Stewart: My name’s Stewart Foley, I’ll be your host. Today’s topic is senior secured loans and we’re joined by Kevin Egan, Senior Portfolio Manager and Co-Head of Credit Research at Invesco. Kevin, thanks for being on man.
Kevin: Stewart, thanks very much for having me. It’s a pleasure to be here.
Stewart: This is a little bit of an unusual deal because my flight got canceled going to Chicago last night, I’m sitting in a hotel room in Philadelphia, and we’re employing all of our technology possible to make this happen today. We tried the timestamp these things because markets are moving so quickly, and so we are recording Friday morning, April 21st. And so before we go too far, I wanted to ask you, where did you grow up? What was your first job ever? Not the fancy first one. And then what’s a fun fact?
Kevin: Okay, so I grew up in a town called Greenlawn, which is a small town on the north shore of Long Island, so about 30 miles from where I’m sitting today. My family still lives out there, so really never moved too far than go to school. Actually, I went to school in Philadelphia for grad school, so very familiar with where you are. You could have taken the train up, we could have done this in my living room.
My first job was pumping gas at the local Getty Station in Greenlawn and then moved on my next summer job after that was selling furniture at Macy’s. So, like you said, not glamorous jobs, but they certainly were fun. Fun fact, I have really a strong work ethic, so much so that my first day here at Invesco 25 years ago, like you, very similar, I was coming in from New Orleans for Jazz Fest and my flight, just like yours, got diverted. And so instead of arriving home on Sunday, I arrived home on Monday, the day I was supposed to start and I didn’t want to be late for my first day of work. So like you, I went to the office dressed as I was from my vacation in shorts and a T-shirt. And fortunately, I had a very understanding boss who really appreciated my effort and was willing to overlook my attire for my first day. She sent me downstairs to a Banana Republic to buy some Chinos. So, not everybody starts their first day of work dressed quite like that, but obviously it’s gotten better from there.
Stewart: It reminds me of a kid that was a student of mine that was going for an internship interview and somebody in his house that he was living with, they parked their car behind his and the battery died and they couldn’t get it started and whatever. And he ran in a suit to the meeting and he was a hockey player and he was wringing wet when he got there and he’s just like, he got there on time and everything, but he ran in dress shoes, right? And it’s like, that shows you something, right? It’s like, this guy wants it and that matters. And he got the internship and it worked out well for him.
Kevin: Good for him. That’s very admirable. I can completely understand. So…
Stewart: Yeah, so one of the things that happens, Kevin, with me is I get a chance to learn a lot on these podcasts. So the asset class we’re talking about today is senior secured loans. And so what I wanted to start level set the thing is, what exactly are we talking about with senior secured loans? And what makes them a compelling asset class today in your mind?
Kevin: Sure. So I guess take a step back and what are senior secure loans? They are exactly what the name would suggests. They are loans made to big US and European corporations, generally Fortune 500, Fortune 1000 corporations, names you would be familiar with, Hertz, Burger King, Carnival Cruises, and they can be made for a number of purposes. Companies are making an acquisition, Burger King being acquired by a private equity sponsor or Carnival looking to finance a new ship. And what happens is they’ll go to a big money center bank, a JP Morgan or a Barclays, the bank will underwrite that loan and then that bank will turn around and syndicate it to a group of investors such as Invesco. And so we’ll buy a portion of that loan.
And the thing about the senior secure loans makes them so attractive is they’re exactly what it says they are, they are senior, they are the senior most obligation in the company’s capital structure, which means that we are first in right of repayment. That makes it very attractive. Secondly, they’re secured by all the assets of the company, the property, plants, equipment. So in the case of Carnival, we’re secured by the cruise ships. So if there’s a default and want to keep in mind these are all below investment grade companies, if there’s a default because we are secured by the assets of the company, we can accelerate, in the same way that the bank can accelerate on your mortgage if you don’t make your mortgage payments and take your house, and we can accelerate, take the company and either sell it in parts or refinance, pay ourselves down first. And so therefore, if there is a default situation, senior secured loans, generally speaking, recover 80 cents on the dollar. A high yield bond, which is below us in the capital structure, generally covers about 40 cents on the dollar. So that seniority and security may provide potential upside protection.
