Q:  What is the history of the floating rate fund? A : BlackRock Floating Rate Fund is one of the most tenured loan mutual funds and currently manages just under $2 billion in assets. It was launched in 1989 and switched from quarterly liquidity to daily liquidity about two years ago. BlackRock is a broad and diversified asset manager and we manage many different types of funds - equity and debt funds - with various investment strategies across the globe. What makes us different with our loan business is that we have an appreciation of what loans are and why people buy them. Loans are contracts, secured fully by the company assets and pay a fixed incremental interest to a floating base rate. As a result they offer a steady source of income in a low volatility asset with solid protection of principal. Q:  What is your investment philosophy? A : BlackRock’s philosophy is simple: the key to success in the leveraged loan market is to avoid bad deals, remain diligent through the investment period and get the right names into the portfolio. Our position in the market allows us to be selective. Given the size and scope of our firm as a whole, and even at $2 billion our fund is not that big relative to some others in the space. This allows us to build a portfolio we want to own, not a portfolio that we end up with by happenstance. We can afford to be picky and we are. That is what our customers expect. In a stable market people forget that quality, selectivity, and closely following each asset matters. Loan prices have shown a degree of volatility, certainly in the last five years, that was unexpected and most of the returns in the period have more to do with principal appreciation than stability of income and quality of selection. Q:  What are key characteristics of floating rate loans? A : Floating rate loans’ key characteristic is interest paid floats with the ups and downs of the market benchmark rate. The benchmark rate is set based on a rate that banks loan to each other, London Inter-bank Offered Rate (Libor), and most loans are set specifically to 3-month Libor which is reset quarterly. This is why loans are referred to as “floating” and they pay coupons quarterly. The convention is that you get a fixed rate of spread paid on top of Libor which floats. Today, that average spread for loans is about 400 basis points. In addition, several investors also demand a floor rate simply because the LIBOR is very low. At present that floor rate is 100 basis points or 1%. So you get paid your spread of 400 plus whatever is higher, Libor or 100 basis points. The Libor is floating but the spread of 400 basis points - or whatever that number is - is constant. Companies pay quarterly interest and loans are secured, which means “first in-line” and first security on a company’s property, plant, equipment, intellectual property and other assets. A loan is a contract not a security, which means even though it may have a CUSIP number, the settlement period can be somewhat longer than a bond, but it trades with the same convention and it is distributed the same way as a bond. Q:  What is your investment strategy and process? A : Our investment process is pretty straightforward. We enjoy having relationships with all the dealers and most of the issuers, given our large global footprint. Our process always starts with meeting the management team. Most management teams we have known for many years. When there is a new deal we sit down with the team in person, going through their expectations of what the management can do, and what is the track record. It is very much a team effort for every loan we buy. We make sure for every security that we add to the portfolio adds relative absolute value and is likely to improve returns and minimize risk. We have a constant and open dialogue with our team members with a common goal of building a better portfolio. Q:  What is your research process and how do you look for opportunities? A : It really depends. It can be a bottoms-up approach where a research analyst is looking at his or her sector and seeing whether there is value and is increasing fund’s exposure to that specific loan. Or it can also be, especially in a market like this where most performing loans trade above par, that something is overvalued and it is time to sell, it is time to take advantage of the new issue calendar and replace loans that have traded up too much with loans that are better priced. Or, it can be using our capital markets group, which is somewhat unique to BlackRock. We have a group that outwardly faces the dealers and the issuers directly to help us figure out what deals we want to put into the portfolio. We are not necessarily waiting for the dealers to bring us transactions, we are thinking on our own as to what names we want to have in the portfolio, what management teams we like, and going out to them and working with the dealers to get those issuers into our portfolios. Rather than always waiting for the deals to come to us, we work to create the deals. We have a large organization and investment infrastructure. The team that focuses on loans is also part of the team that focuses on bonds, from a research perspective which gives them not just a degree of versatility, but also avoids the narrow focus on bank loans or bonds. Because of our size we are able to sit down with many management teams