04 2014

Syndicated loans
DISCUSSION NOTE

Investments in private debt may provide attractive investment Date 09/05/2014

ISSN 1893-966X
opportunities for a large investor able and willing to commit
funds to illiquid instruments. In this note we look closer at one NBIM Discussion Notes
are written by NBIM staff
particular type of private debt investments, the market for syn- members.
dicated loans. Syndicated loans are issued with floating rates, Norges Bank may use
supported by collateral and are normally senior to all other these notes as specialist
references in letters on
debt from the issuer. the Government Pension
Fund Global. All views and
conclusions expressed in
the discussion notes are
not necessarily held by
Norges Bank.

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Summary
Syndicated loans

Firms from all points of the credit spectrum access financing via the loan Syndicated loans
market. Loans are viewed as a flexible source of capital that can be arranged
quickly. However, studies on the US loan market suggest that the credit quali-
ty of the firm is the primary determinant describing the choice between bond
and loan financing.

The syndication process allows the lending bank to share single name credit
exposure with other banks and investors while maintaining the relationship
with the borrower. Covenants serve to limit the credit risk associated with an
investment in a syndicated loan. Findings in studies on the US market sug-
gest that covenants serve as a device for monitoring the borrower and that
covenants may help to mitigate conflict of interest between different partici-
pants in the syndicate, in particular conflicts of interest that may arise when a
loan is sold in the secondary market.

The ability to trade a loan in a secondary market is regulated in the loan docu-
mentation. The most developed secondary market is the market for syndicat-
ed loans provided to non-investment grade or unrated corporates, so-called
leveraged loans. In the US, the leveraged loan market has become quite
transparent and public in nature supported by standardised documentation
and public loan ratings. In Europe, the market remains less standardised and
therefore more private.

Institutional investors have become more active in the market for syndicated
loans over time. As for other type of private investments, a successful strat-
egy requires the ability to keep the exposure through periods when general
market liquidity is scarce.

To examine the historical risk- return characteristics of leveraged loans we

use two indices provided by Credit Suisse, one for the US market and one for
Europe. Despite of the differences in market dynamics the two indices have
offered fairly similar historical returns.

Norges Bank Investment Management / Discussion NOTE 2

Introduction Syndicated loans

A syndicated loan is a type of loan where a group of lenders jointly agree to

provide a credit facility to a borrower governed by a set of common docu-
ments1. A loan syndicate normally compromises a lead arranger that origi-
nates the loan and participant lenders that fund parts of the loan. The partic-
ipant lenders delegate to a certain degree screening and monitoring of the
borrower to the lead arranger. Although the loan is governed by a single loan
contract, every member of the syndicate has a separate claim on the debtor.

The evolution of syndicated lending may be divided into three phases follow-
ing Gadanecz (2004). Credit syndications first developed in the 1970s as a
sovereign business allowing smaller financial institutions to gain exposure to
emerging markets without having to establish a local presence and in 1982
most developing countries debt consisted of syndicated loans. However,
when Mexico suspended interest payments in 1982, soon followed by other
developing countries, syndicated lending came to an abrupt halt. The second
phase in the evolution of the syndicated loan market was characterised by
lower activity and smaller volumes. The start of the third phase dates back
to the early 90s when the market for syndicated loans experienced a revival
driven by developments such as market-based pricing, wider use of cove-
nants, increased transparency through the introduction of public loan ratings
and the emergence of a market for secondary trading. What started out as a
market mainly focussed on loans to sovereigns had by the late 90s emerged
into a market entirely dominated by loans to the corporate sector.

This note is made up of three main sections. First we describe the structure
of the market, introduce key concepts and examine the general features of
a syndicated loan. Second we discuss the motivation for syndicated loans
from the perspective of the originating banks, borrowers and end investors.
We also examine the role of covenants and collateral and whether the pres-
ence of a secondary market for loans alters the dynamics. This discussion
rests on findings in academic studies on the US market. In the last section
we look closer into one particular segment of the loan market, the market for
so called leveraged loans. Leveraged loans can broadly be defined as loans
provided to sub-investment grade or unrated corporates. This is currently the
most mature segment in terms of participation from institutional investors
and a market segment where high-quality return data is available.

1 Loan Syndications and Trading Association (LSTA) and the Loan Market Association (LMA) in Europe have
developed templates for different types of syndicated loan agreements. These templates are widely used and
have facilitated growing participation from institutional investors.

Norges Bank Investment Management / Discussion NOTE 3

Market structure and key features Syndicated loans

Loans play an important role in financing economic growth. Firms from all
points of the credit spectrum (privately held, unrated, high yield, and invest-
ment grade) tap into the loan market. Loans are sometimes syndicated. Ac-
cording to data from Bloomberg2, global syndicate loans volume was about
USD 900 bn. in Q2 2013 and roughly USD 800 bn. in Q1 2013. The Bloomberg
data include both syndication of short-term credit facilities and longer-dated
loans. Further, the data covers a wide range of different types of loans such
as commercial real estate and project finance loans as well as loans provided
to investment grade and high-yield corporates.

