the evolving market for floating-rate loansnews.morningstar.com/pdfs/dws_floating_rate.pdf ·...

white paper 2010

the eVOLViNG MarKet FOr

FLOatiNG-rate LOaNS

While floating-rate loans (also referred to as senior secured loans, leveraged loans, bank loans or syndicated loans) have been around in

one form or another for more than 30 years, in the past decade the market has evolved from a traditional lending market to its current

position as a fully developed asset class within the capital markets. Given this evolution, we expect floating-rate loans to become

a more prevalent part of investors’ asset allocations moving forward, particularly given their diversification potential and the

measure of protection they may help provide in rising-interest-rate and higher-inflation environments. In this paper, we address

three major topics we expect will be of particular interest to clients researching the floating-rate loan market.

1 l aN iNtrOductiON tO FLOatiNG-rate LOaNS

Key characteristics of floating-rate loans (pages 4–7) �

The process of floating-rate loan issuance (pages 8–9) �

Types of companies issuing floating-rate loans today (page 9) �

2 l the eVOLutiON OF the

FLOatiNG-rate LOaN MarKet

A rise in popularity in the 1990s (page 10) �

Greater transparency for floating-rate loans (page 10) �

A brief history of the floating-rate loan market (page 11) �

3 l FLOatiNG-rate LOaNS withiN

aSSet aLLOcatiON

Diversification opportunities relative to traditional �

high-yield (pages 11–12)

Seeks a measure of protection from higher interest �

rates (page 13)

Seeks a measure of protection from higher inflation (page 14) �

Asset allocation does not assure or guarantee better performance and cannot

eliminate the risk of investment losses.

ExEcuTIvE SummAry

This report outlines the key characteristics, evolution and potential portfolio allocation benefits of floating-rate loans—an asset class which may be of interest to investors and their advisors in the current market environment.

cONtriButOrS

Ty Anderson, managing director, global head of high-yield strategies �

Eric meyer, managing director, head of uS loan portfolio management �

Jason vassil, vice president, fixed-income product specialist �

W h I T E pA p E r / / pA G E 2

Senior secured

Floating-rate loans are senior in a firm’s capital structure and �

secured by the issuing company’s assets, historically resulting

in attractive default and recovery rates (see page 7 for details).

diversification

Investment-grade bonds and floating-rate loans have offered a �

negative correlation to each other for the 15-year period ended

3/31/10 (see page 12 for details).

Given this negative correlation, adding a 30% floating-rate loan �

allocation to a hypothetical all-investment-grade bond portfolio

would have reduced overall portfolio risk as of 3/31/10 (see

page 12 for details).

potential protection from higher interest rates

Floating-rate loans offer a coupon that resets to higher interest �

rates, helping to mitigate interest-rate risk.

In fact, as interest rates move higher, this coupon reset may �

lead to potentially higher returns for floating-rate loans as

additional income payments boost returns and drive demand.

While past performance does not guarantee future results, �

in any 12-month period in which interest rates increased by

one percentage point or more, floating-rate loans substantially

outperformed intermediate-term, investment-grade bonds (see


potential protection from higher inflation

The total balance sheet of the Federal reserve hit an all time �

high of $2,174 billion, according to Deutsche Bank private

Wealth management as of 1/31/10. This influx of liquidity

could be cause for inflationary pressures. Generally, inflation is

associated with periods of higher interest rates and stronger

economic growth.

historically, during these periods, floating-rate loans have �

shown solid performance relative to intermediate-term,

investment-grade bonds (see page 14 for details).

This characteristic is supported by the high correlation between �

floating-rate loans returns and inflation, and the low correlation

of intermediate-term, investment-grade bonds and inflation

(see page 14 for details).

past performance is historical and does not guarantee

future results.