on a one-on-one basis as opposed to meeting with a group of investors. At that point we decide if that is a team we want to work with, and if so, we dig into the sector, the structure, and develop financial projections. That early stage takes advantage of our research analysts who know the sector well and determine whether it is a management team we want to work with and invest with. If we think the initial structural and pricing considerations make sense, at that point we have a credit meeting and go through all different metrics: sector, structure, management team, the different ways we are going to be paid back. There will be times when we like a company but we do not like the pricing or structure. That happens a lot in this market, increasingly so. For us there is no deal that we ever have to do. This is important. Because of our ability to source deals in the primary and secondary, we do not feel compelled to buy any deal in particular. In a so-called hot market, that matters a lot. If we like a company and we think the structure makes sense, we will give feedback to the underwriter in the company. At times we may say that we love the company but we would like a different cash flow sweep on the loan. We might like the company but we feel it needs a maintenance covenant. Or we might like the company but, for example, 400 basis points of spread are good, but it should be 425, or 450. Even if we like something we still have to think about what it does to the portfolio. Are we adding the same risk we already have? Are we increasing a concentration in a sector or a ratings bucket that gives us some exposure that we do or do not want? At that point we have to start thinking about the forest and not the trees, and think about the implications on the entire portfolio. It does boil down to single-name idiosyncratic credit decisions. Do we want to lend someone money? And do we feel that even if they try their best and things go wrong, will we get paid back? Most of the market is composed of secured loans. Half of the market currently is coming to market on a covenant-light basis. This does not mean there are no covenants at all; it just means that covenants may not be as full and wholesome as they were in the past. For us, we have to think about the different ways you get paid back. If the company was not going to pay back, or something was to happen, what is going to bring them to the table? Or what degrees of certainty do we have on getting paid back? We think about the multiple ways of repayment. Sometimes it is because the company’s cash flow is good come rain or shine. Other times, if the company does not do well due to management error, there still might be someone who would buy the company and therefore pay us back. When it comes to covenant analysis, it is not just reading it from the top, you do have to dig in, look at definitions, and look at implications. It is a legal document and it has to be treated as such. That process can sometimes be easy, depending upon what the original ask is, or sometimes it can be hard. When the market comes more robust you will see both issuers and dealers trying to push the envelope a little bit. Most covenants attempt to control two things. The first is maintenance of a healthy loan-to-value ratio. As lenders we like to be covered by asset value. That means that a company is worth a lot more than what we lend them. We look for covenants that ensure that in all cases the loan itself does not have more value than the enterprise. The second type of covenant will be a cash flow related covenant that says that even if a company is worth the debt that is on it, does it have an ability to pay back on a year-to-year basis? Does it have the ability to meet its current interest needs? Insofar as macro analysis is concerned, even though as a portfolio manager of loans I am making single-name idiosyncratic decisions based on the following: Do I want to lend to company A or B? Do I want to lend to both or none? Nonetheless the price activity that you have seen in loans over the last five years has had more to do with things that are exogenous to those individual decisions, and more connected to the global intervention that is going on. What investors are telling us in Japan for example, on days like today, is impacting the price of loans and the performance of funds much more than the default rate or some of the decisions I am making on whether I buy or sell something. That is true of most liquid products in the market. Correlations have gone up because we are in a risk on/risk off environment. Knowing what is going on in a macro sense is hugely important, especially in loans today given it feels we are past the end of that secular downtrend in interest rates and we are starting to go the other way. A lot of the flows and a lot of the attractiveness of the asset class are borne out of this secular shift off the yield curve for investors. We have to be very focused on what is going on outside of our portfolio because the price action we are seeing today is impacted by several international fiscal and monetary policies. For the most part you have a low dispersion of coupons and return expectations in any individual loan today. By that I mean most performing loans trade at par and most yield between 4% and 5%. In the loan business it is almost not what you buy, it is what