Globally, there are three types of syndications; an underwritten deal,

best-efforts syndication, and a club deal. In an underwritten deal the
arrangers of the syndicate guarantee the entire commitment and then
syndicate the loan. If they fail to attract sufficient interest to fully subscribe
the loan the arrangers are obliged to absorb the difference. In the case of a
best-effort deal the arrangers commit to underwrite less than the entire
amount of the loan and leave the faith of the loan to the market. If the syndi-
cation process following fails to attract sufficient interest this may impact the
terms of the deal. A club deal is normally a smaller loan pre-marketed to a
group of relationship lenders.

The banks may choose to make all type of loans subject to syndication. The
most commons one are a revolving credit facility or a term loan3. A revolv-
ing credit facility, or revolver for short, allows the borrower to draw down,
repay, and re-borrow. The facility normally runs for a period of 364 days and
acts much like a corporate credit card, expect that borrowers are charged an
annual commitment fee on unused amounts. A term loan is an instalment
loan, which the borrower may draw on during a short commitment period
and then repay on either a scheduled series of repayment (amortizing term)
or a one-time lump sum payment at maturity (bullet loan). Loans targeted for
non-bank institutional investors are normally found within the latter category.
Revolving credit facilities are most often provided by the banking sector.

Syndicated loans issued with a floating rate and normally quoted as a spread
versus a base rate such as LIBOR or LIBOR-equivalent money market rates.
Loans provided to institutions with lower credit ratings are normally senior
to all other debt issued by the company and secured by collateral. Loans to
higher quality institutions are often at the same level of seniority as bonds.
The loans have historically normally been issued with maintenance cove-

2 Bloomberg: Global Syndicated Loans Market Review Q2 2013, http://www.bloomberg.com/professional/

files/2012/08/Global-Syndicated-Loans-2012.pdf
3 Revolving- and term facility are the two main types of facilities. In addition some syndicated loans are
provided as LOCs or acquisition/equipment lines.

Norges Bank Investment Management / Discussion NOTE 4

nants4. Example of covenants commonly seen in loan agreements are max- Syndicated loans
imum debt to EBITA, minimum (tangible) net worth, minimum fixed charge
coverage, minimum interest coverage, minimum ratio of current assets/cur-
rent liabilities, provisions on the use of proceeds from asset sales and on the
disbursement of dividends and limits on type and amount of acquisitions. In
general, the higher the risks perceived with the loan engagement, the stricter
the covenants. With regards to the number and type of covenants in a typi-
cal loan agreement, the market practise in Europe differs from that observed
in the US. We discuss the differences between the European and US market
in more detail later.

A syndicated loan is perceived as a flexible financing tool as it, in contrast to

a public bond, does not require public filings. Private debt markets may also
be more efficient if the need for liquidation or renegotiation arise in a situa-
tion with financial distress. Such processes tend to become more challenging
with a high number of bondholders compared to a limited set of members of
a syndicate.

Loan sales are normally structured as a novation, assignment or participa-

tion. The two first methods result in the lender disposing of its loan commit-
ment and the new lender assuming a direct contractual relationship with the
borrower. In a participation assignment the initial lender retains the contrac-
tual relationship. The two first methods typically require the consent of the
borrower and agent. The terms governing the transfer of a loan or the ability
to trade the loan will be defined in the primary loan agreement. European
borrowers will often use white lists in the primary loan agreement. A white
list is a list or register of those that are being provided a particular privilege,
in this context the privilege to enter into the loan agreement on behalf of the
initial lender. In the US it is more common to use disqualified lender lists to
manage the syndicate as their loan trades in the secondary market.

Investors in loans will, unless they chose not to, receive private information
about the borrower. Investors practical approaches to challenges arising
from being exposed to private information differ. Some investors in loans
choose to rely only on public information memos5 (IMs) and public material
and are able to trade freely in public securities from the same issuer. Other in-
vestors operate on the private side of the fence where they receive private in-
formation which can be very valuable in credit analysis such as management
projections, amendments and quarterly or monthly financial disclosures.

4 Covenants are restrictions that dictate how the borrowers can operate and carry themselves financially.
Covenants allow the lender to intervene before severe losses are realised. Maintenance covenants require the
issuer to pass the agreed hurdle every quarter or suffer a technical default on the loan agreement. The alter-
native is so-called incurrence covenants which are only tested for compliance when the company undertakes
one or more of several designated actions such as taking on more debt. Covenant-lite loans are loans issued
with less restrictive covenants (covenant-lite). These types of loans are normally priced with a significant mar-
gin to other loans. Covenant-lite started to appear in buyouts in 2004, and became a very common feature of
LBO capital structures in the following years. After a period with close to none issuance of covenant-lite loans,
such loans have emerged in particular in the US. As of late 2013 close to 40 percent of loans included in CS
Leveraged Loan index are covenant-lite loans. This is significantly higher than the 20 percent peak register at
the peak in 2007.
5 In most primary syndications arrangers will prepare a public version of an information memo (IM),
stripped of private information like projections. These IMs are distributed to accounts on the public side of the
wall.

