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Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
Senior Loans Are Good for Your "Core"
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Senior Loans Are Good for Your "Core"

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Senior loans have generated attractive real yield. Senior loans had lower volatility and a high recovery rate. Senior loan market has grown exponentially and has become quite durable.

Senior loans have generated attractive real yield. Senior loans had lower volatility and a high recovery rate. Senior loan market has grown exponentially and has become quite durable.

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  • 1. Not FDIC Insured May Lose Value Not Bank Guaranteed INSIGHTS SENIOR LOANS ARE GOODSENIOR LOANS ARE GOOD FOR YOUR “CORE”FOR YOUR “CORE” JOSEPH WELSH, CFAJOSEPH WELSH, CFA HEAD OF HIGH YIELD CORPORATE DEBT TEAMHEAD OF HIGH YIELD CORPORATE DEBT TEAM A large amount of capital has recently entered the senior loan market as investors sought to insulate their portfolios from the rapid rise in U.S. Treasury rates. This has prompted some to ask whether the senior loan trade is over. I believe investors would be better served viewing an allocation to senior loans not as a tactical “trade” at all, but rather as a long-term, core position in their portfolios. Investors generally rely on core positions to consistently deliver desirable attributes regardless of market environment. Senior loans have met this definition in the past, and should, in my view, continue to do so for the foreseeable future. Over several market cycles, including periods of rising, stable and declining interest rates, senior loans have consistently generated higher income than investment-grade bonds (albeit with greater credit risk), while exhibiting lower volatility and stronger diversification benefits than high yield bonds. In this paper, I explore each of these attributes in greater detail, discuss why the market’s exponential growth and proven durability further supports the case for the asset class, and explain how investors can strategically build their senior loan allocations. EXECUTIVESUMMARY Senior loans are worthy of a long-term, core position in investor portfolios. ◆ Potential to consistently deliver desirable attri- butes Senior loans offer high income potential (with greater credit risk), low relative volatil- ity, and potentially strong diversification benefits. ◆ Operating in a durable and evolving capital market The senior loan market has seen tremendous growth over the last 10 years, and has the potential to become of comparable size to the high yield bond market. ◆ Building a core position in senior loans How investors con- struct a core position in senior loans depends on individual needs and goals, but selecting an actual senior loan strategy should be based on a proven ability to consistently generate the attributes senior loans offer.
  • 2. HIGH INCOME POTENTIAL Investors face a unique set of chal- lenges when it comes to generating income in their portfolios. With investment-grade bond yields barely outpacing inflation, investors must seek out new sources of income to meet their needs. Across domestic fixed income offerings, senior loan yield levels have historically exceeded both investment-grade bond yields (with greater credit risk) and inflation rates, only falling below those of high yield bonds. These high income levels have con- tributed to a solid total return profile across most interest rate environ- ments. While past performance is no guarantee of future results, senior loans have delivered positive returns in 21 of the last 22 calendar years, posting an annualized return of 6.03% (as measured by the Credit Suisse Leveraged Loan Index) over that period. Moreover, senior loans have generated this consistently positive performance regardless of whether long-term U.S. Treasury rates were rising, stable or even fall- ing (the latter two being denoted by the shaded portions of the graph). Potential to Consistently Deliver Desirable Attributes *Senior Loans as measured by the Credit Suisse Leveraged Loan Index for the 22-year period ending 12/31/13. The inception date of the Credit Suisse Leveraged Loan Index is 1/1/92. Source: Credit Suisse Research, Barclays Research, JPMorgan Research, as of 12/31/13. High Yield Bonds are represented by the Credit Suisse High Yield Index. Senior Loans are represented by the Credit Suisse Leveraged Loan Index. U.S. Investment-Grade Bonds are represented by the Barclays U.S. Aggregate Bond Index. U.S. Treasuries are represented by the Barclays U.S. Treasury Index. Inflation is represented by the U.S. Consumer Price Index, which produces monthly data on changes in the price paid by urban consumers for a representative basket of goods and services. The indices are unmanaged and cannot be purchased directly by investors. Index definitions can be found on the last page. Past performance does not guarantee future results. *Senior Loans as measured by the Credit Suisse Leveraged Loan Index for the 22-year period ending 12/31/13. The inception date of the Credit Suisse Leveraged Loan Index is 1/1/92. Source: Credit Suisse, as of 12/31/13. Shaded portions represent the year in which the 10-Year U.S. Treasury rate did not increase. Senior Loans are represented by the Credit Suisse Leveraged Loan Index. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. Index definitions can be found on the last page. Past performance does not guarantee future results. Senior Loans Have Generated Attractive Real Income Senior loan yields have generally exceeded those of investment-grade bonds and inflation rates. Senior Loans Have Performed Well in Most Interest Rate Environments Senior loans have posted positive performance (with the exception of 2008) regardless of interest rate trend. CHART 1 CHART 2 0 5 10 15 20% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 I High Yield Bonds I Senior Loans* I U.S. Investment-Grade Bonds I U.S. Treasuries I Inflation I Senior Loans* I Year of Falling or Stable Treasury Rates –30 –20 –10 0 10 20 30 40 50% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2
