Q:  Why should investors consider investing in a leveraged loan fund? A : Even today, interest rates remain very low, and many investors are looking for current income. One way to get that is by investing in longer duration fixed income investments, but the risks with that strategy to me are excessive. Loans offer investors compelling current income without duration risk. Q:  What is your involvement with the fund and how has it changed? A : I joined Invesco in 2000 and have been managing the fund since 2006. Originally, the Invesco Floating Rate Fund was set up with quarterly redemptions because the asset class was not as liquid as it is today. Today, this fund offers daily liquidity. But while the fund has changed slightly, its overall goal has not: to invest in leveraged loans and offer investors a high level of current income without exposing them to duration risk. The changes in the fund parallel the evolution of the loan market. As an example of how the asset class has changed, today you have bank loan ETFs. INVESCO manages a bank loan ETF which has a market cap of approximately $4.5 billion. We have gone from an asset class where people did not think you could offer daily liquidity, to an asset class where you can now have minute-by-minute liquidity. Q:  Why should investors look to Invesco to manage their leveraged loan portfolio? A : We offer a great value proposition to our clients: our people and investment expertise, our access to the Wall Street firms which underwrite and syndicate the loans, our understanding of investor needs and our systems. If you put it all together we believe the final result is a highly effective platform. One of the differentiators between Invesco and many other competitors is that we have a team dedicated to the research and management of bank loans. Our senior investment committee has been together since 2000 and all of us have essentially spent our entire professional careers in the loan space. Reporting to us are four team leaders, and every team leader has in excess of 20 years of experience in the loan market. Reporting to the team leaders are analysts who have experience ranging from 4 to more than 20 years. With 29 investment professionals, all of which have many years of experience in the loan market, Invesco is able to offer a competitive level of depth and knowledge. The other thing is the portfolio optimization, trading and back office systems that we have. We have either designed and created these systems, or taken an “off the shelf” system and then substantially modified it to meet our needs. We think we have the best information technology in the loan market. I cannot prove that to you but I sincerely believe that nobody has systems as sophisticated as ours are for seeking risk-adjusted alpha. Additionally, Invesco’s policy establishes an Information Wall to control communications and allows us to access private information. Very often our borrowers provide access to confidential information that may include material, non-public information. This is an asset class that is private and non-exchange traded, and investors have the option to take a company’s projections and talk with management about issues that are not going to be broadly disseminated to investors who need to stay “public” on a name. We understand this private information is valuable, and our ability to have access to private side information helps us make better investment decisions. The obvious question is why all investors in this asset class don’t take private information, and the answer is that you can’t if you are running a hybrid loan and bond platform. Finally, we are not a retail only shop, and in fact we may be better known as an institutional investor. We are a manager of CLOs, separate and comingled institutional accounts, and of course we have the largest ETF in the industry. The reason why we think this is important is that not only does it provide us with access to the sell-side banks, but it also gives us a very special depth of insight into what all the major classes of investors are thinking, and that perspective—whether it is from the Wall Street firms or clients across the globe--allows us to better navigate technicals. Q:  What part of the loan market do you focus on and what is your investment philosophy? A : We are focused on the larger and more liquid end of the loan market, and currently there are about $600 billion in loans that fit this broad parameter. From time to time, we will make investments in smaller companies, but that tends to be very much the exception rather than the rule. Generally speaking, the companies that we lend to are going to have EBITDA of at least $50 million. It is rare for us to lend to companies who have less. If you use a generic enterprise valuation multiple of five times EBITDA, then the smaller companies that we lend to are going to be worth at least $250 million. Our goal is to look for ways to balance out the risk of a loan with the reward of the interest from that investment. If you are striving to be a top performing manager, as we are, you can’t only invest in the debt of the safest companies. Similarly, you can’t take on too much risk either. Any good manager will tell you that they are striving to strike this balance between risk and reward. What we think is that as a result of our team we do an excellent job understanding and balancing the risks and the rewards. Q:  What is your investment process? A : The core of our portfolio construction starts from the bottom up with the loans that are evaluated for purchase or sale. Some may approach portfolio management almost exclusively from a “top down” perspective, and we think that is an enormous mistake. In this asset class, all the risk is to the downside and therefore caution is essential in terms of individual credit exposure. The first task of the analyst is to avoid the