Q:  How has the bank loan market evolved in the last decade? A : At Putnam Investments, we have been in the high yield business for decades and started investing in bank loans in the late nineties, not as part of a dedicated fund, but to augment our high yield process. Bank loans are different than bonds in several respects. First, they are secured contracts against company assets, while corporate bonds typically are not. In the event of a default, bank loan investors typically have higher recoveries than holders of unsecured bonds. Secondly, bank loans’ coupons or interest rates reset frequently based on changes in short term rates (LIBOR). High yield bonds, meanwhile, are largely fixed rate and whose prices are subject to volatility based on longer term interest rates. Historically, this was a way for us to express capital structure views about companies that issued non-investment grade or high yield bonds. As the loan market evolved, we thought it made sense to add a bank loan-based mutual fund. In 2004, we launched Putnam Floating Rate Income Fund, once we were satisfied that we could offer an appropriately diversified fund with daily liquidity. We did it as an extension of what we do in the high yield bond business where we have 23 investment research professionals. Putnam Floating Rate Income Fund is comprised almost entirely of corporate loans. We tend to focus on the larger, more liquid bank loans in the market. Historically, we have had less focus on smaller issuers and smaller loans for a variety of reasons; they are less liquid, have higher default rates, and lower recoveries. The fund’s three portfolio managers all have experience in commercial banking: Norman Boucher started with Bank of Boston, Rob Salvin started with Chase, and I started with National Westminster Bank. Q:  How large is the bank loan market and how has the role of banks changed in the last decade? A : Before the loan market evolution over the last ten years, banks were generally the only major player in loans and held them on their balance sheets. The larger banks often parceled out part of their exposure through syndications to other banks. Bank loans have been in existence for a long time. What has changed is the investor base. It is not simply banks making and holding loans. The bank loan index that we use is about $525 billion in size, but the true bank loan market is larger than that because there are a lot of non-institutional loans that banks hold. These are often referred to as Term Loan A or simply commercial loans. There are also revolving credit lines that are typically provided by the larger money center banks. There are a variety of ways you can get exposure to this market, but when I think about the institutional loan market I think of it as about $750 billion in size. Bank loans used to be for small companies or they were revolving or trade credit for companies that were a little bit larger. What started happening in the early 1980s as people were pushing on companies to unlock shareholder value, you had a lot of corporate spinoffs and M&A. Many companies were spun off to private equity sponsors. That created a need for greater amounts of external financing and banks could not do that on their own anymore. It was high yield bonds, and then there started to be associated bank debt. For example, you might have a company that was bought for $1 billion. At the time that would have been very large, but it might have $300 million of equity, $400 million of bank debt, and the other $300 million would be a bond. That was not an uncommon financing structure. That $400 million bank debt would stay on the bank’s balance sheets and maybe it would be syndicated among 8-10 other banks. What started to happen was the economy grew and deals started to get larger. At the same time you started to actually have consolidation among the banks. The banks could either keep putting bigger loans on their balance sheets, or they needed to figure out a way to draw in alternative capital. That led to the syndicated loan market as we think about it today. Q:  What makes bank loans popular with corporations? A : If you are the company, you are securing all your assets and that allows you to borrow at a lower rate. It is also tied to the front end of the yield curve, which is typically a lower rate than the longer end of the curve. To borrow money for three months should cost less than borrowing money for 10 years. Ultimately companies found that they could borrow at lower rates because bank loans are tied to the front end of the interest rate curve, where rates are lower and because loans are secured so are deemed less risky. One of the great features of bank loans for the borrowing companies is that they are pre-payable at par at any time. Much the same way a homeowner’s mortgage can be repaid when they move or find a more attractive rate. The reason this ability to prepay is important is because it gives companies more flexibility. When you think about a lot of these merger and acquisition financings or LBOs, one of the ways that people create value is to grow the cash flows, pay down some of the debt, and then ultimately take the company public. If you have a lot of 10-year bond debt that you cannot pre-pay then it is harder to do that. Also, because bank loans are secured and tied to the front part of the curve, they typically have lower interest rates than high yield bonds. Both of those factors helped them become part of the merger and acquisition process. The other thing that started to happen as time went on (up through 2006), was that bank loans had really nice return characteristics because you did not have the volatility associated with interest rates, and loans did not have a lot of credit volatility. You