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What Just Happened?
It appears that we have just completed the first significant market disruption to the senior loan market while experiencing no credit defaults. The impact of Hedge Funds trading in all financial markets has inextricably linked all markets to a degree never seen before. The impact of this linking struck every asset class. Even high-grade municipal bonds experienced a decline equal to the decline in senior loans – i.e. between 3 and 4%. As someone said, it was as if an atomic bomb was dropped in the sub-prime mortgage market and the shock waves were felt all the way to the municipal market and the senior loan market. The hedge funds needed cash to meet margin calls on other asset classes. To get this cash, they had to sell some of their best holdings in these two markets since they were priced at or near par. A case of when in need of cash, sell the best holdings to get the most cash as fast as possible – a vindication of the underlying value in an asset class that holds its value.
This all started in early July, when the flow names were trading at 99.68% of par, off from the first six months of 2007 average of 100.53%1. The pipeline for new loans at that point stood at approximately $230 billion, an unprecedented level facing the market. However, the sub-prime collapse was affecting the conduits and commercial paper facilities, and suddenly the CLO segment (which is a major funding source in this asset) could not structure a CLO that could profitably continue buying loans. Due to the rapid increase in spreads in the conduits and commercial paper markets, the CLO arrangers stopped funding their senior loan warehouses, while hedge funds began selling loans and some CLO warehouses were unwound, exacerbating the selling positions to an extreme measure. This reduced the prices on all senior loans. Suddenly the market was flooded with Sellers and not enough Buyers, a stark contrast to June, when it was precisely the opposite – too many Buyers driving spreads for loans down and propagating the issuance of covenant lite loans.
As the financial markets were experiencing disruption, we witnessed two key responses: the various Central Banks injected liquidity into their markets and the Federal Reserve lowered interest rates by a full one-half of one percent. These steps settled the markets and we have begun to see stabilization come back to the senior loan business. Additionally, approximately $50 billion in new deals were withdrawn from the market or at least delayed, reducing the funding pressure. As the spreads on commercial paper have started to return to a more normal level, the overwhelming fear of significant funding problems has begun to abate and we are seeing CLOs entering the market again. New buyers, private equity firms and other non-traditional accounts entered the market to take advantage of the bargain prices and the opportunity to own a senior piece of paper that is also collateralized. As a result, we are getting to a better balance of Buyers and Sellers, which is bringing prices up slowly.
The Senior Loan market is currently experiencing an increase in NAV as all of the financial markets recover. How long it will take for the market to fully recover is anyone’s guess, however, many observers believe it will take at least a six-month period to get back to “normal”. The average price of the flow names loans according to Standard & Poor’s Leveraged Commentary and Data report of October 2, 2007 has been slowly improving. From a low of 95.13%, they are now back into the 97.64% range, having declined from 100.09% on June 9th. Over the last three weeks, the entire senior loan asset class has exhibited a steady but slow rise in NAV.
Interest Rates
The Federal Reserve surprised the markets by lowering rates by a full one-half of one percent (1/2%) at the September Federal Reserve Meeting. Is this the last reduction? No one knows for sure, but we do know the bond market “experts” are all predicting that the Fed will lower rates again. However, as noted by the current stock market increases and the fact that we have begun to see some new loan activity, while the banks are now reporting the recognition of their problems relating to the recent financial market mess, there seems to be some positive movement in all financial markets, including the senior loan market.
Additionally, Commercial Paper spreads are returning to normal as the issuing banks fully backed the paper they had been issuing. As a result, the fears of significant funding problems appear to be past and the market appears to be returning to normal.
What does all this mean for the bank loan market? We believe it means the bank loan market will begin to receive more appropriate risk spreads and substantive covenants will be included in most of the new Loan Agreements. Any new covenant lite deal will be priced at a substantially greater spread than in recent months reflecting the increased risk. These steps are bringing stability back to the market, permitting the senior loan market to properly assess risk and be paid appropriately even should the economy perform at a slower rate.
The unemployment rate remains very low and indications are it will continue that way for the foreseeable future. Those corporations that borrow using senior secured loans continue to demonstrate strong cash flows and operating margins. It appears this will continue for the remainder of 2007 and into 2008. The trailing 12-month default rate as reported by S&P is approximately 0.55% and continues to establish new lows. (Movie Gallery became only the second loan to default this year in this asset class while total overall there have been 15 corporate defaults this year according to S&P.) Moody’s and S&P are both predicting that default rates will increase in 2007, but that they will remain well below the long-term average, which is in the 3% range.
