CIO WM Research

7 June 2013

Understanding bonds
An introduction to senior loans
Senior loans can offer an attractive alternative to more "traditional"
fixed income segments. In this Education Note we explain the basics of this asset class.
Philipp Schttler, strategist, UBS AG philipp.schoettler@ubs.com Barry McAlinden, CFA, strategist, UBS FS barry.mcalinden@ubs.com

Senior loans are originated by banks and then sold to institutional

investors. Via loan funds, individual investors can obtain exposure to the asset class. The US is by far the biggest and most developed market for senior loans. The US senior loan market has been growing steadily, rising from USD 100 billion in 1999 to USD 560 billion by now.

Loan borrowers are usually medium or large firms with a subinvestment grade credit rating. Thus, the asset class is often compared to high yield (HY) bonds. The most important features to consider when investing into senior loans are 1) their very low interest rate duration due to their floating-rate character; 2) their lower default risk; 3) their high liquidity risk and 4) call risk. In what follows we will take a closer look at each of the four. US senior loans (simply referred to as loans in what follows) offer an attractive alternative to more "traditional" fixed income investments in the current low interest rate environment. As we will show, loans outperform other fixed income instruments when interest rates rise or stay flat thanks to their floating-rate nature. Given the current low level of benchmark rates, chances are very good for either of the two scenarios in the coming 12 months. At a current yield of 5.5%, loans offer appealing income while protecting against higher rates (see Figure 1). Furthermore, loans provide exposure to the most senior part of a company's capital structure and are typically secured by the company's assets (see Figure 2). The current healthy state of US corporate balance sheets and our outlook for very low default rates in the next 12 months contribute further to a supportive fundamental backdrop for US loans. Fig. 1: Loans offer an attractive yield compared to other fixed income segments Yield to maturity in %
25

20

15

10

0 2007

2008

2009

2010

2011

2012

2013

US senior loans US 10-year Treasury

US high yield US investment grade corporate

Sources: Bloomberg, UBS CIO WM - as of 27 May 2013

This report has been prepared by UBS AG and UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 4. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Understanding bonds

Priority of claims

Loans are usually issued by sub-investment grade rated companies, which is why they are also sometimes referred to as leveraged loans. In that respect the asset class shares some characteristics with the high yield bond market. There is some overlap in companies that have both loans and high yield bonds outstanding, although not all loan issuers also have bonds. With more than USD 500 billion outstanding, the US loan market is roughly half the size of the US HY market. But there are crucial distinctions between loans and bonds to be aware of: 1. Duration: The coupon rate on senior loans is floating, which means that it is reset regularly based on the development of a short-term benchmark rate plus a stated credit spread. In the case of US loans, the benchmark is usually the 3-month USD LIBOR and the reset is done every 45 to 60 days on average. As a consequence, rate duration of senior loans is close to zero and the interest rate risk is thus very low, which is especially beneficial in times of rising rates. A recent development since the financial crisis has been the introduction of LIBOR floors, or minimum reset rates. In these cases, the coupon is fixed until the market LIBOR rate exceeds the floor level, which moderately increases the loan's duration. Approximately 80% of the leveraged loan index currently contains a LIBOR floor. 2. Credit risk: As implied by their name, senior loans have a higher ranking within a company's capital structure. That means in case of a default, this part of the debt will be first in priority to obtain recovery values. Additionally, senior loans are typically secured by the borrower's assets giving the lender/investor additional security. Furthermore, loans usually involve protective covenants providing the lender with forceful control over the borrower. These features lead to lower default rates as well as higher recovery values for loans relative to HY bonds (see Figure 3). The average annual credit loss over the last 20 years was 1% on US loans and 2.6% on US high yield bonds. In summary, the credit risk of senior loans is considerably lower than for HY bonds. However, the leveraged nature of issuers does make the loan asset class highly sensitive to credit cycle fluctuations. 3. Liquidity: Loans are traded "over the counter" (OTC) between different banks and mostly loan fund managers. Investors can get access to the market via such a loan fund which usually offers liquidity on a monthly or bi-weekly basis. Furthermore, to protect fund investors from the adverse effect of a forced selling of the underlying loans when prices are low, these funds can "gate" at times of market stress. This means that a liquidation of the investment might not be possible immediately in times of distressed markets but may take time. Thus, senior loans clearly provide less liquidity than even HY bonds. While this feature is actually a useful protection for long-term investors, it has to be considered carefully before making an investment into loans. For US investors who gain loan exposure through open-end or closed-end funds, liquidity risk would be reflected through volatility in the underlying net asset value. 4. Call risk: The majority of loans are immediately callable, although some have a USD 101 soft call where the issuer has to pay a USD 1 penalty to refinance at a lower rate for the first six months or one year following issuance. Many issuers have taken advantage of strong market conditions and have repriced their loans to lower credit spreads by taking advantage of this continuous call feature. Similar to the HY bond market, call features will constrain the price appreciation potential of loans during strong market conditions.