had a very stable return stream. That attracted new investors into the market; people actually created vehicles that borrowed money to buy loans. Q:  How are bank loans different from bonds? A : Stocks and bonds are securities but loans are contracts so they trade a little differently in the market. There is not an exchange where loans are listed and there is not the same transparency of reporting requirements on trades. However, like corporate bonds, their primary risk is tied to the borrower credit profile. Loans also do not have a fixed coupon like a typical bond. They have a fixed spread (currently about 3.5%) over LIBOR. This underlying LIBOR rate resets every 30 to 90 days so it can go up or down depending on the direction of interest rates. Most loans we invest in are secured. They have a claim on the company’s assets and are “in front” of other debt obligations. This means that -- in the event of credit problems -- bank loans get priority treatment. This is not true of most high yield bonds. Q:  What is your investment strategy and process? A : We tend to have an asset valuation bias in our process. I think of our analysts not as bank loan analysts or high yield analysts, but as industry analysts that are really adept at valuing companies and dissecting capital structures. We have a belief in sector specialization and then look at the companies within industries and think about the capital structures. The way we think about the market is as 22 distinct sectors from aerospace to chemicals to healthcare to wireless telecom and so on. We split the market into thirds among Norm (Cyclicals), Rob (Tech and Telecom), and me (Non-cyclicals). This way each person is not responsible for 22 sectors, but seven with similar drivers. Rob Salvin has his arms around technology and how telecom is evolving. He sits down with our analysts who are doing cable or wireless and can have a really differentiated perspective. He was an analyst in that space before he became a portfolio manager. We are trying to have detailed conversations about where a company is going between analysts and portfolio managers that are much more specialized than is typical in the loan market. Between Rob, Norm, and I there are over 75 years of industry experience. That level of experience, when coupled with a deep research team, allows us to come up with a lot of interesting insights. Most of the companies we follow have secured debt bank loans; one or two types of bonds, secured, secondary, unsecured, subordinated, and often have publicly traded equity. We think about how we expect the company to perform and how our view varies from market consensus. Do we think it is improving fundamentally, declining or remaining stable? How is the company going to use those cash flows and what is the best way for us to make money in that capital structure? Q:  What is your research process and how do you look for opportunities? A : Investment ideas tend to be generated from the analysts or by our research-driven trading desk. We have a very transparent culture as exemplified by our large, open trading desk. Two of our traders are former analysts, who do a great job keeping the team connected to developments in the market. New ideas can come in the form of new issues or names that might be trading in a secondary market that we do not own. We utilize a lot of data, as well as spend a lot of time understanding market observations, liquidity and trading every day. Our analysts each tend to follow two sectors, and in some cases have been following them for 15 to 20 years. We have a high level of familiarity across many industries so when a new company issues a loan we are usually able to have a detailed view of the company very quickly. After a thorough examination of fundamentals and the company’s operation, we focus on the capital structure and the value of the company to determine if it offers a good risk-return profile for the fund. We generally do not own companies with less than $75 million of EBITDA or operating cash flow. We tend to invest in loans that are bigger than $300 million. About two thirds of the loans in our bank loan portfolio also have corresponding high yield bonds in the market. In terms of processing specific loan structures, having former bankers on the desk and having a lot of people that either worked on Wall Street or who have been doing this for a long time, means the team is very capable of going through complex indentures and covenants. We are often asked how important covenants are and we believe that good fundamentals and collateral dominate covenant packages. That being said, there are many situations that require thoughtful covenant evaluation and our team has the skill set to do that. One of the things that I think is somewhat misunderstood, is that a below investment grade security or a loan is neither good nor bad. It is a choice about the amount of financial leverage a company wants to have and that the business can bear in order to generate good returns on equity for its shareholders. There are any number of companies in the high yield market that could be investment grade if they chose to be. They have good cash flows and they can pay down debt. Within the high yield market, they found a place in the capital markets where they can issue debt freely for a certain size and they can generate stronger returns on equity with the balance sheets and capital structures they have. For example, if HCA wanted to be an investment grade company it could be. They would just have to redeploy cash flow overtime and reduce leverage. HCA borrowed a lot to pay dividends. It used to be a single-A rated company at one point in its history. It is often a capital structure decision when you choose to be