Relative Values in Floating Rate Loans

Neuberger Berman Floating Rate Fund

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Aug 15, 2013
  • 52 Week HL
    19.14 - $14.24
  • Net Assets
    $89.06 M
  • Expense Ratio
    1.68%
  • Inception Date
    Feb 07, 2008

Q:  What is Neuberger Berman’s asset management profile? A : Neuberger Berman manages about $214 billion as of the end of June 2013, including approximately $105 billion in equities, $93 billion in fixed income, and $16 billion in alternatives. Of the fixed income assets, about $35 billion is in non-investment grade instruments, including about $28 billion in high yield bonds and $7 billion in floating rate bank loans. The Neuberger Berman Floating Rate Income Fund has about $530 million in assets under management. Q:  What are the advantages of investing in floating rate loans? A : A key advantage of investing in a floating rate fund is the low duration, especially when compared to high grade and high yield bond funds. The floating rate loan market is about $600 billion in size and the typical tenure on a loan is six to seven years. But, more importantly the coupon or interest rate is made up of two components – a floating base rate, typically LIBOR, and a fixed credit spread. If interest rates rise, income from the portfolio of loans increases too due to the floating base rate. Importantly, loans offer price protection because of their floating rate nature. We would expect fixed rate bonds to have significant price deterioration as rates move up, but we would not expect to see the same in a loan portfolio. Another advantage beyond duration is attractive income. If you look at most loan funds, the yield is attractive relative to other fixed income alternatives. Third, loan funds offer good diversification. If you look at historical correlations between loans and other fixed income options, loans have a very low correlation compared to investment grade and even negative versus treasuries. Q:  What is your investment philosophy? A : Our philosophy is to attempt to protect on the downside and seek to participate on the upside. To us, protecting on the downside in loan funds means starting with a large team of experienced research analysts performing extensive fundamental credit research. Our analyst team is organized along industry lines and performs bottom-up credit analysis. Analysts meet with management teams, look at industry fundamentals, evaluate company fundamentals and business models. They are tasked first and foremost with avoiding companies with deteriorating credit profiles. Our philosophy also favors asset-heavy companies, which we believe offer our clients downside protection. If you look at most service companies, their assets are people and if things go bad, people can walk out of the door. We prefer to look for companies with tangible assets -- what we call asset-heavy companies. Q:  What is your investment strategy and process? A : We initially apply a quality and size screen to the loan universe. By quality I mean that we avoid industries and companies that are stressed or distressed, or that we believe are heading in that direction. On size, we typically screen out smaller companies which we define as those with under $500 million in debt outstanding. We draw that line at $500 million because liquidity is very important to us. In smaller debt tranches, it is very hard to increase or decrease a position without moving the market. Our investment team at Neuberger Berman is very well known to all of the various U.S. and European banks that arrange these deals. If there is a new deal in the market the banks will brief us on it. Our Director of Research generally will screen those deals and pass them on to our sector or segment analysts for further research. The analysts perform extensive fundamental credit analysis and then present it to our investment committee. We have a very deep, experienced pool of analysts doing the fundamental work, but at the end of the day they have to convince our portfolio managers that their ideas should be included in the portfolio. The end result of our credit research is the formulation of an investment thesis and the assignment of an internal rating and that is what we use to make investment decisions. We are looking for companies that at worst are going to maintain their current credit profile, but preferably will be able to improve it over the coming years. Our loan selection process is mainly a bottom-up approach, but there also is a macro-economic analysis driven by our portfolio managers. For example, at the end of 2011 there was widespread concern the U.S. economy was going to dip into recession for the second time. We felt strongly as a portfolio management team that we were not going to double-dip. As such, we communicated to our research analysts that when stress-testing companies, they should not model a double-dip scenario. Q:  What is your research process? A : High yield and bank loan research is integrated because all of these companies are in the non-investment grade universe. In many cases the companies issuing bank loans are also issuing bonds at the same time. Our credit analysts need to get the credit right and then we will figure out if we want to own the loan, the bond, or both. The first time we see most companies is when there is a new leveraged buyout, a new merger, or a financial transaction in which a company goes private, such as, for example, the recent case with H. J. Heinz Company. Wall Street banks underwrite the debt, both loans and bonds, and then they approach both markets and determine the terms and the size of the offering. We are looking for management teams who want to de-lever their companies through free cash flow generation and debt paydown. Q:  How important is covenant analysis? A : A very important part of our analysis is researching covenants. In both bank loans and bonds, we want to understand what covenants companies have to live by. What are companies permitted and not permitted to do? Also, are there financial maintenance covenants that force companies to deleverage. Q:  What are some of the holdings of your portfolio? A : Some of the bigger holdings in the fund are Univision Communications Inc., Reynolds Group, and Charter Communications, Inc. They are examples of companies with tangible assets that we favor and which have very low senior secured leverage. Univision is a large Spanish broadcaster based in the U.S. It is well supported by good sponsors. Univision has a good growth story in, more generally, a broadcasting industry that is growth-challenged. Univision focuses on the Spanish-speaking market and that is a good demographic theme. Another large holding, Reynolds Group, is a major packaging company with a global footprint. Reynolds generates a lot of free cash flow and the company has the ability to de-lever. A third large holding is Charter, a cable service provider. Q:  What is your portfolio construction process? A : Our portfolio is diversified with between 125 and 175 different companies at all times and our maximum allocation in one loan is around 2-3%. We also diversify by sector. For example, healthcare has a big industry weight in the bank loan market of about 15%. You may see us overweight healthcare with a 17% or 18% exposure, which probably is the largest we would take in any one industry. Our benchmark is typically either the S&P LSTA Loan Index or the Credit Suisse Loan Index. Q:  What drives your sell decisions? A : We usually sell when the holdings deviate from our investment thesis. It could be that something has changed with the company, such as a management turnover, or a change in the industry fundamentals. Our selling decisions will be based on the credit analysis. In recent years, credit markets have been quiet as it relates to defaults so I cannot tell you we have been doing a lot of sells for credit reasons because companies are generally performing pretty well. Most of our selling lately has been in search of relative value. For example, perhaps we bought a BB-rated credit three months ago, when it yielded 4%, and it is now trading at 3.5%. If there is a new deal in the market, also BB-rated, that we think is of similar quality and priced at a premium to what we already own, then we will make that relative value swap, putting the new, higher yielding name, in the portfolio. Q:  How do you define and manage risk? A : In our asset class, the number one long-term risk is default risk. We focus on this because we do not want to lose our principal. The long-term default rate in our asset class is about 4%. The typical recovery in loans as an asset class is in the range of 70-to-80 cents on the dollar. By contrast, if you look at high yield, the typical recovery is 30-to-40 cents. Another risk is taking concentrated bets in a portfolio, so we mitigate that by portfolio construction, diversifying across multiple, issuers, industries, ratings profile, and by other metrics. There is also a liquidity risk. We focus on large cap names because we do not want to be in smaller names that do not trade as often as we like. We don’t want to get stuck with holdings going sideways and the inability to exit. That is why we have the overlay in our screening process to guide us toward larger names. We think we can generate additional return or alpha through trading so we want to be able to execute well when we decide to trade.

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The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.

The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.