credit land mines, and to do that well requires lots of experience. Each of our analysts has a particular area of expertise and each sector has particular credit parameters; obviously, lending to a cable company is going to be different from lending to an auto supplier. We analyze individual credits one at a time. That starts with the analyst doing several things, including: meeting with the management team and asking tough questions, developing a financial model, and talking with clients or competitors. Once the analyst is done with their work, then there is a discussion to determine whether or not we really understand the credit risks of that company and whether or not we are getting paid for the credit risk. So we have the bottom up granular view, we have the top down view in terms of the overall economy that is provided by the senior members of the team, and then we have what I call a side view, which is a sector view. We will meet with our analysts who cover different sectors. Those analysts will offer their view on how we should be positioned in their particular sector. Do we like healthcare right now and if so what subsectors within healthcare? What do we think are the risks to those individual subsectors? From that we will ask whether or not we want to be overweight a particular sector at 12% or do we want to be underweight at 6%? The final way that we look at portfolio management is through more of a technical view which is provided by our traders. We will meld those views together in an effort to achieve an optimized portfolio. This does not mean that we are striving to offer the highest possible return, but it does mean we are looking to provide the highest return associated with the risk that we are taking. Q:  How is investing in floating rate loan different from investing in high yield bond fund? A : These two types of funds are in many ways very similar. They both invest in the debt of non-investment grade companies, and if you looked at the holdings of a loan fund and a bond fund you would see that in many cases the loan fund would be holding the senior secured floating rate debt of the same company whose unsecured bonds are being held in the high yield bond fund. So, what’s the difference between a loan fund and a bond fund? The first difference is when you invest in a bond fund and one of the issuers files for bankruptcy, typically the recovery is somewhere in the neighborhood of 20 to 40 cents on the dollar. There is a range associated with it but it tends to be a quite small recovery in the event of a bankruptcy. But, if you owned the bank debt of that company, the ultimate recovery in the event of a bankruptcy would typically be somewhere in the neighborhood of 80 cents on the dollar. So when you compare a bond fund to a loan fund, you are taking a great deal more credit risk with the bond fund. More credit risk equals more volatility, which means you should get paid more for being in a high yield bond fund. The other difference is one of duration. When you invest in some bond funds, you may be looking at duration risk of about 4.5 years. When you invest in a loan fund, you typically have a duration risk of 45 to 60 days. Again, because you are taking on more volatility in a bond fund than in a loan fund, you should expect to get paid more for that additional duration risk. So, bond funds should give you a higher level of return and a higher level of volatility than a loan fund, and that has certainly been the case over the past decade. But, during most of that time, we have been in a falling interest rate environment. So, if you think that we are likely to be in a rising interest rate environment, then loan funds should not only have less volatility than bond funds, they may also have higher levels of total return. Q:  Why does this asset class exist? A : The reason this asset class exists is, at its core, because it funds M&A activity. If you have two investment grade companies and they are both strategic and they want to merge, we are not going to be financing that merger. But for any non-investment grade company that wants to make an acquisition, or for any private equity sponsor that wants to buy a company, or for any management team that wants to conduct a buyout, they will probably need the leveraged loan market to finance that buyout. Q:  Are floating rate loan funds equivalent or similar to money market funds? A : The Invesco Floating Rate Fund and other floating rate funds are not money market funds because there is volatility associated with this asset class. These funds work well as part of a diversified portfolio, but they are not a one-stop shop for an investor’s life savings. Q:  What is a common investor misperception about investing in leveraged loans? A : Investors get confused when we say we are secured by the stock and assets of a company. They think that what we are doing is loaning 80 cents on a dollar against receivables, and 60 cents on a dollar against inventory, and so on. That is not what we are doing. When we make a loan to the company we are lending against the value of the company as a going concern. For example, imagine that you were a lender to Wrigley’s gum, a company that used to be in our market and therefore one I can talk about publicly. If Wrigley’s were to go bankrupt, you would receive far more money as a secured lender by running and owning the business as a going concern than by trying to sell off the inventory of raw sugar and unwrapped gum that was currently sitting in the warehouse. You certainly wouldn’t maximize your recovery by liquidating the assets. Rather, you would keep the operations going, bring in new management if need be, and sell the company with a reorganized balance sheet. Q:  What is the upper end of the companies you lend to and can you talk a little more about recoveries in a bankruptcy? A : Lyondell Petrochemical was a