Q: What are floating rate loans and how are they different from bonds? A: In the past floating rate loans were called bank loans or leveraged loans. They are instruments issued by non-investment-grade corporate entities; essentially the same companies that are issuing high yield bonds. The difference between loans and high yield bonds is that loans are generally senior in the capital structure of the issuer and are generally secured. One of the reasons why investors have traditionally liked this asset class is that the floating rate loans set their interest rates on a mechanism whereby the coupon is a credit spread above LIBOR – London Interbank Offered Rate. The LIBOR is chosen by the borrower in the credit agreement, generally with an option to reset the LIBOR contract rate at one, two, three, or six-month intervals giving them a short effective duration compared with other fixed income asset classes. In a rising rate environment this mechanism has proven to be effective for investors to shorten the duration in their respective portfolios. This is one of the few alternatives that provides short duration, is readily liquid, and is easy to understand for many investors. The floating rate loan market is generally in the range of $600 billion to $700 billion for large, liquid, institutional loans. Q: What is the history of fund? A: This fund was launched on May 3, 2004. Historically we have seen a high degree of correlation between Fed funds and LIBOR rates. The fund today is approximately $1.6 billion in assets under management. I have been a portfolio manager for this fund since inception. I have two individuals who have assisted me as co-portfolio managers since early 2012, however they have been with the organization, and we have been working together on the same asset management team, for much longer. We are part of the New York Life organization; a large, highly rated, well capitalized, mutually owned organization. The corporate culture is to take a long-term perspective. Because we are mutual we are not beholden to quarterly earnings pressures. We have the liberty of taking a long-term perspective. Q: What is your investment philosophy? A: We manage everything we do in order to be in a position to keep promises to our policyholders and investors. As a life insurance organization, some of those promises that we need to keep maybe many years from now. We have to be prepared to do it in all sorts of environments over a potentially lengthy continuum of time. Our philosophy is also readily apparent within the investment organization of the New York Life enterprise. We tend to take a long-term perspective. We tend not to get too caught up with respect to any market cycle. We are looking to generate consistent, predictable returns through a variety of cycles, ideally superior risk-adjusted returns, by staying diversified, by limiting volatility, and by stressing consistency. Our portfolios tend to be a little more conservatively positioned than our peers. In an environment where the risk-on trade is shooting out the lights, we will not necessarily be near the top of the pack. We like to keep pace but we will not be top decile. However, when the tide turns against us, historically we have not experienced nearly as much volatility, nearly as much downward performance, as many of our peers. This tends to be a fairly pure loan play. We do invest a little in high yield bonds but we traditionally have not invested in derivatives or non-corporate-credit investments. This fund does not use leverage. We try to stick to the BB and B rated portion of the loan market, which has traditionally generated the best risk-adjusted returns through cycles. We tend to be underweight in the CCC rated loans and below, part of the market. In the high yield market you do see CCC new issuance. Loans normally only get to CCC through migration and because there is a problem. Q: What is your investment strategy and process? A: We invest in both the primary issue portion of the market and we are also an active secondary trader. The proportions will vary, in large part influenced by what the primary calendar looks like and what fund flows look like. We do top down and bottom up analysis, but if we were to be more inclined to one or the other it would be bottoms up. At our core we are credit people and we take pride in making good credit selections. We try to stay well diversified both by issuer and industry. No matter how much we like an idea we understand that it is not prudent, in the fixed income space, to be putting too many eggs in one basket. This is an asset class where outperformance is about playing effective defense. We buy issues that are generally issued about par. There are only limited opportunities in this market for capital appreciation. Returns are most often driven by income. Selecting high-quality issues that will generate consistent, predictable income, over a sustained period of time, often drives outperformance. We screen the total universe, whether it is the primary pipeline or secondary issues in market. We take out the issues that do not fit our portfolio in structure. We are not a big buyer of revolving credits. We want to be overweight or underweight in certain industries so we take issues out that do not fit our biases. Ultimately we look at each loan individually and perform credit analysis. On each individual credit we are trying to answer three questions; credit, structure, and price. By credit we mean the business operations, prospects, profile, and financial situation of the issuer. Structure can be capital structure concerns such as where we are within the organization structure of the borrower. Structure can also mean structure within the credit agreement document as it would relate to various