Norges Bank Investment Management / Discussion NOTE 5

Academic studies on lending and Syndicated loans

syndication in the US
The section is based on findings from academics studies mostly using data
on US syndicated loans and therefore reflecting the underlying dynamics in
this particular market.

Banks: Improve diversification and manage credit risk

Banks motivation to syndicate a loan instead of keeping it on their own
books is mainly to reduce excessive single name exposure while maintaining
the relationship with the borrower. The syndication process allows the bank
to tailor its credit risk, adapt to requirements in regulations, reduce the over-
all cost of loan origination and earn fees.

Dennis and Mullineaux (2000) were the first to study the factors affecting the
decision to syndicate a loan. In particular, they found that the more trans-
parent the borrower is, as evidenced by the existence of a credit rating or by
being listed on a stock exchange, the more likely the loan is to be syndicated
and sold in greater proportions rather than being kept at the banks books.

A syndicate is characterised by asymmetric information between the lead

arranger and the participant lenders. Sufi (2007) examines how information
asymmetry between lenders and borrowers influences syndicate structure.
Consistent with moral hazard in monitoring, he finds that the lead bank
retains a larger share of the loan and forms a more concentrated syndicate
when the borrower requires more intense monitoring and due diligence.
When information asymmetry between the borrower and lenders is poten-
tially severe, participant lenders are closer to the borrower, both geographi-
cally and in terms of previous lending relationships. He further finds that lead
bank and borrower reputation mitigates, but does not eliminate information
asymmetry problems.

Bushman and Wittenberg-Moerman (2012), investigate the role played by

the reputation of the lead arrangers of syndicated loans in mitigating infor-
mation asymmetries between borrowers and lenders. Consistent with prior
research (e.g. Sufi 2007, Ross 2010), they measure bank reputation based on
lead banks market share in the syndicated loan market. They document that
higher lead arranger reputation is associated with higher company earnings
and cash flow persistence, and with corporate earnings that more strongly
predict future credit quality of the borrower. Gopalan, et al. (2011) examine to
what extent poor performance damages the reputation of the lead arranger
and find that it does.

Identical contractual conditions do, however, not mean that all members of
the syndicate earn the same return. Hallak and Schure (2011) examine such
return differences and find that large lenders typically receive a larger per-
centage of the upfront fees than smaller lenders and interpreted this is an
indication that the fee structure incorporates anticipated costs associated

Norges Bank Investment Management / Discussion NOTE 6

with borrower illiquidity, notably the costs of coordinating the workout and Syndicated loans
providing liquidity insurance.

Investors: Floating rate exposure with claims on underlying assets

Jiang et al. (2010) document the rising interest from institutional investors in
syndicated loans using a data set for the period 1987 to 2006. They find that
non-bank institutions tend to participate in loans issued by risky borrowers
for risky purposes6. They argue that such preferences are in stark contrast to
institutional investors general preference for prudent investments on the
equity side.

Lim et al. (2014) find that roughly 30 percent of the loan facilities in their
sample had at least one non-bank institutional investor and find that these
loans have a significantly higher spread than an otherwise similar bank-only
loan facility. They hypothesize that non-bank institutional lenders invest in
loan facilities that would not otherwise be filled by banks and that borrowers
are willing to pay spread premiums when loan facilities are particularly im-
portant to the firm. Consistent with this they find that firms spend the capital
raised by loan facilities priced at a premium faster than other loan facilities,
especially when the premium is associated with a non-bank institutional
investor.

Gatev and Strahan (2009) decompose syndicated loan risk into credit, mar-
ket and liquidity risk and investigate how these different types of risks shape
the syndicate structure. They find that commercial banks dominate relative
to non-banks in loan syndicates that expose the lender to liquidity risk in
the form of credit lines. Bank dominance is much less pronounced in term
lending that is fully funded at origin. They argue that commercial banks have
a competitive advantage in hedging this liquidity risk due to synergies linking
deposits to lending. Axelson et al. (2012) examine the composition of debt
in a sample of global LBO-deals as a function of market conditions. They find
that during very liquid credit markets, when leverage is high, banks hold a
lower fraction of traditionally syndicated buyout debt.

Ivashina and Sun (2011a) ask whether the inflow in institutional funding in the
syndicated loan market experienced between 2001 and 2007 led to mispric-
ing of credit. To understand this relation they define the institutional demand
pressure as the number of days a loan remains in syndication. They find that
a shorter syndication period is associated with a lower final interest rate and
that increasing demand pressure from institutional investors causes the in-
terest rate on the institutional tranches to fall below the interest rate on bank
tranches7.