you do not buy. If I were managing equity portfolio and I got nine out of 10 holdings wrong, but I got the 10th one right, technically speaking I could beat the market. In loans, if you get nine out of 10 deals right, and one wrong, you are worse than the market. For most funds, if you get 99 out of 100 deals right, you still underperform. For us, when we think about targets and goals, it is avoiding the bad deals as a primary source of alpha, or additional return. My goal is to fully evaluate anything that would be detrimental to the performance. We do not like to be in the position where we feel like we have to guess. If we are not 100% sure that this is the right management team, we do not buy it. If we are not 100% comfortable with the structure of a deal, even if we like the management team and we like the pricing, we do not buy it. And, if we do not like the pricing that is pretty easy, we do not buy it. In this industry the most powerful thing we do every day is to say “no.” All we can do is get your money back. It is not a home run business. It is not like you can double your money on loans now that they are trading at par. All we can do is have certainty in return of principal, and if you focus on that your performance ends up being rather decent and you are able to do it with a lower degree of volatility than the market. The downside never matches the upside, especially when loans are at or around par. Q:  What is your portfolio construction process? A : The goal is to focus on approximately 175 names. The view is that given performing loans are at par it does not make a whole lot of sense to have a massive concentration in any name. If they are all going to pay you the same amount, or close to the same amount, having a big concentrated bet in anything, analytically, does not make a lot of sense. In addition we have a new issue calendar, which has been rather robust, and we can get value buying new issues. For us we have taken our name count up a bit. We are very active portfolio managers. That said, you do not make money in this market trading for the sake of trading. We stick to the philosophy that we know what we own. To this end, we have a big pool of analysts so our number of names per analyst is relatively low, but we are still able to own 175 names. Compared to other public loan funds it is a smaller number than most. The S&P Loan Index or the S&P LSTA Loan Index has about 1,000 names. It is a very decent benchmark representing the market. We are very benchmark aware, but we do not invest in the benchmark as a rule. Our goal is to beat the benchmark with lower volatility. So if you knew that some of the biggest names in the index are likely to default, that means do not own it. The average loan, when issued, usually has maturity between five and eight years. They pay interest quarterly based on LIBOR. This particular fund offers investors daily liquidity, meaning you can trade the shares of it like you would any other equity and settle on the third day. What is interesting is that loans themselves take a lot longer to settle, two to three weeks on average. For a loan fund to offer daily liquidity is a pretty good deal for investors given that the underlying assets themselves are not that liquid. As a manager you will always keep a little bit of cash handy. Maybe you will own some bonds that offer more liquidity, but that is something you have to manage. The interest that we are seeing from both a retail and institutional perspective is pretty robust. What we have found is that whether it is an individual investor or an insurance company, historically both parties have made a respectable amount of money in the last 30 years with the yield curve going one way. Obviously in the last two years people have been trying to think about what happens when rates stop going down and what happens when they start rising? What we have found is that people, in this market where you have a GDP growth rate of near 2% with a strong support from the government and central bank, will ask which is the bigger risk today, duration risk or credit risk? While the market would tell you today the credit risk, the risk of not getting paid back has been pretty low, and the risk of rates moving up has not just been high -- it is manifesting itself of late. We have seen decent flows across both truly large institutional clients as well as those retail flows that you see. I believe we have just hit our 52nd week of positive retailing fund flows. Q:  How do you define and manage risk? A : Risk can come in many different forms and oftentimes it seems to be more technical than fundamental. By that I mean there has been some pretty significant price action, while at the same time the underlying portfolio quality actually increased. For us, risk is measured in different ways. You can get single name risk by buying lower rated and more risky companies, you have to manage your ratings exposure and you need to think about things like sector concentration. One of the biggest risks today, outside the deals themselves, is the correlation to the high yield or equity market, when you have periods of volatility. Even though loans are floating, when rates are going up and equities are going down like they are today, that creates a risk-off environment from dealers and other investors, which could impact the price of loans.