They are also, which is very compelling in the current market, floating rate instruments. So unlike a high yield bond which has a fixed coupon, a senior secured loan floats generally over three or six-month LIBOR or so forth. So as rates go up, and that’s obviously what we’ve seen over the last year or so, as rates go up, coupons on our loans go up almost in lockstep. So we saw a 400 basis point increase in rates last year. We’ve seen almost a 400 basis points increase in coupons on our portfolio. So that may potentially benefit some investors in a rising rate environment. Senior secured loans are the only asset class that actually benefits from rising rates. They have almost no duration, whereas every other fixed income asset class obviously suffers in a rising rate environment.
Stewart: And so what about deal flow and are these rated instruments or are they not rated instruments?
Kevin: These are all rated instruments. Again, they’re generally below investment grades, so single B, double B names generally speaking. In terms of deal flow, while this is a private asset class, you as an individual can’t go out and buy a loaned Carnival. It can only be acquired through institutional investors like ourselves. Even though it’s a private asset class, these are not securities. It’s actually a $1.4 trillion asset class here in the US, just about the same size as the high yield bond market.
So while people are much more familiar with high yield bonds, loans are a very important part of corporate capital structures. And in terms of market size, the equivalent of high yield bonds. They’re also very liquid instruments. We can offer daily liquidity products in the loan space. So there are loan ETFs. In fact, Invesco has the first and by far the largest loan ETF in the bank loan space. It’s about a $4 or $5 billion fund today. And our institutional products can offer daily liquidity as well. So, large liquid asset class trades frequently. You can’t buy it as an individual, but again, as big as the high yield bond market here in the US.
Stewart: That’s interesting. And so, not a lot of fixed income instruments did well in 2022, as you alluded to, a big increase in interest rates means a big decline in price for most of these fixed income instruments. How did senior secured loans do in 2022 and how have they performed this year?
Kevin: Well, they performed exactly as you would expect in a rising rate environment. They outperformed every other fixed income asset class, despite the fact that we obviously saw a lot of volatility in markets in general, senior secured loans were down just 1.1% in 2022. And then you compare that to high yield bonds, which were down almost 11%, and investment grade down more than 15%. So very strong outperformance on a relative basis. And even though they had negative returns in 2022, it was marginal. And that was actually only the third year in the last 34 years that loans even had a negative return overall because that high current income that you get on our coupons right now, coupons on the asset class are running just about 9%. That buffers a lot of volatility.
You move forward to 2023 and loan performance has been even stronger. We’ve seen very strong demand for the asset class. Loans are up almost 4% year to date. Investors are clipping a current coupon and sort of 9%. So every quarter you’re getting, let’s call it two and a half percentage points of coupon. And we’ve seen strong price appreciation because institutional demand, particularly in the form of CLOs, has been very strong for the asset class to start the year.
Stewart: Let’s switch over just a little bit to risks. So the risks in the asset class, I was fortunate enough to be at a couple of industry events in the last couple of weeks and there was some discussion of, while these floating rate instruments, the coupon resets higher, is there a point at which the companies who are the borrowers begin to struggle to repay those higher interest rates? Can you talk a little bit about the risk in the asset class and where you see it?
Kevin: Sure. So as you correctly identified, the number one risk to the asset class is the risk of default and the risk of loss-given default, and defaults can be caused by two different things. One, as you said, the inability for the company to be able to service its debt. And certainly in a rising rate environment, rising rates are a double-edged sword for the asset class. On the one hand, they result in much higher coupons. That’s great for investors who are benefiting from higher coupons as rates go up. But as you correctly point out, companies are also faced with higher interest burdens. The good news about the asset class is that coming into this hiking cycle, companies were in very good shape in terms of both one, their leverage-their leveraged today is actually lower than it was in 2019, and two, their ability to service their interest costs.