A number of the institutional investors in syndicated loans also hold signif-

icant equity positions in the same firm, so called dual holding. Jiang et al.
(2010) study what happens when shareholders also are creditors and find
that syndicated loans with the presence of dual holders are associated with

6 Risky borrowers in this study are defined as companies with high book-to-market, high leverage, poor
credit ratings, poor recent stock performance, and/or high return volatility. Examples of risky purposes are
LBOs and take overs.
7 This effect is significantly larger for loan tranches bought by structured investment vehicles.

Norges Bank Investment Management / Discussion NOTE 7

lower loan yield spreads (18 to 32 bps). They argue that the presence of dual Syndicated loans
holder mitigate the conflicts between shareholders and creditors, and thus
lower the yield spread.

Borrowers: A flexible source of funding

The trade-off theory, which is one of the most commonly used explana-
tions for leverage in the literature on company capital structure, suggests
that the capital structure of a firm should be tailored to the characteristics
of that firms assets (see Myers (2001) for a detailed discussion).The implicit
assumption has been that a firms leverage is completely a function of a firms
demand for debt. Faulkender and Petersen (2006) show that access to capital
is also an important determinant of observed capital structure and show that
firms with access to the public debt market have substantially higher financial
leverage than firms lacking such access. Maskara and Mullineaux (2011) com-
plement this research and show that syndicated loans provide an alternative
source of funding for firms that would otherwise not have been able to raise
funds through public debt issues or bilateral bank loans such as small firms
with already high leverage. The high level of leverage excludes these issuers
from the bilateral loan market while the fixed costs associated with a bond
issuance make this route less appealing.

Denis and Mihov (2003) examine the borrowers choice among bank debt,
non-bank private debt, and public debt. They find that the primary deter-
minant of the debt source is the credit quality of the issuer. Firms with the
highest credit quality borrow from public markets while firms with medium
credit quality borrow from banks and firms with the lowest credit quality
borrow from non-bank lenders. The debt choice is also related to a firms age.
Johnson (1997) finds that a firms age is positively related to the probability of
issuing public instead of private debt. Firms in the early stage of their life cy-
cle create credit reputation through bank loans and use this reputation later
to access the public debt market (Diamond 1991).

As in Denis and Mihov (2003), Arena (2011) identifies a pecking order on debt
choices depending on credit quality although with some important differenc-
es regarding the use of traditional private placements. When examining the
incremental debt issue decision Arena (2011) finds that high credit quality
firms prefer public bonds while good credit quality firms that are not large
enough to overcome the barrier created by flotation costs prefer to raise cap-
ital through traditional private debt offerings rather than bank loans .These
bank loans are extensively used by a large group of moderate quality issuers
while firms with the poorest credit quality preferentially issue 144A debt8.

Altunbas et al. (2010) investigate how the financial characteristics of Euro-

pean firms influence their marginal financing choice between the market for
syndicated loans and corporate bonds respectively. They find that syndicated
loans are the preferred instrument on the extreme end where firms are very

8 144a is an SEC rule that modifies the two year lockup requirement on private placement securities. 144a
allows debt private placements to trade to and from QIGs or qualified institutional investors with above
$100 million of investments. Banks must pass a $25 million minimum net worth test to qualify as QIG for 144a
trades. 144a securities are often called restricted securities. 144a has served to increase the liquidity for
private placements.

Norges Bank Investment Management / Discussion NOTE 8

large, have high credibility and profitability, but fewer growth opportunities. Syndicated loans
Their findings are summarised in the figure below, taken from their paper.

Figure 1: Firm financial state and debt structure

Size, financial leverage, profitability

- +

Private Bilateral Bond Syndicated

debt bank loans markets loans

+ -

Financial stress, growth opportunities

The role of covenants and collateral limit credit risk

1
Bharat et al. (2007) argue that the lead arranger has more information than
other syndicate participants and may prefer to renegotiate a loan instead of
enforcing the covenant because it finds other benefits in building/maintain-
ing its lending relationship with the borrower.

Rajan and Winton (1995) investigate how loans made by financial interme-
diaries on behalf of other investors can be structured to best enhance the
institutions role as delegated monitors. They find that covenants make a
loans effective maturity contingent on monitoring by the lender and can be
motivated as a contractual device that increase a lenders incentive to mon-
itor. Berger and Udell (1998) find that the close monitoring of the covenants
associated with bank debt and traditional private-debt reduce the cost of
debt for small firms that are early in their life cycle and have not had the op-
portunity to build reputation about their credit quality yet.