Solid performance

class S shares are ranked in the top 24% (33/134 funds) and

top 7% (7/100 funds) for the one-year and since-inception

periods (inception date of 6/28/07), respectively, as of 3/31/10

based on total returns in the morningstar Bank Loan category.1

Strong bear and bull market performance

The fund was the only fund within the morningstar Bank

Loan category that finished in the top 35% in the 2008 bear

market and top 24% in the 2009 bull market. (class S shares,

based on total returns, of 46/126 funds and 32/134 funds,

respectively (see page 16 for details).1

experienced and deep team

A team of seven individuals with more than 20 years of

experience on average is dedicated to the portfolio.

unique overlay strategy

The fund utilizes an additional proprietary overlay strategy,

which seeks to enhance returns with minimal impact on

volatility. This is supported by the high correlation between

floating-rate returns and inflation, and the low correlation of

intermediate-term, investment-grade bonds and inflation (see


SuMMarY OF FLOatiNG-rate LOaN KeY characteriSticS

dwS FLOatiNG rate pLuS FuNd hiGhLiGhtS


Share class 1-month 3-month Ytd 1-year Life of fund inception date

Unadjusted for sales charges

A 2.40% 4.99% 4.99% 41.29% 3.11% 6/28/07

Adjusted for the maximum 2.75% sales charge

A –0.41% 2.10% 2.10% 37.40% 2.07% 6/28/07

No sales charges

S 2.42% 5.05% 5.05% 41.55% 3.29% 6/28/07

INST 2.31% 5.05% 5.05% 41.56% 3.29% 6/28/07

S&p/LSTA Leveraged Loan Index 2.25% 4.64% 4.64% 44.49% n/a n/a

class a S iNSt

Gross 1.62% 1.61% 1.45%

Net 1.20% 0.95% 0.95%

contractual through 9/30/10 9/30/10 9/30/10

Nasdaq symbols a c S iNSt

DWS Floating rate plus Fund DFrAx DFrcx DFrpx DFrTx

DWS FLOATING rATE pLuS FuND

Average annual total returns as of 3/31/10 (returns of less than one year are cumulative)

Performance is historical and does not guarantee future results. Investment return and principal fluctuate so your shares may be worth more or less when

redeemed. Current performance may differ from data shown. Please visit www.dws-investments.com for the fund's most recent month-end performance.

Unadjusted returns do not reflect sales charges and would be lower if they did. Fund performance includes reinvestment of all distributions. Not all share classes are

available to all investors.

The S&p/LSTA Leveraged Loan Index is an unmanaged, market-value-weighted total return index that tracks outstanding balance and current spread over the London Interbank

Offered rate (LIBOr) for fully funded loan terms.

ExpENSE rATIOS AS OF LATEST prOSpEcTuS

The net expense charge for this fund reflects a contractual fee waiver and reimbursement of various expenses by the fund’s advisor. Without this waiver/reimbursement,

returns and any ratings/rankings would have been lower.

riSK iNFOrMatiON

Loan investments are subject to interest-rate and credit risks. Floating rate loans tend to be rated below-investment grade and may be

more vulnerable to economic or business changes than issuers with investment-grade credit. Adjustable rate loans are more sensitive

to interest rate changes. As part of the global alpha strategy, the fund may use derivatives. Investing in derivatives entails special

risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. In certain situations, it may be difficult

or impossible to sell an investment at an acceptable price. This fund is non-diversified and can take larger positions in fewer issues,

increasing its potential risk. See the prospectus for details.


1 l AN INTrODucTION TO FLOATING-rATE LOANS

Floating-rate loans are variable-rate, senior-secured-debt

instruments issued by non-investment-grade companies.

Floating-rate loans have three characteristics which make them

unique as compared to most traditional fixed-income investments.

Each of these characteristics will be discussed in more detail

throughout the paper. Building on these key characteristics,

we will also explore how allocating a portion of a portfolio to

floating-rate loans can help add greater diversification and a

measure of protection from rising interest rates and higher

inflation. Of course, diversification neither assures a profit nor

guarantees against loss.

while historically banks made up the vast majority of lenders,

in the past decade institutional investors, such as mutual

funds, have become the most prevalent market lenders,

according to S&p/LSta.

FLOatiNG-rate LOaNS at a GLaNce

1. Floating-rate loans are issued with floating-rate coupons

that are tied to a variable rate index, most commonly,

the London Interbank Offered rate (LIBOr), and reset

every 30 to 90 days.2

2. Floating-rate loans are senior in a firm’s capital

structure, meaning investors receive principal and

income before equity or other debt holders.