Senior Loan Market
Over the last couple of weeks, the multi-billion dollar First Data loan was successfully syndicated using several innovative techniques including an Original Issue Discount (OID), thus improving the economics for the buyers of the debt. The secondary market picked up on this and we have seen increased secondary trading take place. This seemed to unlock the market and more transactions have started coming through the pipeline. For example, nine new transactions entered the market the last 10 days of September after only a couple in the previous two weeks.
A number of new buyers have entered the market, and several of the hedge funds that had been selling loans in July and August due to the sub-prime chaos have been able to get back into the buying mode. The return to more normal levels in the commercial paper market and the conduits has also been favorable in that CLOs may again become buyers. As was noted in the previous Commentary, the market had swung into a highly unbalanced buyer – seller mode with so many more sellers than buyers that the prices of all loans had to decline. Obviously with a balance, prices and spreads may return to more normal levels and covenants may be re-inserted, strengthening the senior position in the capital structure. Lenders are demanding better protection (covenants) and greater compensation (greater spread over LIBOR). With Lenders demanding better spreads, existing loans experience pricing pressure.
The new issue calendar has been significantly reduced thus relieving some of the pressures on the market. We remain convinced that investment selection remains critical to providing a competitive return on investment for our Investors. Our investment philosophy is that it is the loan you do not make that is vital in maximizing the return over time to the shareholder. Throughout this difficult period, the asset class has continued to demonstrate positive returns with an approximate 3 to 4% decline in NAV but a coupon of approximately 7%. NAV is improving and the dividends remain strong even with the one-half percent decline in Federal Funds.
Outlook
Throughout this troublesome period of the last three months, we have not seen a decline in the credit quality in our senior loan portfolio. We continue to see strong earnings from the companies in which we have invested. We expect the credit quality to remain strong and the risk of a major generalized increase in defaults to remain small over the next 12-18 months or more. The external factors noted above are causing us some short-term pain in NAV. However, we expect that all performing senior secured loans that may be temporarily market priced below par will repay its obligations at par.
Further, as we have noted in earlier Commentaries, as the issuing banks grew ever more aggressive in their lending practices, we have been increasing our turndown ratio such that we are now declining over 65% of all new transactions. The deals we have been declining are often over leveraged, under priced, covenant lite, under weak management or within a distressed industry. When the next economic decline does arrive, the deals most likely to experience financial difficulty will be these kinds of transactions.
We continue to believe that interest rates will stay at or close to current levels for some time to come. The economy should remain strong and although it may not grow at the rate it did in 2006 and the first 2 quarters of 2007, it will continue to grow at a more moderate rate. A large number of corporations and equity investors continue to pursue merger and acquisition opportunities. Merger and acquisition activity has historically meant greater opportunities for senior secured lenders. The new issue calendar for the remainder of 2007 is in response to the increased demand from both the public investor via mutual funds and institutions though separate accounts and/or leveraged vehicles.
1 S&P’s LCD Quarterly Report, “Leveraged Lending Review, 3Q07”
The information above reflects the views of the Portfolio Manager and the Senior Loan Group at the time of writing. These views may change in response to changing circumstances and market conditions. Please note the opinions expressed herein do not purport to represent a complete picture of the Senior Loan marketplace nor the future
1S&P’s LCD Quarterly Report, “Leveraged Lending Review, 3Q07”
performance of any Van Kampen product. The forecasts and opinions in this piece are not necessarily those of Van Kampen and may not actually come to pass.
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There is no assurance that the closed-end fund will achieve its investment objective.
Like stocks, a closed-end fund’s share price will fluctuate with market conditions and other factors. At the time of sale, your shares may have a market price that is above or below the net asset value and may be worth more or less than your original investment. Accordingly, it is possible to lose money investing in the trust. The information presented contains forward-looking statements. You are cautioned not to place undo reliance on forward-looking statements, which speak only as of the date on which they are made and which reflect management’s current estimates, projections, expectations, or beliefs, and which are subject to risks and uncertainties that may cause actual results to differ materially.
Please be aware that this Trust is subject to certain additional risks, including the following: The Borrower, under a Senior Loan, may fail to make scheduled payments of principal and interest, which could result in a decline in net asset value and a reduction of the Trust's yield. There is no guarantee that the collateral securing a Senior Loan will be sufficient to protect the Trust against losses or a decline in income in the event of a Borrower's non-payment of principal and/or interest.
The Trust may invest in Senior Loans made in connection with leveraged buyout transactions, recapitalizations, and other highly leveraged transactions. These types of Senior Loans are subject to greater risks than are other Senior Loans in which the Trust may invest. A substantial portion of the Senior Loans in which the Trust invests may be rated below investment grade. Debt securities rated below investment grade are viewed by rating agencies as having speculative characteristics and are commonly known as “junk bonds.” Should the Trust employ leverage, the portfolio may experience increased volatility.
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