covenants, baskets, tests, and other provisions or limitations of the borrowing document. Then there is price, which is just a simplified term for the economics that will be paid and the effective yield we expect to earn on that investment. Q: What is the asset under management in the strategy? A: We manage a number of portfolios in different strategies. We manage in the total return space, MainStay Floating Rate fund as well as a sister fund through our variable annuity channel, the MainStay VP Series. We manage floating rate loans for the general account of New York Life, as well as high yield bonds for the general account of New York Life. We also manage assets in CLO structures; leveraged vehicles, largely marketed to institutional investors. Assuming that we like the credit we will look to see in which portfolios, any or all, that individual investment may fit. We do have approximately $1.3 billion in the floating rate asset class that we manage for New York Life. I do not think there is another floating rate manager out there that has as much of their own proprietary capital devoted to investing in the same issues as their third party investors. If there is a problem in any one of our third party portfolios, we have similar types of exposures in our general account because there is a high degree of overlap in terms of the issues that are owned. That demonstrates a significant alignment of interest with our external investors. Q: How is your investment team organized? A: We all look at the numbers, we all look at the financials, and we all look at where they are from a competitive standpoint in relation to the customers and vendors. What distinguishes us from other investment managers is that as part of a large global multi-asset class platform, we are talking with industry analysts within other asset classes, all of whom are co-located on our floor in New York. We have analysts that will cover the same industries as our industries and they can talk about industry trends. Subject to information barriers, in many cases they are able to talk about companies that may be a competitor or vendor to our issuer. Those insights and idea exchanges frequently provide us with an expansive market view of what is going on in each particular industry or sub-segment of that industry. It provides a good source of competitive intelligence. We have a career analyst track. There are 10 people focused on research on my team. The director of research has 35 years of experience and nine analysts who average 18 or 19 years of experience. We do not have a lot of junior analysts that have to become portfolio managers or leave. That is the same across all asset classes. We have senior analysts who do their own work and build their own models. In most cases they have been covering their industries for a sustained period of time. Q: What is default rate experienced in your loan portfolio? A: The credit culture pervades our organization. We do take pride in a track record that has resulted in far fewer defaults than the market as a whole. Our experience across our third party accounts runs less than one quarter of the market rate. From 2001 to June 2013, we have an annualized default rate of 0.66% versus the Credit Suisse Loan Default Rate of 3.31%. Q: What is your research process and what business and financial metrics you look for? A: The specifics we look at in an individual company may vary significantly from industry to industry. Many of the fine points and metrics we look at are industry specific. In general we look first and foremost at free cash flow. Declines in free cash flow and constraints in liquidity are the first signs of financial distress. We also look at management teams’ track records, their proven ability and track record of being able to execute on business plans. We look at the underlying collateral of a business. That may be hard collateral such as property, plant, and equipment. It may be inventory, receivables, or stock of subsidiaries. There may be some intangibles where patents, trademarks, brands, and intellectual property do matter. With respect to structure and covenants, that can vary widely. The current environment is one in which the covenant-light structure seems to be ubiquitous. The vast majority of large, broadly syndicated loans that we see coming to market are coming covenant-light. That means there is an absence of financial maintenance covenants in the deal. Those structures will customarily have certain affirmative and negative covenants that must be managed and observed, but the traditional financial tests, which must be observed on a maintenance basis, i.e. effective at all times, are no longer in these structures. If we are worried about covenant-light as an indicator of a more risky environment, first and foremost when we look at risk, we tend to look at the leverage levels being applied against companies, and exactly how much flexibility they have with the acquisition baskets, restricted payment baskets, dividend flexibility, et cetera. Historically, covenant-light has not necessarily indicated that those issuers are more risky from a default perspective. In the last default spike in 2008 to 2009 certain evidence suggests covenant-light loans performed better from a default and recovery perspective than deals with covenants. That may have been due to the fact that the issuers who were more readily able to get covenant-light structures done in the market, were the better companies in any given industry. We recognize that covenant-light adds a higher degree of volatility to the market than in the past. This is because in prior vintages, if the company underperformed and came up against financial covenants or broke through them, then deals that had financial covenants were