As interest rates rise, bank loans look good

Money managers that run senior secured loan strategies are poised for a spike in business as institutional investors seek protection from rising interest rates.

Until recently, plan sponsors largely overlooked these strategies as too small or illiquid for a meaningful allocation. But growth prospects have become huge, especially as more investors consider alternatives to asset classes such as high yield, money managers said.

Senior secured loans are corporate bank loans of below-investment-grade issuers with floating interest rates generally based on LIBOR. The loans are typically senior secured obligations. They are considered an attractive investment option because they're secured and because of the floating rate structure, low price volatility and lack of correlation with other asset categories. Collateralized loan obligations are funds that invest in senior secured loans as collateral.

The $13.3 billion San Francisco City & County Employees Retirement System is exploring bank loans as an alternative to Treasury inflation-protected securities because of the difference in spreads, said Clare Murphy, executive director.

The senior secured loan market — or leveraged and high-yield loans — has more than doubled in size since 2000. Institutional investors held a total of $242 billion in senior secured loans as of Oct. 31, according to data from Standard & Poor's, New York. That's up from $193 billion as of Dec. 31 and $117 billion at the end of 2000. S&P did not have growth projections.

"The rising interest rates are adding fuel to the fire and really forcing people to look" at the senior secured loan marketplace, said Jack Yang, partner at Highland Capital Management LP in New York

Floating rate loan rates reset routinely and are therrefore less sensitive to interest rate changes than fixed-rate bonds. Senior secured loan strategies also offer attractive risk-adjusted returns and low correlation to other asset classes and low volatility. They also boast the highest Sharpe Ratio (85) of any asset class over the past decade, Mr. Yang said, four times the ratio for stocks in the S&P 500.

Highland expects to close 2005 with approximately $20 billion in assets under management, up from $11.9 billion at year-end 2004, with growth in its strategies across the board — separate accounts, alternative fixed income, collateralized loan obligations and hedge funds. About 70% of assets is institutional senior secured loans. Earlier this year, the firm acquired the CLO management business of ING Capital Advisors from ING Wholesale in New York, adding $850 million in assets.

While expansion is taking place, the money management landscape for senior secured loans is fragmented, with only a handful of established firms and a number of start-up managers, divestitures and spinoffs entering the field.

"In the past, (the bank loan and senior secured loan marketplace) was a well-kept secret of sorts," said Maggie Ralbovsky, vice president at Wilshire Associates, a consulting firm in Santa Monica, Calif.

Other pockets of activity are being reported by firms such as Franklin Advisors Inc., a unit of Franklin Templeton Investments, San Mateo, Calif., which recently won a $150 million senior secured bank loan portfolio from an undisclosed client.

"This is the first (mandate) we've seen coming out of high yield and into a bank loan," said Mark Boyadjian, a senior vice president of Franklin Templeton Investments, which had $1.8 billion in institutional bank loan assets under management as of Sept. 30.

"We're getting significant inquiries from plan sponsors to look at the asset class," hesaid, declining to identify any prospects.

Most of the recent senior secured loan activity has been confined to discussions among managers, consultants and their clients, according to several sources. However, some of the nation's largest pension funds are at the forefront of loan investing, including the $193.3 billion California Public Employees' Retirement System, Sacramento, which in May renewed a contract with Highland for a $322.2 million distressed bank loan portfolio. CalPERS initially made the investment in 2001.

Eaton Vance Management, Boston, is another firm receiving inquiries from investors about the asset class. The firm, known mostly for its retail mutual funds, is pushing into the institutional marketplace. It offers separately managed senior secured loan portfolios and collateralized loan obligations as well as its Institutional Senior Loan Fund, a mutual fund with a six-year track record. Those strategies represent $5.7 billion in institutional assets as of Nov. 8.

Walt Shulits, vice president – institutional bank loan relationships at Eaton Vance, said $4 billion of the institutional money has come in the last three years. "We tried to market (loans) to institutional investors for five years before we had success," he said.

Eaton Vance began offering senior secured loan strategies in 1995, and gained its first institutional client in this area two years later, according to Mr. Shulits. The client, which he declined to identify, invested in a senior secured loan strategy as part a fixed-income 401(k) option. Those assets became the seed money for the institutional senior loan fund. Today, Eaton Vance has 70 institutional clients invested in the fund, as well as other strategies. To further expand the business, Eaton Vance introduced a bank loan structured investment vehicle in September for institutional investors, he added.

Other money managers are just getting a toehold in the market. West Gate Horizons Advisors, LLC, Los Angeles, finalized a deal in September to purchase $2 billion in leveraged loan assets from ING Capital Advisors, Los Angeles.

With a dedicated loan group, West Gate Horizons plans to build business with "seasoned" institutional investors that can commit $50 million or more to its CLOs and separately managed leveraged loan portfolios, said Patrick Mitchell, a board member.

Wilshire's Ms. Ralbovsky said senior secured loans have mainly been used by its client's hedge fund managers "to arbitrage the mispricing in the capital structure of one specific issuer."