3. Floating-rate loans are secured by the issuing

company’s assets, which can be transferred to the loan

holder in case of default.

BENEFITS OF FLOATING-rATE LOAN ISSuANcE

Benefits to the borrower

Lower borrowing cost relative to bond and equity issuance

An additional source of funding that would not be available

through bilateral loan agreements or individual lines of credit

Less expensive and more efficient to administer than bilateral

or individual credit lines

Benefits to the lender

contractual control

of company activities

most loan agreements require that a

company maintain a pre-determined

level of financial ratios (e.g., debt/

coverage) in order to avoid violating the

loan terms

Senior in capital

structure

Loan holders are first to be paid

income and principal, leading to greater

recovery rates in case of default

collateral Generally, loans are secured by assets

that can be transferred to the holder of

the loan in case of default, leading to

higher recovery rates

Diversification Because multiple parties are involved in

lending to a corporate entity, investors

avoid excessive single-name exposure

In the floating-rate loan structure, two or more parties agree to

make a loan to a borrower, with each lender having a separate

claim on the debtor, although there is a single loan contract.

Given that floating-rate loans are not publically registered

securities, they differ from traditional bonds in regard to who

can generally purchase loans. Direct purchases of floating-rate

loans are generally limited to institutions or accredited investors.

however, today non-accredited or non-institutional investors are

easily able to gain access to floating-rate loans through mutual

funds. Floating-rate loans have come to serve an important

purpose in today’s lending markets as they provide companies

with an alternative to funding operations through high-yield bond

issuance or bilateral commercial bank loans.


KeY characteriSticS OF FLOatiNG-rate LOaNS

While floating-rate loans are debt of non-investment-grade companies, there are some key differences between floating-rate loans and

traditional non-investment-grade bonds, each of which this paper will discuss in detail.

chArAcTErISTIcS OF FLOATING-rATE LOANS AND hIGh-yIELD BONDS

characteristic uS loans uS high-yield bonds relative benefits

Fixed/floating rate Floating rate mostly fixed rateLoans offer floating-rate coupons, which potentially offer less

interest-rate risk

Seniority SeniorSenior or

subordinated

Loans are the most senior debt in the capital structure of non-

investment-grade companies

Security Secured unsecuredLoans are generally secured by company assets, potentially

leading to higher recovery rates

Term at issuance 6 to 9 years 7 to 10 years Loans are generally slightly shorter-term

Liquidity Lower higher however, loans generally are less liquid than high-yield bonds

Floating-rate coupon

One key characteristic of floating-rate loans is that their

coupons float and are tied to a variable interest rate such

as LIBOR. Therefore, a floating-rate loan will be issued with a

coupon that pays a predetermined excess rate above that variable

interest rate. This excess rate or “spread” will be determined by

several factors, including the credit quality of the loan at issuance,

maturity of the loan and collateral, as well as other factors.3

Generally speaking, the higher risk of the loans (i.e., their lower

credit quality), the higher the spread associated with the loan.

historically, average yields on loans have ranged anywhere from

5.5% to 14.5% depending on credit quality of the loan, according

to S&p/LSTA.

As the example at right highlights, when a loan coupon’s variable

rate increases, the loan’s interest payment increases accordingly.

Loan coupons generally reset to the new variable rate every 30 to

90 days depending on the issue. This floating-rate component of

loans helps to mitigate interest-rate, or duration, risk.4

unlike a fixed-rate instrument, whose price will increase or

decrease inversely to the interest-rate move, the price of floating-

rate loans would not be expected to increase or decrease

due to interest-rate moves; however, the higher interest rates

should provide investors with higher income payments as the

loan coupon payments reset. A point to note: While interest

payments are not expected to impact loan pricing, other factors,

such as negative credit events, changes in loan supply and

demand, would potentially impact loan prices.

issuance

Loan spread LIBOr + 250 basis points (bps)

LIBOr rate 50 bps

Loan coupon 300 bps (50 bps + 250 bps)

LIBOR moves from 50 bps to 100 bps

Loan spread LIBOr + 250 bps

New LIBOr rate 100 bps

New loan coupon 350 bps (100 bps + 250 bps)

Source: S&p/LSTA. A basis point (bps) is one hundredth of a percentage point.