company that at the time it filed for bankruptcy had revenue in the neighborhood of $50 billion. It was, and is, an important global petro chemical company, and the senior lenders were secured by the stock and the assets of the company. Today, Lyondell Petrochemical is a publicly listed company (ticker LYB), and if you wanted to buy the equity in the company and you had $37.4 billion, you could do it. The reason I am using this as an example is it gives you an idea of the magnitude of the sort of companies that we are lending to, but also the difference between the value of the enterprise as a whole versus the value of the inventory. Similar to my Wrigley’s example, the value of the company is as a going concern. We are collateralized by the assets of the company, but the reason that you want to be collateralized by the assets of the company is not so you can sell off the individual assets, it is so that when you have the Chapter 11 proceeding, you as a senior secured lender are first in line for the recovery of the enterprise value. Not all companies work out like Lyondell, and some of the time the average recovery may be closer to $0. If you plotted a distribution curve of recovery values you would find a few cases where we get very low recoveries and that is what is responsible for the fact that you have an average $0.80 recovery level. A few bad investments drive your average down but frequently we get 100 cents on the dollar back. But on average the ultimate recovery to senior lenders is $0.80 on the dollar. Q:  What is your portfolio construction process and your sell discipline? A : When you think about our asset class, particularly today when the loan market is trading essentially at par, this is an asset class where when you make a mistake as a portfolio manager it is not because you failed to buy a particular loan, it is because you bought a loan and the loan goes to zero or you suffer a big loss. It is very different from being an equity manager. As a result, we run diversified portfolios because that is what the asset class requires. What we are really trying to do is to optimize the returns for investors. We are looking to generate as high a level of total return as we can while taking an appropriate amount of risk. That does not mean we are looking to hit home runs in terms of the portfolio as a whole, or individual positions within the portfolio. We have about 300 names in the fund. Right now the 100 largest names account for less than half of the portfolio, and a decent benchmark for us is 45% to 50%, which is roughly in line with the major loan market indices. We decide to sell a position when we are not being adequately compensated for the risk. I talked earlier about our credit process and portfolio construction. To be brief, there are many reasons why we might sell a loan, whether it is for individual credit concerns, industry views, ratings views or technical reasons. One thing that you will see in our portfolios is that we are very active in trading our positions. We are not “buy and hold investors.” Rather, we are active and are staffed accordingly. We have two full-time traders that are not only looking to execute directed trades in the most efficient manner, they are also looking at arbitrage opportunities. For us it is all about trying to maximize return associated with levels of risk, while recognizing that from a portfolio management perspective there is a bias towards risk aversion. Q:  How do you define and manage risk? A : I spoke earlier about how loans had limited credit risk and little interest rate risk, and as a result, loan prices may be less volatile, and that is true from a long-term, fundamental perspective. But, in the short run, loan prices for the market as a whole are highly influenced by technicals. The major risk in this asset class is idiosyncratic risk and an unexpected shock, which causes loans to do something that they are not supposed to do. When you make a loan to a company one or two things are going to happen. Either the company will file for bankruptcy or they will pay you off at 100 cents on the dollar. If it files for bankruptcy usually you recover 70 cents to 80 cents on a dollar. At the end of 2008, loans hit 60 cents on the dollar. What caused that level of price dislocation was massive amounts of forced selling on the part of investors and it was something that is very difficult for a portfolio manager to deal with. It was a shock that was beyond anyone’s control, and it began in June of 2007 with the collapse of parts of the mortgage-backed market and the fall of Bear Stearns. People forget that 2007 was a bad year for loans, with prices falling by six standard deviations. Then, in 2008, loans had a 17 standard deviation event with prices falling to levels that no one could have imagined. Imagine that you had invested in AFRAX at the peak of the market in June 2007 and held through a six standard deviation loan market event in ’07, a 17 standard deviation event in ’08, and the worst recession since FDR was president. If you had held on until the end of 2010, I’m not saying you would have enjoyed that wild ride, but I am saying that over the long run loan fundamentals proved themselves out and as an investor you would have made money. Now I don’t think that we are likely to ever see a year like 2008 again. The market has gotten deeper and more sophisticated, and we just don’t have the level of leverage in the financial markets today that we had then. Furthermore, at Invesco I know that we have learned from that experience and we have gotten smarter since then in terms of risk dampening. Some of that has to do with diversification, and some of it has to do with the fact that we believe we have gotten much better at understanding the technicalities in the loan market. Nevertheless, 2008 should be a cautionary tale for all investors and managers.