Dass et al. (2011) argue that in addition to being a device for monitoring
the borrower, covenants can help mitigate conflicts of interest between the
lead-arranger and participants in the syndicate. They develop a simple model
and find empirical support9 for its predictions that covenants are less like-
ly to be present in non-syndicated loans than in syndicated loans and that
covenants are less likely to be present when the leads allocation is greater.
In general, it appears that the more covenants are demanded by the other
participants in the syndicate, the lower is the fraction of the loan the leads
need to retain.

Failure to meet a covenant generally results in an increased spread in order to

better compensate the lender for the current level of risk. Chava and Roberts
(2008) show that financial covenants violations also have an effect of busi-
ness activity. They find that capital investments decline sharply following a
financial covenant violation and argue that the transfer of control rights asso-
ciated with a violation of a covenant serves as a mechanism through which
financing frictions impact investments.

9 Based on data from the Dealscan database.

Norges Bank Investment Management / Discussion NOTE 9

Trading a loan in the secondary market Syndicated loans
In contrast with typical loan syndication which is dominated by loans to in-
vestment grade companies, the secondary loan sales market is dominated by
more risky loans or so-called leveraged loans. The majority of loans traded in
the US secondary market are purchased by non-bank, institutional investors
(Yago and McCharthy, 2004 and Druker and Puri, 2009).

Altman et al. (2010) examine whether the relative monitoring advantage of

banks10 persist in the presence of an active secondary market for bank loans
and conclude that it does. Nevertheless, the secondary market represents
some challenges to banks and their borrowers. First, a loan sale can dilute
the monitoring incentives of banks since they can more easily offload to
third parties. Second, a loan sale represents an opportunity for lenders to sell
loans they know, based on private information, will perform badly.

Bushman and Wittenberg-Moerman (2009) examine whether the secondary

market trading of syndicated loans compromise the quality of bank lending
practises. For loans originated by reputable lead arrangers, they find evidence
that borrowers of traded loans actually perform better than borrowers of
non-traded loans do. Loan sales therefore appear to have a positive effect
on reputable arrangers incentive to monitor and screen borrowers. For loans
originated by lower reputation lead arrangers, they find some evidence that
the performance of borrowers of traded loans is worse than for non-traded
loans while restructuring purpose loans11 perform worse relative to other
loans, regardless of whether or not they are traded.

A loan sale might exacerbate information asymmetries between lenders and

borrowers as the new lenders are likely to have less borrower-specific infor-
mation and ability to monitor the borrower. Druker and Puri (2009) examines
the secondary market for loans sales and find that sold loans contain addi-
tional covenants and more restrictive net worth covenants than loans that
are not sold in the secondary market. Since covenants are written into the
contract at origination, lenders have to anticipate future selling at the stage
of entering into the contract. This indicates that some of the concerns raised
above are mitigated through the design of initial loan contract. Further, their
analysis suggest that sold loans are nearly two times larger and entail higher
risks as measured by the leverage ratio than loans that are not sold.

A loan that is trading in the secondary market is more liquid than loans
remaining in the books of the members in the initial syndicate. Gupta et al.
(2008) find that this liquidity is reflected in the pricing of US term loans at
origination. Banks charge lower spreads on loans that are expected to trade
in the secondary market, in doing so banks appears to pass over some of
their cost savings to the borrower. When comparing liquidity between the
two main categories of loans, they find that leveraged loans are more liquid
than investment grade loans mirroring the more active secondary market for
leveraged loans discussed in previous sections.

10 View for example Diamond 1984, Ramakrishnan and Thakor 1984 and Fama 1985
11 Restructuring purpose loans = loans with primary purpose of takeover, LBO, MBO or recapitalisation

Norges Bank Investment Management / Discussion NOTE 10

A number of academic studies document a positive and statistically signifi- Syndicated loans
cant return associated to press articles on loan agreements. This evidence
suggests that market participants view press reported bank loans as material
events (see, for example, Mikkelson and Partch (1986), Lummer and Mac
Connell (1989), Best and Zhang (1993), James and Smith (2000)). A number
of studies have examined the relationship between bank loans and stock
market prices and found that loan announcements tend to have a positive
impact on stock prices. Gande and Saunders (2012) investigate the relation-
ship between secondary market trading and equity returns and finds that
loan trading is valuable to equity holders. Their findings are at odds with
findings in earlier studies, such as Dahiya et al. (2003). Gande and Saunders
(2012) argue that this discrepancy mirrors a sea change in the way equity
holders value the loan market. The latter is no longer perceived as a market
where the only transactions that take place are the ones where informed
lenders off-loaded their troubled borrowers loans.

Investors in loans routinely receive private information about the borrower.

Ivashina and Sun (2011b) ask whether institutional investors use private loan
information to trade in public securities. They find that institutional partic-
ipants in loan renegotiations subsequently trade in the stock of the same
company and outperform other managers by approximately 8.8 percent in
annualised terms in the month following loan re-negotiations.