Seniority

Another attractive characteristic of floating-rate loans is that

they are senior in the capital structure of non-investment-

grade companies. What this means to investors is that a loan’s

interest and principal is paid before that of any other equity or debt

holders in a firm’s capital structure. As a result, the risk of losses

on loans relative to traditional non-investment-grade bonds is

reduced. For a typical firm, loans comprise about 45% to 50% of

the firm’s capital structure, meaning loans benefit from a cushion

from subordinated debt and equity commitments.

Therefore, as income and principal are repaid, loan investors are

paid first. If a company defaults, then equity and bond holders

take losses first. In short, income and principal repayments flow

from the top down (from floating-rate loan investors to equity

investors) and losses flow from the bottom up (from equity

investors to floating-rate loan investors). As a result, floating-rate

loan investors carry lower risk than other investors in the capital

structure.

Secured by assets

In the floating-rate loan market, collateral usually includes

tangible and intangible assets of the borrower, including assets

such as property, equipment, intellectual property, accounts

receivables and inventories, among others. In the case of default,

these assets can be sold and proceeds dispensed to the loan

investor. This aspect of loans is highly attractive because it helps

to mitigate downside risks associated with the investment.

It is also important to note that in some cases loans may be

over-collateralized. This simply means there are generally more

assets or collateral than the outstanding value of the loan. While

this aspect of floating-rate loans does not immunize investors

from potential losses, it does help to minimize potential losses, as

highlighted by floating-rate loans’ higher recovery rates, which will

be discussed in more detail later in this paper. In addition, this may

help provide investors with a measure protection from potential

deterioration of asset or collateral value.

A TypOLOGy OF FLOATING-rATE LOANS

Source: Deutsche Asset management

Second-lien loans Mezzanine loans

High-yield bonds

Equity

Floating-rate loans

Characteristics and benefits of floating-rate loans

Junior secured capital

Unsecured capital(Second loss capital)

First losscapital

Characteristic —Most senior debt obligation in capital structure

Secured by assets

Benefit —Interest and principal paid before equity and debt holders

A measure of downside protection in case of default

Sen

iorit

y

Floating-rate loans

Senior unsecured bonds

Senior subordinated bonds

Subordinated bonds

Equity

Floating-rate loans(Senior secured loans)

(Generally 45%-50% of firm’s capital structure)


The senior secured aspect of floating-rate loans is an

important characteristic to shareholders as highlighted by

historical default and recovery rates. As a way of explanation,

a default occurs when a borrower does not make interest or

principal payments as agreed upon. A recovery rate is the

percentage of the outstanding loan or debt value which is

recovered by an investor in the case of default. For example, if a

company defaults and an investor realizes a 100% recovery rate,

then the entire value of outstanding loan was recovered by an

investor. On the other hand, if the recovery rate is 50%, then an

investor only recouped 50% of the initial investment.

From 2001 to 2009, floating-rate loans have experienced

about half of the default rate of traditional non-investment-

grade bonds. From 1987 to 2009, they provided a recovery

rate of more than 81% on average. compare this latter figure

to traditional subordinated debt, which has an average recovery

rate of 31%. In short, this means that given the senior secured

aspect of floating-rate loans, even in the case of default, investors

recouped 81% of what was owed to them, while a subordinated

debt investor recouped only 31%. This lower default rate and

higher recovery rate highlight the potential protection floating-

rate loans may offer investors relative to traditional unsecured or

subordinated debt.

what these characteristics mean to investors: Floating-rate loans offered attractive default and recovery rates

ATTrAcTIvE DEFAuLT rATES AND rEcOvEry rATES

Source: moody’s Investor Services as of 12/31/09. Past performance is historical and does not guarantee future results. Default rate is for the trailing 12-month period.

Default rates for 2001, 2002, 2003 and 2004 are by number of issuers. Subsequent to 2004, the default rate is dollar-weighted. Default rate is for the trailing 12-month period.

Default is defined as missed interest or principal disbursement, bankruptcy, distressed exchange or an ongoing covenant violation. Average recovery rates over other time

periods might not be as favorable.