Fig. 2: Loans rank senior within a company's capital structure Priority of claims of different securities

Senior loans Senior unsecured bonds Subordinated bonds Tier 1 / hybrid bonds Equity
Source: UBS CIO WM

Fig. 3: Loan default rates are consistently lower Annual default rates on US loans and high yield bonds with long-term averages (lines)
16% 14% 12% 10% 8% 6% 4% 2% 0%
19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12

US senior loans

US high yield bonds

Sources: Moody's, UBS CIO WM - as of 27 May 2013

Fig. 4: Loans lagged other segments in a phase of structurally declining interest rates... Total return indexes (31 December 1996 = 100)
350 300 250 200 150 100 50

Sources: Bloomberg, BoAML, UBS CIO WM - as of 27 May 2013

19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13
US corporate bonds US high yield bonds US Treasuries US senior loans

UBS CIO WM Research 7 June 2013

Understanding bonds

As can be seen in Figure 4, senior loans have provided relatively stable positive total performance since 1996 (with the important exception of the 2008 sell-off) but total returns fell short of the returns of other fixed income segments. However, this masks an important point: Floating-rate instruments perform best when interest rates rise (or remain flat, but still provide good yield pickup). As shown in Figure 5, loans achieved very attractive returns of 8% annualized in periods of rising interest rates, thereby outperforming most other fixed income segments by a wide margin. When rates fall however, loans are the clear laggard. As such it is not surprising that other fixed income segments benefited more from the structural decline in government bond rates over recent decades. From current low levels a further fall in interest rates looks unlikely to us. We expect US Treasury yields to increase gradually over the next 6 and 12 months by 20 basis points and 50 basis points, respectively. To summarize, US senior loans provide an attractive credit market alternative to "traditional" fixed income investments when investors anticipate stable or rising benchmark interest rates and seek relatively stable coupon income. While the volatility of senior loans can be expected to be lower than for HY bonds, so is liquidity. Investors considering an investment in loans should be well aware of the fact that liquidity is limited, and can easily dry up, particularly if market conditions worsen. Thus, senior loans should only be considered by investors with an adequate risk profile who would otherwise be comfortable investing in HY bonds.

Fig. 5: ...but loans outperformed in periods of rising rates Average annualized returns; the interest rate regime refers to the change of the 5-year Treasury yield
20% 16% 15% 16% 13% 10% 10% 6% 5% 8%