The market for leveraged loans

Leveraged loans can broadly be defined as loans provided to sub-investment
grade or unrated corporates. This is currently the most mature segment in
terms of participation from institutional investors12.

Market size and structure

As for other non-exchange traded instruments, high-quality comprehensive
datasets are hard to come by. The leveraged loan market in US amounted to
1.544 bn as of end December 201313. This figure includes USD-denominated
non-investment grade bank debt, covering both non-institutional (revolvers
and pro-rata) tranches and institutional facilities. Of the leveraged loan mar-
ket, fully drawn institutional term loans made up roughly half of the market.
The corresponding figures for the European leveraged loan market as of end
December 2013 was EUR 394 bn. and roughly one third of the loan market14.

12 Note that the term leveraged refers to the credit quality of the issuer and not a potential use of leverag-
ing strategies.
13 Source: Credit Suisse
14 Source: Credit Suisse

Norges Bank Investment Management / Discussion NOTE 11

Chart 1: Market size and new institutional loan volume for the US leveraged loan market Syndicated loans

1800 Market Size ($Billions) New Institutional Loan Volume ($Billions)

1600

1400

1200

1000

800

600

400

200

0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: Credit Suisse

Chart 2: Market size and new institutional loan volume for the Western European leveraged loan
market
600 Market Size (Billions) New Leveraged Loan Volume (Billions)

500

400

300

200

100

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Credit Suisse

Market Dynamics
The US and European market for leveraged loans differ a long a number of
dimensions. The most important ones are the pricing standard, the use of
public ratings, the liquidity, the availability of information and the require-
ments for documentation. In general, the US leveraged loan market is more
mature, public and transparent than that in Europe which is more private and
negotiated in nature.

In Europe, banks have traditionally been the key funding source for corpo-
rates, while US corporates to a greater extent have tapped into other sources
of funding15. It is fair to assume that the relative importance of banks shapes
the way the leveraged loan market works in respective regions16. Banks
generally play a more prominent role in the European market than in the

15 85 percent of European corporate debt was on banks balance sheets compared to 53 percent for the US.
The estimate for the US corporate sector also includes lending to farms and small unincorporated firms. If you
exclude these segments the share of corporate debt on banks balance sheets falls to 30 percent. (Samuels,
Harrison and Rajkotia: There Must Be Some Way Out of Here Can European bank funding be fixed?, Barclays
Equity Research , 19 March 2012).
16 View section 5 for a discussion on the dynamics in the leveraged loan markets in US and Europe.

Norges Bank Investment Management / Discussion NOTE 12

US where institutional investors are more active. In addition, the fact that Syndicated loans
the European corporates tend to have a more complex corporate structure
than US corporates due to the multi-jurisdictional nature of Europe and the
dominant role played by private equity firms (see below) may also partly
explain the observed differences in market dynamics. Table 1 is based on the
summary one European loan manager has made on key differences between
these two markets.

Table 1: Key differences US and European market for leveraged loans

Characteristics Europe US
Type of Borrower The market has traditionally More evenly balanced be-
been dominated by corporates tween levered corporates
owned by Private Equity funds and corporates owned by
Private Equity funds.
Type of Lender Commercial banks and some Institutions, credit funds,
institutions. prime/retails funds and
some banks
Lender dynamics Consolidated, barriers to entry, More of a capital market,
large new issue allocations fragmented, small alloca-
tions
Type of syndication Underwritten deals. Usually best effort
deals.
Pricing Largely standard, i.e. fixed Market driven. Most loans
spread vs. LIBOR. are today issued with a
LIBOR floor.
Information Disclo- Any information transmitted Loans and bonds are
sure between issuer and lender is traded on a comparable
confidential. Investors have ten- information basis and
dency to stay on the private side may be managed by the
of the wall. same desks.
Documentation Bespoke, strong protection Standardised, weaker
of lender through high voting protection of lenders than
thresholds, strong burden on in Europe, covenant-lite
lenders to do due diligence, cov- loans common
enant-lite loans not common
Defaults Most bankruptcy regimes in Public defaults,
Europe and the dominant role of court-driven and more
relationship banking favour pri- transparent, less ability
vate restructuring of distressed for secured lenders to
transactions rather than public influence the process
default. Generally a secured
lender driven bankruptcy pro-
cess, but this requires capacity
to engage in time consuming
restructuring processes.
Public ratings Growing, but a still a minority of Universal
the market
Secondary market Variable Better than in Europe,
liquidity primarily because of the
type of lenders active in
the market
Source: M&G Leveraged Finance

Norges Bank Investment Management / Discussion NOTE 13

Historical performance leverage loans Syndicated loans
To examine the historical risk-return characteristics of leveraged loans in the
US and Europe we use two indices provided by Credit Suisse, the Credit Su-
isse Leverage Loan Index (CS LL) for US and Credit Suisse Western European
Leveraged Loan Index (CS WELL).