High-yield

Average default rate from 2001 – 2009 Average recovery rate from 1987 – 2009

Floating-rate loans Senior unsecuredFloating-rate loans Subordinated debt

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

3.63% 7.12% 81.10 % 44.60% 31.00%


the prOceSS OF FLOatiNG-rate LOaN iSSuaNce

For those who are somewhat unfamiliar with floating-rate loans,

loan structuring and issuance may seem complex, but in reality it

is relatively straightforward.

Floating-rate loan issuance begins when a company (or issuer)

decides to raise capital through the loan market instead of the

debt or equity markets. This firm will reach out to a commercial

or investment bank (known as an arranger) to facilitate the loan

issuance. An arranger serves the role of raising investor dollars

for a firm that is need of capital. Before awarding a mandate, the

issuer might solicit bids from a variety of arrangers.

Once the mandate is awarded, the syndication process starts. The

arranger will prepare an information memo describing the terms

of the transactions. The information memo typically will include

a variety of information, including the issuing firm’s financial

statements, terms and conditions of the loan and collateral, etc.

Loans are not securities, so the offering is usually confidential

and made only to qualified and accredited investors. (however,

as previously mentioned, today non-qualified investors have the

ability to invest in loans through mutual funds.) As the information

memo is prepared, the arranger solicits informal feedback from

potential investors about interest in the deal and potential pricing.

FLOATING-rATE LOAN ISSuANcE prOcESS

While the above description highlights loan issuance on the primary market, a highly active secondary market for loans also �

exists. Secondary sales occur after the loan has closed and been allocated and investors are free to trade the loan. Investors

usually trade through dealer desks and can sell or buy loans in one of two ways: assignment or participation.

In the assignment arrangement, the new owner of the loan (assignee) becomes a direct signatory of the loan and receives �

interest and principal payments directly from the issuer of the loan (through the administrative agent). Assignment typically

requires consent of both the borrower and agent. In short, the purchaser of the loan becomes its legal owner.

In the participation arrangement, the original investor remains the legal owner of the loan but agrees to allow another investor to �

share in a portion of the loan for a fee. Therefore, the new purchaser receives interest payments on a portion of the loan but is

not a legal owner of the loan.

the SecONdarY MarKet FOr FLOatiNG-rate LOaNS

After this information has been gathered, the arranger will formally

market the deal to potential investors. Once investors in the

loan are finalized and the loan is closed, the final terms are then

documented in detailed credit and security agreements. During

the process an administrative agent, which is generally a bank, is

chosen to handle and transmit all interest and principal payments

to investors in the loan. Following issuance, loan terms can be

revised and amended from time to time, but amendments require

approval from the investors.

Issuing company— Company which borrows money

through syndication process. Loan becomes a direct

debt obligation within firm’s capital structure.

Lead arranger or bookrunner— Bank hired by

borrowing company to stucture syndicate, promote

and sell the loans to investors.

Administrative agent— Bank which handles and

transmits all interest and principal payments to

investors and monitors the loan.

Loan investors (Participants)— Investors providing

the funds to the issuing company by purchasing

the loan. Consists of more than one investor.

Loan

is a

dire

ct d

ebt

oblig

atio

n of

the

issu

ing

com

pany


a GrOwiNG MarKet FOr FLOatiNG-rate LOaNS

The floating-rate loan market has grown more quickly in recent years relative to the non-investment-grade (high-yield) bond market.

As of 12/31/09, the floating-rate loan market had $531 billion in outstanding loans—almost two thirds the high-yield market.

tYpeS OF cOMpaNieS iSSuiNG FLOatiNG-rate LOaNS

Today a broad and diverse universe of companies, across multiple sectors, issue floating-rate loans. The S&p/LSTA Syndicated Loan Index

contains more than 1,000 loans across nearly 40 industries from about 600 issuers, such as Georgia-pacific corp., Goodyear Tire & rubber

co. (0.3%), Delta Airlines (0.7%), Ford motor co. (0.8%) and Wrigley co. (0%) to name a few.5

