment objectives and guidelines of our institutional and retail clients. Each group has very defined guidelines governing the management of the portfolios. The separation allows us to dedicate our time and efforts to understanding and meeting the unique needs of our constituent investors. However, we share across all of our core portfolios a philosophy that minimising defaults and losses in the event of default is an important goal. We seek to provide our investors with a high floating rate income while minimising the principal volatility as much as possible. We do not actively seek price appreciation at the expense of the default.
Tyler Chan (TC): Our credit research team defines the investable universe by using confidential information and conducting independent, bottom-up analysis of below investment-grade loans. We stringently assess the debt-servicing capability of the issuer by examining the cash flows, collateral, capital structure, growth prospects, and analysing the covenants. The analysts provide a probability of default rating (low, medium, or high) and a loss given default rating (low, medium, or high) for every loan. Because our objective is to minimise defaults and losses given default for both primary and secondary loans, our analysts begin with management's projections and then stress-test the forecasts to determine what could cause a payment default to occur. For loans we already hold, our analysts continually review financial performance, earnings, company-specific news, and industry trends. Companies may be placed on our watch and sell lists if, among other criteria, a significant negative credit event is expected or forecasted within the next two quarters, if they consistently and/or significantly miss quarterly forecasts, or if they repeatedly seek covenant amendments.
DA: From the universe defined by our credit research team, our portfolio managers seek to build diversified portfolios of higher-quality corporate debt securities from companies that have the ability to generate free cash flows and have asset coverage for their debt. The companies in which we are interested have dominant market share, strong management teams, and stable growth prospects. We place great emphasis on seeking to minimise the expected default frequency and loss in the event of default, so we avoid companies for which those events appear to be likely. We also add selectively to existing positions through the secondary market.
TC: Risk management is an integrated part of the portfolio construction process. Our analysts estimate expected probability of default and expected loss in event of default, as well as total value at risk. We conduct thorough evaluation of downside risk while emphasising income and downside asset protection and continually monitor the fundamentals of the loans we hold.
Why would investors consider bank loans in general and Franklin Templeton's capabilities specifically?
TC: The total market size for high-yield bank loans is about US$600 billion. Bank loans are rated below investment-grade corporate debt, like high-yield bonds. However, the assets differ in several significant ways. First, the interest rate on a bank loan floats; it changes every three months—it's a spread over LIBOR. In contrast, the income on a high-yield bond is usually fixed for the life of the bond. Another difference is the claim on assets; loans have senior priority within the capital structure and are secured by collateral. Bonds are unsecured and subordinated to bank loans. Finally, when investing in bank loans, we are able to use proprietary information from the issuer, such as the management's forecasts, its financial reports, and confidential projections; bonds are restricted to public information.
DA: The assets differ, also, in how their respective markets have evolved over the last few years. As a result of opportunities for leveraged buying in the asset class, we saw many new entrants into the loan marketplace, which hasn't been the case for high-yield bonds. The Franklin Floating Rate Debt Group has a solid presence in the marketplace and our investment professionals have significant experience in the asset class, having actively participated in the primary and secondary markets for more than 10 years. Between our core strategies and our subadvised accounts, we manage nearly US$4.4 billion in assets (as of 30 September 2008). Our long-term track record is still, in our view, compelling, despite the recent market upheavals.
TC: Some investors seek high beta and principal return. That's not who we are. We are among the more conservative bank loan investors in the market and preservation of principal is one of our primary goals.
DA: Bank loans also tend to be very paper intensive and require a robust operations group to handle the processing of interest, principal, amendments, and fees. Our dedicated operations team has the knowledge and capacity to manage all of these processes efficiently.
How has the leveraged loan market been affected by the credit crunch?
TC: The market has had two distinct phases, like a bubble inflating, then deflating. In the first stage, there was huge growth in collateralised loan obligations (CLOs) and high demand for loans. A lot of leveraged buyouts (LBOs) were financed with bank debt in CLOs. Since July 2007, when the credit crunch began, the bubble has been deflating and the market unwinding. There are few new CLOs and little demand for new loan products; the credit crunch is severely affecting the loan market.
DA: Hedge funds were also using leverage to buy loans until July 2007. That demand decreased when financing became more difficult. As the credit crisis unfolded, the leverage began to unwind so that various hedge funds, market-value CLOs, and total return swaps liquidated, placing more technical pressure on loans.
TC: Of those three, it is hedge funds, because of their redemptions, that have caused most of the selling in the loan market and this has created downward pressure. When the bubble was inflating, it was the hedge funds and CLOs that were buying into new loans; they were the source of cash. Now that the bubble is deflating, those hedge funds have to sell; they need the cash.