required to come back to their lender group to negotiate an amendment or a waiver. In order to do so the issuers generally had to provide additional economic compensation to their investors, be it fees, increased credit spreads, or changes in structure. In the absence of financial covenants, providing that sort of leverage for the investor community the additional economic compensation will need to be achieved through greater discount. It is a change in the risk reward relationship between primary and secondary investors. The majority of floating rate loan investors today invests across loans and high yield bonds, really looking at the same issuer community and playing at different places within the capital structure. You find that many floating rate loan investors, by default, will stay public. In the situations where there is financial distress, almost all investors have the ability to go private. To the extent you own the bonds you would be restricting your ability to trade those bonds. To the extent that you do not own the bonds and do not intend to buy into them and trade them, there is no impediment to going private as long as you forego trading the public instruments. In terms of priority of recoveries and bankruptcy, loan investors have tended to recover more significant amounts from recoveries that, by rule of thumb, have been on average about twice that of unsecured bond investors by virtue of being senior and secured within the company’s capital structure. One example of our research is a company that was brought to market by a large money-center bank. The company essentially did pre-cooked hamburgers for the food service and quick service restaurant business. They had a significant exposure to a large fast food chain. The marketing bank told us that this fast food chain was their largest customer. We were able to go to the bank and tell them that we did not think that was true because we knew the fast food chain bought all of their supplies, food, packaging, and cleaning supplies through a consolidator. We had a relationship with the consolidator for a number of years, so we knew this was not true. In those situations we are able to get a good view of what that business relationship entails by virtue of the management at that intermediary. We were well educated on the dynamics of that business because of an investment our firm had through a firm that played in that industry. That does not make us unique but it does make us distinct. Q: What is your portfolio construction process and what role diversification play in your portfolio? A: The rules under the prospectus are that there will be no more than 25% exposure in any given industry and no more than 5% in any issuer. We have internal practices that are more restrictive than that. Historically we have had less than 1% average position sizes. We have stayed less than 2% individual position sizes. Loans, for example, we may be managing cash balances related to repayments or inflows from time to time, which are more than 2% in a treasury issue while we are waiting to settle on a loan investment, but in our corporate credit positions we generally stay under 2% weightings. With respect to industries we are generally under 10%. The exception to that rule is healthcare. That is the largest single industry in the index and has historically been anywhere from 10% to 13% of the index from time to time. Where we like bets in a particular industry, we have taken industry weightings up to twice what the index weight may be. We will take the weightings up and down as frequently as necessary. We have a process where, from a formal perspective, we review the industry weightings at least quarterly. We are strong believers of diversification, both by issuer and industry. We review our issuer weightings at least quarterly, but practically speaking it is every week. We meet as a team, our portfolio managers, traders, and analysts, almost every day to go through best ideas, looking at price movers, looking at our weightings, and challenging each other to see if we are still comfortable with those weightings. The stated benchmark of the fund is the Credit Suisse Leveraged Loan Index. When we launched the fund in 2004 that was the index used by the other three peers in the industry at the time and was the largest, most broadly available index available to the market. We also look at the S&P/LSTA Loan Index. The published turnover of the fund most recently was 47%. That statistic is not just trading activity but also includes repayment and refinancing activity. In any given environment the repayment and refinancing activity can constitute the vast majority of turnover. Q: Do most investors hold loans to maturity? A: The final maturity of the loan at time of issue generally ranges from five to eight years. Most of the loans we see in market are seven-year final maturity loans at time of issue. However, in this market loans rarely go to final maturity. My over 20 years of experience has shown that nearly all of them will be refinanced, restructured, and get amended before maturity. Those that have problems tend to get worked out. The average tends to be between three and four years. In terms of interest rate sensitivity, most managers and investors use the weighted average days to LIBOR reset of their portfolios as the effective duration measure. If the underlying contracts for these loans can see LIBOR reset on a 30, 60, 90, or 180-day basis, and you take an average across the portfolio that may well be on the order of 40 to 60 days. In general the portfolio that I manage, along with my colleagues, has seen weighted average based to LIBOR reset levels fluctuate between 45 and 55 days at any given point. Q: What are your views on LIBOR floors? A: The vast majority