Source: Standard & poors and morningstar as of 12/31/09

FLOATING-rATE LOANS ISSuED By cOmpANIES FrOm vArIOuS SEcTOrS

Source: S&p/LSTA, as of 12/31/09

0

100

200

300

400

500

600

700

800

900

1000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

$ bi

llion

s

35

209

73 101

247

117 130 132 148

274338 373

496562

193248

588643

400

675

557

709

596

782

531

887

High-yield bonds outstandingFloating-rate loans

Utilities

Telcommunications

Retailers

Publishing

Oil and gas

Leisure

Hotels/motels/inns and casinos

Health care

Food products

Financial intermediaries

Electronics/electric

Chemical/plastics

Cable television

Business equipment and services

Building and development

Broadcast radio and television

Automotive

Other

0% 5% 10% 15% 20%

7.09%

3.74%

3.99%

7.66%

2.91%

3.33%

4.59%

9.43%

1.98%

4.59%

3.22%

5.78%

4.45%

5.72%

3.60%

4.59%

5.00%

18.31%

GrOWTh OF FLOATING-rATE LOAN mArKET vS. hIGh-yIELD BOND mArKET

W h I T E pA p E r / / pA G E 1 0

These two aspects of floating-rate loans caused most investors to

view loan mutual funds as more conservative “cash alternatives.”

Because of the lack of ratings, some investors were not aware

that these were non-investment-grade securities, and given the

fair value pricing of loans, price movement on loans or the funds

that invested in them was minimal. In short, floating-rate loan

portfolios had very little pricing and investment transparency.

Greater traNSpareNcY FOr

FLOatiNG-rate LOaNS

however, the environment for floating-rate loans changed

dramatically between 2000 to 2002 as the pending recession

and regulatory changes left some floating-rate loan fund

investors surprised.

In 2000, the Securities and Exchange Commission (SEC)

mandated that floating-rate loan managers begin pricing

securities at mark-to-market levels. The new pricing

transparency associated with the mark-to-market rules led to

floating-rate loan funds to experience negative returns for the first

time (first category monthly loss in march of 2001 following more

than 12 years of consecutive monthly gains).

The credit crises of 2007 to 2008 were also important for the

floating-rate loan market. A deteriorating economy, increasing

default rates and a vicious cycle of financial deleveraging drove

loan prices to historic lows. This was the first calendar year loss

for the floating rate fund category since its inception in 1988.

While the market downturn was driven in a large part by technical

factors such as a lack of liquidity and supply/demand factors, the

subsequent rebound quickly brought back loan valuations, making

up most of the 2009 losses.

Like any investment with credit risk, the economic environment

that is advantageous for potentially increasing or reducing

exposure is a key factor to success. When used correctly,

floating-rate loans can offer attractive opportunities, which we

will now discuss.

STAGES OF FLOATING-rATE LOAN mArKET

DEvELOpmENT

The floating-rate loan market has grown rapidly in recent years,

with total loans outstanding having grown from $35 billion in 1997

to more than $530 billion as of 12/31/09 (source: S&p/LSTA).

three stages of floating-rate loan history

1970s and

early 1980s

The primary market for floating-rate loans

was dominated by government borrowers

of emerging economies.

mid- to-late 1980s This period of development was driven by

the boom in mergers and acquisitions and

leveraged buyout activity.

1990s to today General corporate funding has become

the dominant part of the floating-rate loan

market.

2 l ThE EvOLuTION OF ThE FLOATING-rATE LOAN mArKET

a riSe iN pOpuLaritY iN the 1990s

Over its evolution the loan market has become much more

transparent and information is increasingly available. Two key

unsustainable factors led to floating-rate loan fund success

and popularity in the early and mid 1990s.

First, floating-rate loans generally were not rated by any credit

rating agencies until the mid-1990s, and then, until more recent

years, only on a limited basis (in 1996 Standard & poor’s began

rating corporate floating-rate loans, according to the milken

Institute, 2004).

Second, the secondary market for loans was limited, as floating-

rate loans were valued within floating-rate loan funds at fair value

and not market value.6 In January 1996, The Loan Syndications

and Trading Association (LSTA), began providing monthly mark-to-

market pricing based upon dealer quotes.7 In late 1999, the LSTA

licensed Loan pricing corp. to run the mark-to-market service,

which resulted in an overnight four-fold growth in the number of

loans priced daily.