  • 3. volatility in high yield bond prices. This disparity is the primary reason that senior loans have displayed historically lower volatility than high yield bonds. At the same time, senior loans may provide better downside price protec- tion relative to high yield bonds should a company experience distress or, in rare cases, default. The reason is that senior loans typically hold a senior and secured position in the capital structure and have garnered higher recovery rates. As an issuer’s fundamentals deteriorate over time, and its loan and bond prices fall towards their expected recovery rates, loan prices might decline less, all things being equal. Consequently, while many investors like to focus on senior loans’ default rate, we believe the more relevant metric for analyzing the asset class is their default loss rate—the percentage lost in a default after recovery. LOW RELATIVE VOLATILITY Investors may be attracted to both senior loans and high yield bonds because of their high income poten- tial. However, due to their floating rate coupons, senior loans carry extremely low interest rate sensitivity (if any), espe- cially compared to high yield bonds. Thus, while interest rate fluctuations may have little impact on senior loan prices, they may result in meaningful Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as rates change. Senior loans represent an investment in a generic, floorless senior loan with a 90-day reset period. Source: JPMorgan Research and Credit Suisse Research, as of 12/31/13. Annualized standard deviations are based on monthly returns for the 20 years 12/31/93–12/31/13. Senior Loans are represented by the Credit Suisse Leveraged Loan Index unless otherwise noted. High Yield Bonds are represented by the Credit Suisse High Yield Index. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any particular investment. Index definitions can be found on the last page. Past performance does not guarantee future results. Less Volatility While Recovering More Lack of interest rate sensitivity and a senior/secured position in the capital structure have helped senior loans to experience historically lower volatility and default loss rates, respectively. CHART 3 Asset Class Duration Annualized Standard Deviation Capital Structure Claim Average Recovery Rate Average Default Rate Average Default Loss Rate SSeniorenior LLooananss 0.0.2255 55..5%5% SSeniorenior//SSecurecureded $$00.6.699 33..5%5% 11.1.1%% High Yield Bonds 3.59 8.1% Subordinated/ Unsecured $0.41 3.9% 2.3% INSIGHTS 3
  • 4. DIVERSIFYING A PORTFOLIO Over the past 20 years, senior loans have also exhibited relatively low correlations to other asset classes, delivering strong diversification benefits. Importantly, historical senior loan correlations to U.S. and international stocks have been meaningfully lower than those of high yield bonds. The reasons are twofold. First, high yield bonds and equity have subordinated claims in a company’s capital struc- ture. This means that both may suffer more in “risk off” or recessionary environments, and prosper more in expansionary markets, relative to senior loans. Second, a sustained tightening cycle in interest rates is generally less favorable for stocks and duration-carrying high yield bonds than for senior loans, which have minimal interest rate risk. Correlation expresses the strength of relationship between distributions of returns between two data series. Correlation is always between +1 and –1, with a correlation of +1 expressing a perfect correlation, meaning that the two series being compared behave exactly the same, a correlation of –1 meaning the two series behave exactly opposite and a correlation of zero meaning movements between the two series are random. Diversification does not guarantee profit or protect against loss. Source: Bloomberg 12/31/13. U.S. Stocks are represented by the S&P 500 Index. International Stocks are represented by the MSCI EAFE Index. U.S. Treasuries are represented by the Barclays U.S. Treasury Index. U.S. Investment-Grade Bonds are represented by the Barclays U.S. Aggregate Bond Index. International Bonds are represented by the Citigroup Non-U.S. World Government Bond Index. Commodities are represented by the Dow Jones-UBS Commodity Index. Senior Loans are represented by the Credit Suisse Leveraged Loan Index. High Yield Bonds are represented by the Credit Suisse High Yield Index. Correlation factors presented are based on monthly returns for the 20 years 12/31/93–12/31/13. Chart is for illustrative purposes only and does not predict or depict the performance of any particular investment. Indices are unmanaged and cannot be purchased directly by investors. Index definitions can be found on the last page. Past performance does not guarantee future results. Senior Loans May Help Diversify Individual Investor Portfolios Senior loans have displayed historically low correlations to other commonly held core positions. CHART 4 Asset Class U.S. Stocks International Stocks U.S. Treasuries U.S. Investment- Grade Bonds International Bonds Commodities Senior Loans High Yield Bonds SSeniorenior LLooananss 0.0.4433 00..4747 ––0.0.3322 ––00.0.033 ––00.0.055 0.0.3366 1.1.0000 00.7.788 High Yield Bonds 0.62 0.64 –0.14 0.19 0.13 0.35 0.78 1.00 4