0% -1% -5%

interest rates fall

Treasuries High yield corporate bonds

-3%

interest rates rise

Investment grade corporate bonds Senior loans

Sources: Bloomberg, BoAML, UBS CIO WM - as of 27 May 2013

UBS CIO WM Research 7 June 2013

Understanding bonds

Appendix
Global Disclaimer
UBS CIO WM Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal as principal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected with an issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties for any reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law. In developing the Chief Investment Office economic forecasts, CIO economists worked in collaboration with economists employed by UBS Investment Research. Forecasts and estimates are current only as of the date of this publication and may change without notice. External Asset Managers / External Financial Consultants: In case this research or publication is provided to an External Asset Manager or an External Financial Consultant, UBS expressly prohibits that it is redistributed by the External Asset Manager or the External Financial Consultant and is made available to their clients and/or third parties. Australia: 1) Clients of UBS Wealth Management Australia Ltd: This notice is distributed to clients of UBS Wealth Management Australia Ltd ABN 50 005 311 937 (Holder of Australian Financial Services Licence No. 231127), Chifley Tower, 2 Chifley Square, Sydney, New South Wales, NSW 2000, by UBS Wealth Management Australia Ltd.: This Document contains general information and/or general advice only and does not constitute personal financial product advice. As such the content of the Document was prepared without taking into account the objectives, financial situation or needs of any specific recipient. Prior to making any investment decision, a recipient should obtain personal financial product advice from an independent adviser and consider any relevant offer documents (including any product disclosure statement) where the acquisition of financial products is being considered. 2) Clients of UBS AG: This notice is issued by UBS AG ABN 47 088 129 613 (Holder of Australian Financial Services Licence No 231087): This Document is issued and distributed by UBS AG. This is the case despite anything to the contrary in the Document. The Document is intended for use only by Wholesale Clients as defined in section 761G (Wholesale Clients) of the Corporations Act 2001 (Cth) (Corporations Act). In no circumstances may the Document be made available by UBS AG to a Retail Client as defined in section 761G of the Corporations Act. UBS AGs research services are only available to Wholesale Clients. The Document is general information only and does not take into account any persons investment objectives, financial and taxation situation or particular needs. Austria: This publication is not intended to constitute a public offer or a comparable solicitation under Austrian law and will only be used under circumstances which will not be equivalent to a public offering of securities in Austria. The document may only be used by the direct recipient of this information and may under no circumstances be passed on to any other investor. Bahamas: This publication is distributed to private clients of UBS (Bahamas) Ltd and is not intended for distribution to persons designated as a Bahamian citizen or resident under the Bahamas Exchange Control Regulations. Bahrain: UBS AG is a Swiss bank not licensed, supervised or regulated in Bahrain by the Central Bank of Bahrain and does not undertake banking or investment business activities in Bahrain. Therefore, Clients have no protection under local banking and investment services laws and regulations. Belgium: This publication is not intended to constitute a public offering or a comparable solicitation under Belgian law, but might be made available for information purposes to clients of UBS Belgium NV/ SA, a regulated bank under the "Commission Bancaire, Financire et des Assurances", to which this publication has not been submitted for approval. Canada: In Canada, this publication is distributed to clients of UBS Wealth Management Canada by UBS Investment Management Canada Inc.. Dubai: Research is issued by UBS AG Dubai Branch within the DIFC, is intended for professional clients only and is not for onward distribution within the United Arab Emirates. France: This publication is distributed by UBS (France) S.A., French "socit anonyme" with share capital of 125.726.944, 69, boulevard Haussmann F-75008 Paris, R.C.S. Paris B 421 255 670, to its clients and prospects. UBS (France) S.A. is a provider of investment services duly authorized according to the terms of the "Code Montaire et Financier", regulated by French banking and financial authorities as the "Banque de France" and the "Autorit des Marchs Financiers". Germany: The issuer under German Law is UBS Deutschland AG, Bockenheimer Landstrasse 2-4, 60306 Frankfurt am Main. UBS Deutschland AG is authorized and regulated by the "Bundesanstalt fr Finanzdienstleistungsaufsicht". Hong Kong: This publication is distributed to clients of UBS AG Hong Kong Branch by UBS AG Hong Kong Branch, a licensed bank under the Hong Kong Banking Ordinance and a registered institution under the Securities and Futures Ordinance. India: Distributed by UBS Securities India Private Ltd. 2/F, 2 North Avenue, Maker Maxity, Bandra Kurla Complex, Bandra (East), Mumbai (India) 400051. Phone: +912261556000. SEBI Registration Numbers: NSE (Capital Market Segment): INB230951431, NSE (F&O Segment) INF230951431, BSE (Capital Market Segment) INB010951437. Indonesia: This research or publication is not intended and not prepared for purposes of public offering of securities under the Indonesian Capital Market Law and its implementing regulations. Securities mentioned in this material have not been, and will not be, registered under the Indonesian Capital Market Law and Regulations. Italy: This publication is distributed to the clients of UBS (Italia) S.p.A., via del vecchio politecnico 3, Milano, an Italian bank duly authorized by Bank of Italy to the provision of financial services and supervised by "Consob" and Bank of Italy. UBS Italia has not participated in the production of the publication and of the research on investments and financial analysis herein contained. Jersey: UBS AG, Jersey Branch, is regulated and authorized by the Jersey Financial Services Commission for the conduct of banking, funds and investment business. Luxembourg: This publication is not intended to constitute a public offer under Luxembourg law, but might be made available for information purposes to clients of UBS (Luxembourg) S.A., a regulated bank under the supervision of the "Commission de Surveillance du Secteur Financier" (CSSF), to which this publication has not been submitted for approval. Mexico: This document has been distributed by UBS Asesores Mxico, S.A. de C.V., a company which is not subject to supervision by the National Banking and Securities Commission of Mexico and is not part of UBS Grupo Financiero, S.A. de C.V. or of any other Mexican financial group and whose obligations are not guaranteed by any third party. UBS Asesores Mxico, S.A. de C.V. does not guarantee any yield whatsoever. Singapore: Please contact UBS AG Singapore branch, an exempt financial adviser under the Singapore Financial Advisers Act (Cap. 110) and a wholesale bank licensed under the Singapore Banking Act (Cap. 19) regulated by the Monetary Authority of Singapore, in respect of any matters arising from, or in connection with, the analysis or report. Spain: This publication is distributed to clients of UBS Bank, S.A. by UBS Bank, S.A., a bank registered with the Bank of Spain. UAE: This research report is not intended to constitute an offer, sale or delivery of shares or other securities under the laws of the United Arab Emirates (UAE). The contents of this report have not been and will not be approved by any authority in the United Arab Emirates including the UAE Central Bank or Dubai Financial Authorities, the Emirates Securities and Commodities Authority, the Dubai Financial Market, the Abu Dhabi Securities market or any other UAE exchange. UK: Approved by UBS AG, authorized and regulated in the UK by the Financial Services Authority. A member of the London Stock Exchange. This publication is distributed to private clients of UBS London in the UK. Where products or services are provided from outside the UK, they will not be covered by the UK regulatory regime or the Financial Services Compensation Scheme. USA: This document is not intended for distribution into the US and / or to US persons. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc., UBS Financial Services Inc. is a subsidiary of UBS AG. Version 1/2013. UBS 2013. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.

UBS CIO WM Research 7 June 2013