So, coming into 2022, the average company interest coverage ratio, the number of times their earnings actually compensated for their interest costs was about four times. So the average company could service their interest costs four times over. We did an analysis that suggested that for every 100 basis points of rate increases, the average interest coverage ratio would fall by half a turn. So coming into 2022, when we saw 400 basis points of rate increases, you would expect interest coverage ratios to go from four times to two times. Companies generally don’t get into trouble until their interest coverage ratio falls below one and a half times.
So, the average company could easily absorb those higher interest costs. What is even more interesting is that interest coverage ratios didn’t fall by two turns. They didn’t fall from four times to two times, they actually fell from four times to 3.4 times. And that is because during that same period of time, EBITDA growth from our companies was substantial. We saw even in the fourth quarter of 2022, year over year EBITDA growth was 14%. So companies had higher EBITDA to absorb higher interest costs and therefore their ability to service their interest expense was much greater than expected.
The other thing that happened is a lot of companies hedged out their interest costs, swapped the floating for fixed, and that helped them absorb higher interest costs as well. So as a result, defaults right now at the end of March are only running 1.3%. So despite very sharp hiking cycle, we only have 1.3% defaults. And while we do expect that to go higher, investors right now are being compensated for about a six and a half percent default rate in the market, where most prognosticators think defaults in 2023 would be somewhere between 3% and 4%. So, even with the higher interest burdens you mentioned, companies have very strong ability to absorb higher interest costs and defaults are going to move higher certainly, but probably only approach their long-term average of about 3%.
Stewart: That’s extremely helpful, thank you. And so, with regard to the issuer fundamentals, and it sounded like when you talk about interest coverage going from 4% to 3.4%, that that’s somewhat, and I don’t want to put words in your mouth here, but that sounds like a result of solid underwriting analysis on your part in terms of security selection. What can you tell me about the fundamentals of the companies that you’re investing in? Are you focused on particular industries? Are you avoiding certain things? I mean what can you tell us about that?
Kevin: Yeah. So as I said, underwriting is obviously key to this asset class and we have the largest team dedicated to just the bank loan asset class of any asset manager. And we’re also on what’s called the private side of the information wall, which means that we can receive information on our companies that are not available to high yield bond investors or other public investors. So we have a real informational advantage here in underwriting companies. As you said, underwriting is key here in terms of the fundamentals, leverage for companies in our portfolio is lower today than it was pre COVID. So you’ve seen companies lever up during pre-COVID and that leverage has come down sharply. We definitely are focused on sectors that we think are one, more resilient in the face of recession, so our base case scenario is to run interest rates up to five and a quarter percent, cut EBITDA by 10%, and look for those companies that can survive that type of scenario.
And we’re really focused on a couple different areas. One, the leisure and travel space. As you know from paying from airfare recently, demand for travel, demand for hotels, even in the face of recession remains very strong and some of those companies are still trading at a discount. You look at Carnival Cruises for instance, their bookings right now are ahead of what it was pre COVID, so very strong demand for travel. We’ve been overweight in that space as a result.
We’ve also been overweight in the chemical space because as oil prices have come down, we’ve seen companies be able to retain pricing, have lower feed stock costs, their margins are expanding. That’s very defensive in the current environment. Conversely, we’ve been underweight companies that have a very large labor component because as we all know, labor inflation has been very strong, labor has been very sticky. And so industries like healthcare for instance, where the government is your payer, the government is obviously not giving you big price increases, but you’re facing large wage cost increases, their margins are getting squeezed. That’s a very unattractive place to be.