The CS LL is an index designed to mirror the investable universe of the USD

denominated leveraged loan market. The index inception is January 1992.
The index frequency is monthly. A new loan is added to the index on its effec-
tive date 17 if:

It is rated rated 5B18 or lower

It is a fully- funded term loan
The tenor is at least one year
The issuer is domiciled in developed countries

So-called fallen angels19 are added to the index subject to the new loan
criteria above. Loans are removed from the index when they are upgraded
to investment grade, or when they exit the market (for example, at maturity,
refinancing or bankruptcy workout). Note that issuers remain in the index fol-
lowing default. The total return of the index is the sum of three components:
principal, interest, and reinvestment return. The cumulative return assumes
that coupon payments are reinvested into the index at the beginning of each
period.

The CS WELL is designed to mirror the investable universe of the Western

European leveraged loan market. The index includes loans denominated in
USD and Western European currencies and follows the same principles for
inclusion and exclusions as the US version of the index albeit with a smaller
number of issues. In the below analysis we examine the historical risk return
characteristics of the two indices over the period from January 1998 through
November 2013. The CS WELL is hedged to euro. Despite of the differences
in market dynamics the two indices have offered similar historical returns as
shown in Table 2.

Table 2: Historical risk and return, (monthly data, Jan 1998 Nov 2013, annualised returns)
United States Western Europe
Average return 5.2 % 4.9 %
Volatility 6.2 % 6.8 %
Min (monthly return) -13.0 % -17.7 %
Max (monthly return) 8.0 % 8.5 %
Source: Credit Suisse

The three key risks an investor is exposed to are credit risk, call risk and
market volatility. Although a loan normally enjoys seniority over other credi-

17 The effective date is the date the loan is closed.

18 The term 5B is in terms of credit rating used to described loans issued with a Baa1/BB+ or Ba1/BBB+
rating
19 A fallen angel is a term used to describe an issuer or borrower that once investment grade but that since
have been downgraded to sub-investment grade

Norges Bank Investment Management / Discussion NOTE 14

tors, the loan is nevertheless provided to a non-investment grade corporate. Syndicated loans
Each loan requires on-going credit research and monitoring. Due to their
position at the top of the capital structure loans have historically had lower
default rates and higher recovery rates than high yield bonds. JP Morgan loan
data from the US from 1990 to June 2013 stipulate long-term default rate for
senior loans to 3.5 percent with a recovery rate of 68 percent resulting in an
average default loss rate of 1.12. The corresponding number for high yield is
4 and 40.2 percent and 2.32

During the financial crisis the US leveraged loan market experienced a sharp
decline in market values and a spike in volatility. The sell-off was driven by
technical factors, caused by excessive new issuances and forced selling by
leveraged vehicles with market-value based triggers. Prices fell into the low
60s for vanilla first lien loans, mid-50s for first-lien covenant-lite and as far
as the low 40s for second lien loans as shown in Chart 3. Second lien facili-
ties are loans where the claim on collateral is junior to that of other first lien
loans.

Chart 3: Average price by seniority, CS LLI

120

100

80

60
Credit Suisse Leveraged Loan Index

First Lien
40
Second Lien

20

0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Source: Credit Suisse

Issuers ability to redeem the loan at par (callability) is a standard feature of

loan contracts. A loan investment therefore exposes the investor to call risk.
Supply-demand imbalances may expose an investor to volatility risk. Invest-
ments in loans require the ability to keep the exposure through such periods.
Before the financial crisis, performing loans generally traded close to or even
slightly above par. The potential for appreciation was capped by the callability
while the seniority in the capital structure capped the potential for deprecia-
tion.

Leveraged loans in a portfolio context

Loans are typically grouped together with traditional fixed income invest-
ments. While it is true that the principal amount that an issuer of a contract
has to repay at maturity is fixed, there are distinct differences between loans
and other type of fixed income instruments such as bonds, most notably
the floating rate and the seniority in the capital structure. Since the loan rate
normally is reset on a quarterly basis, interest rate sensitivity expressed as

Norges Bank Investment Management / Discussion NOTE 15

loan duration is typically around 0.25 years compared to around 5 years in the Syndicated loans
broader fixed income indices.

In Table 3 we compare risk and return characteristics of the Credit Suisse Lev-
erage Loan index to a set of US fixed income indices; high-yield, treasuries,
corporate (investment grade).