  • 5. The reasons for the market’s growth include: ◆ Wider acceptance and increased investor demand. ◆ Companies’ age-old need to raise funds via capital markets to maintain or grow their operations. ◆ Companies’ realization that they may lower their cost of capital and enhance their flexibility in terms of call protection (loans may be easier to refinance than high yield bonds). ◆ Recent regulation making it less attractive for banks to carry loans on their books, and more attractive to underwrite/syndicate them. I believe that continued investor demand for senior loans may lead to additional growth should these trends prove sustainable, especially given long-term U.S. Treasury rates’ potential to move higher. While attempting to forecast the future size of the market may be difficult, it is not unreasonable to believe senior loans could become of comparable size to, and even surpass, high yield bonds at some point in the next several years. Reminiscent of the high yield bond mar- ket in the 1990s, the senior loan market has seen very rapid growth over the last 10 years, with the number of securities doubling to nearly 1,500, and the size of the market quadrupling to nearly $800 billion as of December 2013 (for comparison, the high yield bond market has only increased 50% over the same period). As a result of this impressive growth, the senior loan market has become quite durable, remaining very much open with transactions occurring frequently during the last two market swoons of late 2008 and August 2011. Operating in a Durable and Evolving Capital Market Source: Credit Suisse Research, as of 12/31/13. The chart represents the historical market sizes by calendar year. Past performance does not guarantee future results. Senior Loan Market Continues to Grow Trends in the senior loan market could point to continued expansion. CHART 5 I Senior Loans I High Yield Bonds Senior Loans 297.5%Senior Loans 297.5% High Yield Bonds 50.5% 2003-2013 MARKET GROWTH RATES 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 0 200 400 600 800 1,000 1,200 1,400 $1,600 INSIGHTS 5
  • 6. The idea that senior loans have merely a temporary, tactical role to play in a portfolio is outdated. Still, many remain unsure how senior loans fit as a core holding in a broader portfolio. As with the construction of any core position, the best way to allocate strategically to senior loans depends on an inves- tor’s needs and goals. If the primary objective is to increase a portfolio’s income potential, reducing investment- grade bond exposure and investing the proceeds in senior loans may be an appropriate solution. If, on the other hand, the goal is to seek lower overall volatility, an investor may wish to pare down the amount of high yield bonds held in favor of senior loans. When selecting a specific senior loan strategy in which to invest, it is essential to find a manager who has historically delivered the key attributes senior loans have provided. In managing senior loan portfolios for over 15 years, I believe the best way to achieve this is to employ a fundamental, bottom-up investment process. Performing rigorous credit analysis on every issuer in the market is a crucial step toward unlocking value on the most granular level and consistently generating the high income potential, low relative volatility, and diversifica- tion potential that investors need in all market environments—not just when interest rates rise. Building a Core Position in Senior Loans 6
  • 7. This page intentionally left blank. INSIGHTS 7
  • 8. Past performance does not guarantee future results. The Credit Suisse High Yield Index tracks the investable universe of below-investment-grade bonds in the United States. The Credit Suisse Leveraged Loan Index is a composite index of senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior bank loans and includes reinvestment of income (to represent real assets). The Barclays U.S. Aggregate Bond Index is an index of U.S. Government and corporate bonds that includes reinvestment of dividends. The Barclays U.S. Treasury Index represents public obligations of the U.S. Treasury with a remaining maturity of one year or more. The S&P 500 Index is a market capitalization weighted index of the 500 largest domestic U.S. Stocks. The MSCI EAFE (Europe, Australasia, Far East) Index is designed to measure developed market equity performance, excluding the U.S. and Canada. The Citigroup Non-U.S. World Government Bond Index is composed of foreign government bonds with maturities over one year. The Dow Jones-UBS Commodity Index is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. Fixed income investing entails credit risks and interest rate risks. When interest rates rise bond prices generally fall and a fund’s share prices can fall. Senior loans are typically lower rated (more at risk of default) and may be illiquid investments (which may not have a ready market). The underlying loans held in senior loan funds are subject to significant credit, valuation and liquidity risk. Diversification does not guarantee profit or protect against loss. These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open of business on April 30, 2014, and are subject to change based on subsequent developments. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund’s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting oppenheimerfunds.com or calling 1.800.CALL OPP (225.5677). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY 10281-1008 © 2014 OppenheimerFunds Distributor, Inc. All rights reserved. DS0001.412.0414 April 30, 2014 CONTACTCONTACTUSUS Visit oppenheimerfunds.com Call 800.225.5677 JOSEPH WELSH, CFA HEAD OF HIGH YIELDHEAD OF HIGH YIELD CORPORATE DEBT TEAMCORPORATE DEBT TEAM Joseph Welsh is co-portfolioJoseph Welsh is co-portfolio manager of Oppenheimermanager of Oppenheimer Senior Floating Rate FundSenior Floating Rate Fund and Oppenheimer Seniorand Oppenheimer Senior Floating Rate Plus Fund. He hasFloating Rate Plus Fund. He has specialized in non-investment-gradespecialized in non-investment-grade investing since 1991.investing since 1991. Follow us: Visit blog.oppenheimerfunds.com Search Google Currents for OppFunds to access our timely thought leadership Visit oppenheimerfunds.com | Call 800.225.5677 Scan this code to learn more about us:

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