Similarly, retail and restaurants, you think about that very large wage components there, not as much pricing power as they would like. You’re getting squeezed there as well. So really looking for those industries where labor is not a big component of their cost, whether they have very strong demand or types of companies such as chemicals where if we go into a downturn, it’s a relatively defensive play.
Stewart: And so you mentioned a little bit about this a moment ago, but is there anything else that investors should be expecting from this asset class this year? And I’m going to go, maybe unrelated, but something that was brought up to me and I think is relevant here. So, given what’s going on in the banking sector, it’s hard to see how the banks become a bigger component of meeting the capital needs of companies. And it seems like private credit is, there was a commentary out there that said, “Oh yeah, well once the 10-year note gets back to 4%, all this demand for private credit’s going to go away.” And it doesn’t seem like that’s the case at all. It seems in fact that given what very well may be tighter regulations for some banks, that the availability of bank lending could be lower and that private credit is going to be a very important source of funding to grow the US economy. How do you feel about that statement? What do you think?
Kevin: No, I think you’re right. I think you’re right on base and you sort of have to look at the private markets in two different components. There’s the broadly syndicated market, which is where we play, which are the large corporates there. And in that case, you’re right, the banks, while they underwrite the loans, they don’t hold them on their balance sheets, they are syndicating them. So you think about Morgan Stanley for instance, brings out a large deal, or JP Morgan, they’re not holding their credit and for exactly that reason, they don’t want to be in the business of holding that on their balance sheets. So they turn around and syndicate it to private lenders like ourselves. And we have become an increasingly large component of the broadly syndicated market.
In fact, banks hold very little or almost none of the big corporate loans that are originated in America today. So that is definitely true. Firms like ourselves have stepped into that void to provide that financing for corporate America.
At the smaller scale, the direct lending scale, which is typically loans less than $250 million, you’re completely correct there in that respect. In that case, banks aren’t even involved in the process at all. There’s a direct relationship between firms like ourselves that have a direct lending practice and smaller corporations. And those small companies that are small dental practice roll ups, for instance, or landscaping companies, will approach two or three small companies or lenders like ourselves directly for a loan. And that is becoming an increasingly large part of the market as well. So is that the high end? You’re right, banks have been completely disintermediated. At the lower end, banks aren’t even involved in the process at all. And that’s a good thing because it allows credit to flow more freely. You have institutional investors like ourselves who are completely agnostic and focused solely on returns for their investors.
Stewart: And as you know, our entire reader base and listener base is essentially insurance investors. So, whenever I speak to someone who’s an expert in an asset class, I want to try to put on my CIO hat. So with that in mind, if I’m an insurance company and I like this asset class, should I be buying it in SMA form? Should I be looking at your ETF? And if I do an SMA, how much customization can I get into the mandate?
Kevin: Yeah. I think that’s the last point is key. If you have an SMA, you can customize it any way you want to. We have SMAs that range from, I only want double B assets, I only want double B and single B, I only want a minimum of 10%, 20%, 30% in any sort of asset class. You can put concentration limits on individual issuers. You can put concentration limits on industries. An SMA is completely customizable and most of our insurance clients are actually in SMAs just for that reason because it allows them to dial the risk up and down depending upon their demand and where they see the market.
An ETF is a passive strategy. Our ETF holds the 100 largest loans in the loan market because that enables it to provide daily liquidity because those 100 largest loans are also the most liquid loans in the market, but there is no ability to customize. You can have a triple C asset in the top 100, the ETF has to hold that. In an SMA, you can say, listen, I don’t want any triple C assets. And so you can serve as ballast on the downside there. So SMA completely customizable. The ETF does have the advantage of daily liquidity, but most of your insurance clients, most of our insurance clients don’t want daily liquidity, they want to have their money locked up fully invested. Certainly you could liquidate at any point in that time, but again, completely customizable. And that’s generally speaking the route we’ve seen insurance investors go.