DA: That's one of several reasons we're currently experiencing a huge deleveraging event. The disintegration of structured investment vehicles (SIVs), which held a lot of collateralised debt obligations and mortgage-related paper, is another contributing factor in the credit crisis. SIVs began unwinding last year because they had borrowed short term to invest long term. Short-term rates were so low that they created the opportunity for SIVs to borrow at those short-term rates through commercial paper. SIVs then invested in mostly AAA-rated investments to profit from that arbitrage. When borrowing rates began to rise and the mortgage problems occurred, SIVs were hit on both sides. Their financing costs went up at the same time their credit portfolios came under pressure.
TC: SIVs couldn't roll over their commercial paper because that was a short-term loan and they had invested in a long-term asset. We were initially criticised for not participating in SIVs. The result has reinforced our conservative, traditional approach to investing in loans, which we believe has served us well over the long term.
Where do you see CLO issuance trending?
DA: It's very difficult to see the new-issue market for CLOs opening up anytime soon. Secondary spreads have widened significantly, which affects where new-issue spreads would come out in the arbitrage for any new CLOs. AAA spreads were as low as 23 basis points over LIBOR in early 2007 and now stand at approximately 525 basis points over LIBOR (as of 3 November), if you look at the AAA tranches trading in the secondary market. The traditional buyers of AAA paper were commercial banks and they're not currently in a position to risk capital. Credit insurance from monolines is either not available or not economical. Often, the banks would use their balance sheets to purchase the AAA paper, and then buy credit insurance for the credit risk from the monolines. Most of the monolines now have been downgraded and are having to post collateral, which they didn't have to do in the past. This has negatively impacted the demand for AAA paper, which makes up the majority of the capital structure of a CLO.
Currently, defaults remain low. How long do you think the default rate can remain stable given the economic slowdown?
TC: We expect defaults to increase substantially during the economic slowdown. During the bubble, when there was easy credit, we saw a lot of deals, many of which were very weakly structured and with companies that were not all that substantial. In the 12 months prior to July 2007, we looked at more than 600 deals and decided to buy fewer than one-third of them, since most were, in our view, not sustainable during an economic downturn. Now that we're in a weak economy, where lower cash flows will be generated within those companies, we are likely to see more defaults as companies are unable to service their debt.
DA: The peak of the low credit quality issuance occurred in 2006 and 2007. Typically, we've seen an approximately three-year lag before defaults peak, so in the next year or two, as we hit that point in time, we will probably see much higher default rates. The recovery rates will probably be a lot lower as well, as a result of the aggressive issuance in those years.
What is your view of the new-issue market? Are covenant-light deals still being issued or has that dynamic changed?
TC: There are very few new issues coming out now. Much of it has to do with the fact that hedge funds, which invested heavily in loans, are now actually going through redemptions. They need to raise cash; they're not investing in new loans. Since few new CLOs have come to market, the source of cash necessary to fund the loans for LBOs is not available and investment bankers are finding it very difficult to bring new issues to market. Now that the market's orientation has shifted to favour the lender rather than the borrower, very few covenant-light deals—which are pro-borrower, anti-lender—are being done. That dynamic has very definitely changed and the turning point really was July 2007.
DA: The new-issue market will return eventually. However, the market may look different from what we saw in the past. We will likely see lower-leveraged deals of smaller size and higher credit quality.
TC: The market is changing. Hedge and high-yield bond funds were opportunistic buyers into the asset class; they won't be staying in the market. Commercial finance and insurance companies may remain in the market, to some extent, but they're not pursuing the same opportunities in prime rate corporate loans as are CLOs and prime rate funds. New CLOs have essentially come to a stop at this time and prime funds are having some redemptions, but these are the investors— representing about half of the total market—who are the stable players and staying in the market.
DA: The market will likely be smaller.
TC: And that's fine. We are among those who will be staying in the market.
DA: As a result of market changes, we've lost some very active investment banks. We now have fewer counterparties with whom to trade. This will impact our ability to get multiple bids on paper that we're trying to sell in the secondary market.
TC: The decline in the number of investment banks has also had an influence on the growth and size of the primary market. When there were many investment banks, there were more and more marginal deals as investment bankers sought business. Now, with fewer investment banks and fewer investment bankers, I believe there will not be as many lower-quality deals.
Where are you currently finding opportunities in the market?
DA: Given the current technical imbalance, we're finding opportunities across various industries. The S&P Flow Names were trading at approximately 75 cents on the dollar (as of 6 November), resulting in a spread to maturity of more than 750 basis points over LIBOR. These are unprecedented high spread levels that we believe can provide attractive opportunities to investors with capital to put to work over the long term. Liquidity premiums are extremely high in this environment, so we are focusing on credits that have good asset coverage and sufficient liquidity to weather the current credit storm. Buyers in this market should have the ability to hold these loans for some time, as the technicals are not currently in the market's favour. Historical trends may not be good guideposts and should be viewed cautiously when making investment decisions.
