Senior Loan Market Commentary

Nuveen Closed-End Funds - Information & Press Releases: Quarterly Commentary & Research:

Senior Loan Market Summary and Outlook Fourth Quarter 2008

The fourth quarter of 2008 was the worst quarter in recent history for virtually
every asset class. During this period of time, the market saw the collapse of
some of the largest and most respected firms in the world, including Lehman
Brothers (which filed for bankruptcy on September 15, 2008) and American
International Group. While nearly every market and asset class were effected by
this unwind, perhaps none was more impacted that the senior loan market. The
collapse of Lehman Brothers, which had a large amount of credit-related assets
on its books (senior loans, corporate bonds, high yield bonds, securitized debt,
etc.), led to a massive deleveraging in the credit markets. Not only was the
market affected by the forced selling of assets by Lehman Brothers into a
volatile market, but Lehman Brothers was also a major counterparty in the credit
default swap (CDS) market. Investors who faced Lehman Brothers in the swap
market were attempting to offset exposure and the uncertainty surrounding
created significant dislocations during the period.

As Lehman Brothers (LEH) began to flood the market with paper as a known
forced seller, buyers were non-existent. Quite the contrary, as so many parties
had some exposure to LEH (either direct of indirect) or held similar assets to
those that Lehman was pushing out into the market at firesale prices, they too
became forced sellers. Forced selling took a number of different forms through
Q4, however it all resulted in the same effect: the simultaneous and broad
selling of assets with little or no buyer. One dominant forced seller during this
period of time was the market-value CDO (collateralized debt obligation).
These structures all have diversified asset portfolios which are funded by the
simultaneous sale of debt. As the market value of these structures’ assets (or
collateral) came down, many were forced to delever as the mark-to-market
value of their assets became too low relative to their liabilities. When a CDO
unwinds, it generally puts its collateral up for auction in what is known as a
“BWIC” (or bids-wanted-in-competition). These BWICs are a list of assets
(primarily senior loans and high yield bonds) that must be immediately sold to
the highest bidder. During this time, it was not uncommon to see $3B worth of
BWIC activity in a single week. As a BWIC order was filled, investors who held
the same paper within their own accounts were forced to mark these assets to
market, often times at massive discounts, despite the fact that the assets were
not impaired. Another group of investors that became affected by this
cascading effect were hedge funds and non-traditional loan buyers. When
hedge funds historically bought senior loans they did so through a total return
swap facility (or “TRS”), which in some cases gave investors five to seven times
leverage on these assets. While this seemed reasonable during more benign
market conditions, the volatility in late September and October resulted in
widespread margin calls. The result of a margin call is, again, more forced
selling.

Hedge funds and CDOs were not the only investors that felt the pain of forced
selling. Both closed-end and open-end funds were forced sellers as well. Amid
the panic of the Lehman Brothers collapse, investors fled both high-yield bond
and senior loan open-end funds, which resulted in redemption requests that
were funded via the sale of assets. Even closed-end funds (which are not
subject to redemption requests) were in many cases forced sellers. CEFs have
an asset and liability relationship that is in some ways similar to CDOs, albeit
with far less leverage. (CDOs can employ upwards of 10 times leverage versus
less than .5 times for a typical closed-end fund). The asset prices of these
funds were being marked down on a mark-to-market basis, meanwhile their
liabilities (preferred shares and bank lines) remained effectively static. Given the
limitation of how many liabilities can be written against a given amount of
assets under securities laws, funds were forced to sell assets to pay down
liabilities. As with other market participants, this process was extremely
painful. Few people were willing (or more accurately able) to step in and buy
paper, despite the fact that this sharp downturn was driven by supply/demand
imbalances, as opposed to the impairment of the assets through default or
other fundamental deterioration.

This cascading effect continued through mid-December in various stages as
continued markdowns were met with the continued sale of assets. In many
cases, this selling was driven by liquidity, meaning that investors sold what they
could to raise cash. Within the credit space, the senior loan market (and
convertible bond market) has become larger than the high yield bond market
and as such, senior debt underperformed on a mark-to-market basis despite
the fact that it remains senior to bonds within a company’s capital structure. At
several points in time, we saw senior secured debt yielding more than high yield
bonds within a single issuer. From a “rational” long-term investment
perspective this makes little sense, given that senior secured lenders (who own
loans) are paid first in event of default and often have a lien on the issuers
assets, which is why loans have historically enjoyed a higher recovery value than
bonds in the event of default.

In mid-December, while fundamentals (defaults, earnings, etc.) began to
deteriorate the technical landscape began to improve. With more than $15B of
BWIC activity over with (according to Credit Suisse), and the closed-end fund
community seemingly in a better position as a result of the necessary
adjustment of leverage, forced selling abated. At the same time, the market saw
literally zero new-issue, which helped alleviate the supply side of the equation.
On the demand side, the market saw some stabilization and mitigation of “tail
risk” as a result of actions taken by the U.S. government. Meanwhile, companies
continued to repay debt, including Alltel’s $3.5B early repayment as a result of
the Verizon transaction. This fresh cash was quickly put to work as many loans
remained at unprecedented levels. In many cases, we saw non-investment
grade, higher-quality issuers, in defensive industries (hospitals, utilities, cable
companies) with strong balance sheets that were yielding above 12% based on
current market levels.

Buyers moved into the senior loan market in late December into January. While
fundamentals remained weak, with a swift acceleration in defaults and broad
weakness in earnings, investors came in on the premise that the market was
already pricing in most foreseeable weakness. Senior loans were seen by some
investors as offering senior secured risk profiles, with return potential that was
equal to (or in some cases greater than) unsecured and junior parts of the
capital structure. Moreover, loans were priced to unprecedented yields despite
3-month LIBOR (London Interbank Offered Rate), the base rate of most senior
loans’ coupon payment, which was at 1.08% on 1/14/09 (1.425% on 12/31/08).
Since these assets were trading with implied spreads so wide, despite a low
LIBOR rate, investors view loans as offering a “free option” on LIBOR actually
going back up at some point in the next four years, which many view as highly
likely and an added benefit to the holder of senior loans.

January proved, for any doubters left in the room, that loans have in fact
become an increasingly volatile asset class. In January, the senior loan market
rallied hard, despite a falling equity market. While the credit markets were
strong overall, no part of the market matched the senior loan market as the
Credit Suisse Leveraged Loan Index returned 5.78% during the month of
January. This return is more than double the second highest monthly return
seen since inception of the Index in 1992 (the second highest was April of 2008
at 3.31%).

The recent buying activity in the loan market remains focused on higher-quality
(still not investment grade) on-the-run issuers. Smaller deals continue to
languish only a few points off of all-time lows seen in mid-December.
Meanwhile the market continues to discount predominantly negative
information as the market holds firm. Consensus seems to be that the technical
sale of loans has reversed course and, like on the way down, is overpowering
fundamentals. Through the end of January, we continue to believe that loans
are at depressed levels versus their intrinsic value. This environment may likely
create an opportunity for investors in loans who have deep fundamental
capabilities to select mispriced names.