Stewart: Yeah, it makes total sense to me, Kevin, that the customization has its advantages. I came from a small insurance company and I’ve always got the smaller firms in my head and it’s nice though that they can still get access to the asset class in smaller bites efficiently, which is, I think a lot of insurance companies that are smaller don’t necessarily have a way to measure how challenging it is to get access to some of these asset classes. So that’s a great, it seems like it’s a good alternative for that crowd.
Kevin: Absolutely. And we offer both ETFs and also we offer commingled institutional funds for those insurance clients that want an actively managed strategy versus a passive strategy. Very similar in terms of their fee structure, but you have the option of the ETF passive or you have an actively managed strategy and a commingled fund for institutional investors as well.
Stewart: That’s helpful. So how do you see the current and projected interest rate environment affecting the asset class? And to bundle that together, what market technicals are affecting the asset class this year?
Kevin: Yeah, I think the technical picture has really been the biggest driver of the asset class this year. We’ve seen very strong demand from CLOs. CLOs are probably 65% to 70% of demand for the asset class currently. And year to date we’ve seen about $33 billion of CLO issuance, which is the same pace as we saw in 2022. And 2022 was the second largest year on record in terms of CLO issuance. So very strong demand from institutional investors. At the same time, very little supply. Many banks were still stuck with deals. For instance, the Twitter deal that was stuck last year, those deals have not yet cleared the market. And so bank underwriting has been slow and so therefore, new supply issuance has been slow as well.
So you have the technical where you have very strong demand, very little supply, and as a result, prices in the secondary market have been bid steadily up because as the CLOs look to ramp up- no new issuance, have to go into the secondary market to buy, and that’s bid prices up by more than 2% year to date. So, very strong technical picture in terms of the supply demand imbalance. We continue to see the new issue calendar going forward to be relatively weak. And as a result, we expect prices to continue to move up. So that’s largely a positive for the asset class. But right now, instead investors are clipping a 9% or so coupon, so that’s very attractive from a current income perspective. The yield on loans today is actually higher than the yield on high yield bonds. So you’re getting senior secured, top of the asset, top of the capital structure, and you’re getting a better yield than high yield bonds, which historically have demanded a yield premium because they’re subordinated and unsecured.
So that’s shaping up for a very strong technical picture for the asset class this year. And we expect that returns with the asset class will be well in excess of 10% for the year. So I think that shapes up as a very attractive relative value. JP Morgan did a study that showed even if interest rates declined by 1%, senior secure loan yields would still be double digits for the year. So you may serve to reduce downside potential of the floating rate asset class; as rates rise, coupons rise, your returns increase, but even if rates decrease, which obviously is not the base case scenario, senior secured loans are still going to offer very competitive returns for the year.
Stewart: That’s terrific. So every time I have somebody on like this, I learn a bunch, and I learned a lot about this asset class today. I’ve just, I really appreciate you being here. I got one, this is a new question for 2023, Kevin, this is a good one, right? So here we go. I’m going to try it out. What’s the best piece of advice you’ve ever gotten?
Kevin: The best piece of advice is probably don’t make assumptions, ask the questions. And I think that that’s key to credit analysis. You want to be curious, you want to be tenacious, but you’re also going to be able to work with people. And I’ve been very fortunate all throughout my career to have great colleagues, great partners, wonderful teams to work with, and no one does it by themselves. And without that, I wouldn’t be sitting here talking to you today. So always ask the question, never make the assumption.
Stewart: I love it. Thank you very much. We’ve been joined today by Kevin Egan, Senior Portfolio Manager and Co-Head of Credit Research at Invesco. Kevin, thanks for taking the time.
Kevin: Stewart, thanks for having me. Appreciate it.
Stewart: Thanks for listening. If you like what you’re hearing, please rate us and review us on Apple Podcast. We certainly appreciate it. My name’s Stewart Foley and I’ve been your host, and this is the InsuranceAUM.com podcast.