non-investment grade. The company is making a decision to bear more leverage to deploy capital either to new business initiatives or to return cash to shareholders. There are clearly some companies that are more speculative in their business model, and they may not have the critical mass. There is a huge size skew of larger companies to the investment grade market because there is a level of implied diversification and scale of a business. Q:  What is your portfolio construction process? A : The benchmark we think about is the Barclays U.S. High Yield Loan Index. We tend to run a more diversified posture than most of our peers in the loan space. Generally, we do not have positions that are bigger than 1%. There are probably 200 names in the fund with 229 individual securities because some of them are subsidiaries of the same company. Our top 10 names make up 11% of the fund. If we invest in potentially more volatile securities, we hold them in relatively small amounts. We also own a higher proportion of names that also issue high yield debt. We tend to have a bias towards larger, more liquid names and do not buy a lot of middle market or smaller loans. Q:  What drives your buy and sell decisions? A : Our decision to sell is often based on both our credit view and our perspective on relative value. Right now, there is a very big cluster of loans trading in a tight range near the issue price. There are some distressed securities, there are a couple of big ones that are lower dollar price, but the bulk of the universe is tightly dispersed around par or $100. When we make a buy decision, we think about how the security compares to other names of similar risk in its sector, and think about spread and call protection. When we make a sell decision it is typically related to a changing credit view or a change in our view of our credit volatility. Secondarily, it might be about refinancing risk. It might be a premium, high dollar-priced security, with no call protection. Or the call protection is lapsing and the market has not quite recognized that yet. Q:  How do you define and manage risk? A : We think about risk as a negative experience for the shareholder. Our goal is to be a strong performing bank loan fund with appropriate levels of volatility. My hope is that when the market is strong we do a good job of keeping up with that without having excessive levels of volatility. Generally we have tended to outperform in the down markets such as in May and June of 2013. There are two primary drivers of risk. First, there is overall portfolio risk or how the portfolio is positioned versus its benchmark or the market. We think about ratings buckets and spread buckets. We also have a centralized risk system that gives us portfolio beta and market sensitivity. We also think about idiosyncratic risk or the risk associated with specific companies or borrowers. Right now the bank loan asset class is very asymmetric. They are issued at 99, sometimes par, they can go to 101, maybe 101 and a quarter based on call protection, and the historical recovery is 70. There are loans that can have more adverse outcomes than that. We are trying to manage the overall portfolio risk, but at the same time think about populating it with securities that offer better excess return potential. You cannot change the symmetry of the bank loan market in aggregate, but you can better position your portfolio in a way that may be better than the general loan market. One of the ways that we have done that is by taking advantage of LIBOR floors. We tend to own more bank loans with LIBOR floors. In these loans you get paid a minimum rate if the LIBOR remains low, but also participate if LIBOR moves up meaningfully. This is another way you can improve the shareholder experience. Q:  What lessons did you draw from the financial market crisis in 2008 and 2009? A : If there was a lesson that we learned in the 2007 and 2008 period of time, there were a number of asset classes, bank loans being one of them (auction rate preferred securities and AAA commercial mortgage backed securities are other examples) that really disappointed investors because people did not think they would be as volatile as they behaved. What all three of those had in common was that they happened to go into a lot of investor hands where people had used borrowed money to buy them. So one of the things we think about more now with respect to the loan market technicals includes the health of various participants in the market including players whose capital might not be as durable or permanent as others in the market. Q:  How are bank loans expected to behave in the rising rate environment? A : One of the benefits about loans is you participate in the continued credit improvement that we are observing against a backdrop of a moderate economic recovery. You do not need a lot of economic growth for loans to remain in very good shape. At the same time you also get some benefit from the structure of loans. Some people think about loans as they guard against rising rates. I do not necessarily think about them as a hedge but they clearly do not have the same interest rate sensitivity of most other fixed income instruments. Pure interest rate exposure has some meaningful headwinds over the intermediate to longer term, the private sector is going to have to set 10 and 30-year rates for the U.S. Government, not the Fed. Against that backdrop I think people are going to be very happy to own floating rate bank loans that are secured by assets, have good collateral, for a group of companies that I think are in very good shape right now. Moreover, you have that exposure with a floating rate structure that offers far less rate sensitivity than most other parts of Fixed Income.