of loans in our portfolio, and most other floating rate portfolios in the market, will have LIBOR floors. Some people suggest this adds duration because as interest rates change, you will not get the immediate benefit of that rate movement. Indeed, if rates go up by a quarter or half a point, most loans in our portfolios will not see any increase in yield—you are already getting that yield and being paid at a higher level for the risk that you are bearing as an investor—what some people miss is that those loans with the LIBOR floors will still be paying a yield enhancement to the extent LIBOR is less than the floor. They are still paying more than their un-floored counterparts, all other things being equal, such as credit spreads. There will be more demand for those instruments because they continue to be higher yielding. Once LIBOR goes up by 75 basis points or more it starts to break through the floors of the loans and the floor becomes almost irrelevant, investors will see yield pickups, and that is what most investors are worried about. Most investors are not worried about a 25 or 50 basis point movement in Fed funds or LIBOR, they are worried about a 200 basis point movement. In that case the yields of these loans will adjust and reflect the new interest rate environment. The other misconception is that when economists are talking about yield curve movements, some people get confused about what is driving the interest rates on these loans. For this asset class you should look at Fed funds because they have been the number one predictor of LIBOR. There is an almost perfect correlation, with a slight time lag, on a historical basis. Q: Are all loans in the portfolio dollar denominated? A: All of the loans we buy are U.S. dollar denominated. I would not characterize the portfolio as having only U.S. issuers; we do have some foreign exposure. A high proportion of the portfolio is comprised of large, global, multi-national companies that are doing business in a number of different geographies in North America, Asia, and potentially other emerging markets but the portfolio obligors are, for our portfolio issuing U.S. dollar denominated issues. Q: How do you define and manage risk? A: At its most basic, risk to us means losing money. There are also risks in terms of volatility that effects information ratios, et cetera, but first and foremost I worry that it is much easier to give them the money than to get it back. My most basic risk is whether they are going to pay me my interest and principal in full and on time. We also look at market volatility. We may hold it until maturity and get repaid in full and they may pay their interest on time but if the price fluctuates widely and it is trading at deep discount for a lot of the time then that is not good from a total return perspective because I have some investors coming into or out of the market in any given point in time. Pricing fluctuations could hurt some of those people. Beyond that we start getting into political and currency risks. Although we do not buy anything in a foreign currency, that can still have an impact on the operations and earnings of many of the issuers. I worry about systems risk. I worry about disaster risk. I thought late 2008 and early 2009 were a great time to buy. Unfortunately in this portfolio format, a daily liquidity floating rate mutual fund, when investors want their money you have to be in a position to give it to them. We look at the technical tradeoff during late 2008 and early 2009 as driven more by illiquidity than by credit stress. At one point in time, late in 2008, the average market price for the large flow names in the index was about $0.65 on the dollar. That would suggest you would have a 100% default rate within that select cohort and 65 recoveries. That was not going to happen and did not happen. Rather the market default rates and default losses were in the low single digits from a percentage basis so nearly all of that tradeoff was driven by technical factors and illiquidity. What we learned is that liquidity is paramount and being able to have a sense of the market and anticipate the market movements is important, but this is an asset class that has a delayed settlement period. Par loans settle on a contractual basis at T+7 days and the effective settlement time within the industry, according to the LSTA, has more recently been in the range of T+21 to 23 days. For a mutual fund that is obligated to make settlements at no longer than T+3 that can present a problem. We understand that having a little bit of cash on hand in these funds makes sense. Having a large fund complex that has access to liquidity lines and has the management and board foresight to understand those lines are critical for situations where there is market dislocation is paramount. We are fortunate to benefit from management and a board that perceive those risks, are sensitive to them, and emphasize the importance of being well prepared. Lastly, we think it is important that we communicate and talk about these kind of risks openly and candidly. We understand that in the 2007, 2008 timeframe there were many people out there who were marketing floating rate funds as money market funds on steroids. We, as fund managers, did not do that. We understood there was a degree of credit risk and technical influence the markets will provide. It is not as stable as money market funds have traditionally been. Many investors should consider this investment as a core portion of a well-diversified portfolio where allocation to this asset class can be taken up or down depending upon the dynamics of the market, but it is not riskless. It is however, an asset class worth considering within a diversified portfolio seeking yield and limited duration.