We also see some interesting opportunities in the secondary market for AAA tranches of CLO paper because there are no natural buyers at this time. The secondary spreads have widened and we are looking at this opportunity closely. The cash flow waterfall structure can be very attractive for the AAA investor because the tranche has substantial subordination, typically around 30% of subordinated bonds below it. Also, the CLO indentures typically have triggers that divert cash flows away from the subordinated bond to the AAA tranche, securing the AAA paper and helping to ensure that the AAA will have first priority with respect to cash flows. Even in the event that default rates rise significantly, those triggers are still in place and the AAA investor, depending on what the entry point was, can actually have higher yields with those higher default rates if the default rates force par prepayments to the AAA investors. In other words, the AAA investors can get their principal back earlier as a result of higher defaults. That only works up to a certain point; once a certain threshold of defaults is crossed then, depending on recovery values, the AAA investor actually risks principal. Our view is that if an investor is able to purchase the AAA paper at a low enough dollar price, it is possible to significantly reduce the risk in that very high default rate scenario.
What is your long-term outlook for the asset class?
TC: The asset class is here to stay, though there will be some bumps, because some of its characteristics make it very attractive to investors. The interest rates float; we can expect interest rate volatility. We also have security and are at the top of the capital structure. Those are very strong competitive advantages versus unsecured debt. Prices for bank loans and high-yield bonds from 2001 to July 2007 were nearly on top of each other and fairly stable. When the bubble deflated in July 2007, the unwinding began, everything dropped, and many began to sell. Effective spreads between the assets changed, as well, after July 2007. Up to that point, there was a gap, as you'd expect. Returns were lower for bank loans because they had less risk than high-yield bonds, since the latter are subordinated and unsecured. Then the technicals overwhelmed everything as large investors raised cash to fund redemptions and margin calls by selling loans, pushing prices down.
DA: If you look at the yields between the two, the spreads between loans and high-yield bonds have increased substantially, currently at more than 720 basis points (as of 6 November). That's up significantly from early 2007, when the option-adjusted spreads of loans and bonds were almost on top of each other.
Our long-term outlook is cautiously optimistic. Volatility will likely remain elevated for some time and there will be some serious challenges over the next few years as a result of higher defaults, lower recoveries, and questions surrounding refinancing. Many of the loans that we talked about earlier, ones that were done in 2006 and 2007, will likely mature around five years out and, depending on the state of the market at that time, there could be some difficulties for those issuers. Additionally, some of the more traditional investors may be smaller in the future, depending on how well they are able to weather this credit crisis. Although we believe the landscape will change, we do think that loan issuance will eventually return. Given our team and our capabilities, we are well equipped to handle these challenges. One of our key strengths is credit selection; we believe that strength will help keep our portfolios diversified and well positioned for the future.
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All investments are subject to certain risks. Generally, investments offering the potential for higher returns are accompanied by a higher degree of risk. Stocks and other equities representing an ownership interest in a corporation have historically outperformed other asset classes over the long term but tend to fluctuate more dramatically over the shorter term. Small or relatively new companies can be particularly sensitive to changing economic conditions due to factors such as relatively small revenues, limited product lines, and small market share. Smaller company stocks have historically exhibited greater price volatility than larger company stocks, particularly over the short term. The significant growth potential offered by Emerging Markets remains accompanied by heightened risks when compared to developed markets, including risks related to market and currency volatility, adverse social and political developments, and the relatively small size and lesser liquidity of these markets.
The information contained in this piece is as of its date, unless otherwise indicated, and is not a complete analysis of every material fact regarding the market, and any industry sector, a security, or a portfolio. Statements of fact cited by the manager have been obtained from sources considered reliable but no representation is made as to the completeness or accuracy. Because market and economic conditions are subject to rapid change, opinions provided are valid only as of the date of the materials. References to particular securities are only for the limited purpose of illustrating general market or economic conditions, and are not recommendations to buy or sell a security or an indication of the author's or any managed account's holdings. Such securities may or may not be in one or more Templeton managed portfolios from time to time.
The manager's opinions are intended solely to provide insight into how the manager analyses securities and are not a recommendation or individual investment advice for any particular security, strategy or investment product. Any performance quoted is historical and, of course, past performance does not guarantee future results and results may differ over future time periods.
This publication is for professional/institutional investors, institutional investment consultants, and eligible counterparties only. It is not directed at private individuals and in no way does it constitute investment advice.
Date of material: November/December 2008 Institutional Conversations interview conducted on 21 October 2008.
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