Table 3: Historical risk return (monthly data, annualised returns)

Panel A: Full sample (01/01/1999 - 29/11/2013)

CS LLI High Yield Treasuries Corporate
Mean return 5.2 % 8.0 % 5.1 % 6.1 %
Standard deviation 6.3 % 10.0 % 4.6 % 5.7 %
Return / st. dev. 0.8 0.8 1.1 1.1

Panel B: Sub-sample (01/01/1999 - 31/10/2005)
CS LLI High Yield Treasuries Corporate
Mean return 5.1 % 6.0 % 5.3 % 6.1 %
Standard deviation 2.4 % 8.2 % 5.0 % 4.9 %
Return / st. dev. 2.1 0.7 1.1 1.2

Panel C: Sub-sample (31/10/2005 - 29/11/2013)
CS LLI High Yield Treasuries Corporate
Mean return 5.3 % 9.8 % 4.9 % 6.2 %
Standard deviation 8.3 % 11.4 % 4.4 % 6.4 %
Return / st. dev. 0.6 0.9 1.1 1.0
Source: Credit Suisse, Barclays NBIM calculations

The perhaps most striking result is the differences in risk return character-
istics between the two sub-samples. In the first sub-sample (Panel B) lever-
aged loans was the most attractive fixed income investment when measured
in terms of return per unit of risk, while it was the least attractive one if we
limit our analysis to the second half of the sample (Panel C). The latter has
to be seen in relation to the development in the leveraged loan market at the
height of the financial crisis in 2008, when loans traded down nearly as much
as high yield bonds, but with about half of the coupon of high yields.

In Table 4 we examine the correlations between the same five indices. We

find that the returns on the CS LLI has been positively correlated to credit
spread sensitive instruments such as high-yield and corporate bonds, while
the correlations to interest rate sensitive products such as Treasuries have
been negative.

Norges Bank Investment Management / Discussion NOTE 16

Table 4: Correlation between different fixed income indices Syndicated loans

Panel A: Full sample (01/01/1999 - 29/11/2013)

CS LLI High Yield Treasuries Corporate
CS LLI 100 %
High Yield 78 % 100 %
Treasuries -37 % -20 % 100 %
Corporate 32 % 55 % 57 % 100 %

Panel B: Sub-sample (01/01/1999 - 31/10/2005)
CS LLI High Yield Treasuries Corporate
CS LLI 100 %
High Yield 61 % 100 %
Treasuries -22 % -5 % 100 %
Corporate 7% 36 % 86 % 100 %

Panel C: Sub-sample (31/10/2005 - 29/11/2013)
CS LLI High Yield Treasuries Corporate
CS LLI 100 %
High Yield 86 % 100 %
Treasuries -50 % -31 % 100 %
Corporate 40 % 63 % 37 % 100 %
Source: Credit Suisse, Barclays NBIM calculations

When we compare the performance of leveraged loans to other fixed income

investments during periods with rising and falling interest rates20 we find that
both leveraged loans and high yield bonds historically have performed well
during periods with rising interest rates. Possible explanations are that credit
spreads on high yield bonds have a tendency to compress in periods with
rising interest rates21 and that high-yield indices tend to have shorter maturity
than other fixed income indices22.

Table 5: Performance in different interest rate environments

CS LLI High Yield Treasuries Corporate
Rate up: mean return 11.1 % 12.5 % -6.7 % -2.6 %
Rate down: mean return 0.3 % 4.4 % 16.3 % 14.2 %
Source: Credit Suisse, Barclays, NBIM calculations

Leveraged loans and high-yield bonds are seen as close substitutes by many
investors and relative valuation methods are often applied to gauge the rela-
tive attractiveness. However, there are challenges in the evaluation. Convert-
ing a LIBOR based loan into yield to compare returns on leveraged loan to
high yield bonds to LIBOR-based is not straight forward. Loans are callable at
any time. Quantifying the prepayment risk is difficult at best. It is not only the
absolute level of interest rates but also changes in issuer credit quality and
required spread level that affect prepayment behaviour. The calculated yield
on the CS LLI is the equivalent fixed-rate yield-to-refunding of the facility. The

20 Measured by the 5-year US Treasury constant maturity.

21 View NBIM Memo On Fixed Income Investments, dated 18 March 2011
22 Average duration Treasuries 5.5 years, Corporate 6 years and High Yield 4.5 years over the sample period.

Norges Bank Investment Management / Discussion NOTE 17

index provider calculates this yield given different assumptions about maturi- Syndicated loans
ty. In chart 5, the maturity is fixed to three years.

Chart 4: US Leveraged Loan Yield vs. High Yield Bond Yield

20%

CS Lev Loan Index Yield (Assumes 3yr Refi)

18%

16% HY Yield-to-Worst

14%

12%

10%

8%

6%

4%

2%

0%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Source: Credit Suisse

When comparing the two instruments it is critical to appreciate and un-

derstand those nuanced differences between loans and bonds in order to
identify attractive investment opportunities. Broad indices covering investing
opportunities in the high-yield and leverage loan market respectively do not
necessarily include the same issuers. To gauge differences in the pricing of
secured and unsecured debt investors need to dig deeper into respective
indices and compare bond and loans by same issuer.

Norges Bank Investment Management / Discussion NOTE 18

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