A BrIEF hISTOry OF FLOATING-rATE LOANS (mOrNINGSTAr BANK LOAN cATEGOry mONThLy

rETurNS, 1989-2010)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

morningstar Bank Loan category returns 9.60% 8.03% 6.21% 5.70% 6.60% 7.80% 6.75% 7.31% 6.28% 6.23%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

morningstar Bank Loan category returns 6.23% 2.30% 0.84% 10.11% 5.02% 4.58% 6.61% 1.08% –30.22% 41.44%

Source: morningstar and DWS Investments as of 3/31/10. Source for default rates is moody’s Investor Services. Past performance is historical and does not guarantee

future results. Data is for illustrative purposes and does not represent any DWS fund. category returns do not reflect fees or expenses. It is not possible to invest directly in

an category. performance over other time periods might not be as favorable.

3 l FLOATING-rATE LOANS WIThIN ASSET ALLOcATION

Institutional clients have long recognized the benefits of investing

in floating-rate loans. however, in the past decade more retail

investors have also begun to recognize how allocating to floating-

rate loans can potentially benefit a portfolio. In this next section,

we explain the three unique benefits of floating-rate loans. Asset

allocation does not assure or guarantee better performance and

cannot eliminate the risk of investment losses.

diVerSiFicatiON BeNeFitS reLatiVe tO

traditiONaL hiGh YieLd

Investors have historically limited fixed-income allocations to only

two markets: investment-grade and sub-investment-grade bonds.

however, institutional investors have long recognized the benefits

of another unique fixed-income asset class in floating-rate loans.

This asset class is considered by many to be a hybrid market with

a risk/return profile that falls between that of investment-grade

and non-investment-grade bonds.

–15

–10

–5

0

5

10

3/109/099/089/079/069/059/049/039/029/019/009/999/989/979/969/959/949/939/929/919/909/89

Ret

urn

Time period

2008 Liquidity/credit

crunch drives prices to all-time lows

March 2001 Bank loan

category has first monthly loss

1989Van Kampen and

Eaton Vance funds launch8

2009 Great credit recovery: Prices

rise even as defaults hit record high of 10.87%

2002Recession

drives default rates to 7.41%

2000SEC mandates mutual funds mark loans to

market value

1988Pilgrim Fund

launches

hOw addiNG FLOatiNG-rate LOaNS caN

aid pOrtFOLiO aSSet aLLOcatiON

diversification: The risk/return characteristics of floating-

rate loans are unique in that they fall between traditional

investment-grade debt and sub-investment-grade debt,

making them a key diversification tool. Diversification

neither assures a profit nor guarantees against loss.

potential protection from higher interest rates:

Floating-rate loans offer floating-rate coupons, which

can help mitigate interest-rate, or duration, risk.

potential protection from higher inflation: Floating-rate

loans have historically offered a measure of protection

from higher inflation because the environments in

which they tend to outperform are generally the same

environments that lead to higher inflation.


Floating-rate loans and investment-grade bonds carry different

risks, and when used in combination, they may offer an

opportunity for an attractive return stream that can potentially

benefit investors during multiple market cycles. The chart below

highlights differences in key risk characteristics.

Given that investment-grade bonds carry less credit and liquidity

risk but more interest-rate risk, they will generally outperform

during periods of weakening economic conditions, which are

associated with higher default rates and lower interest rates.

however, the opposite holds true for floating-rate loans, which

contain a higher level of credit and liquidity risk but with minimal

interest-rate risk. Therefore, floating-rate loans generally

outperform during periods of improving economic conditions,

which are associated with lower default rates higher interest

rates. Of course, past performance does not guarantee

future results.

The differences between floating-rate loans and investment-grade

bonds are what led to the attractive risk/return characteristics.

The diversification benefits of combining both floating-rate loans

and investment-grade bonds are highlighted by the fact that the

correlation between floating-rate loans and investment-grade

bonds is –0.02% for the 15-year period ended 3/31/10, according

to morningstar, Inc.9

DIFFErENcES IN KEy rISK chArAcTErISTIcS

interest-rate risk credit risk Liquidity risk income potential potentially optimal environment

Floating-rate loans Low medium medium mediumStrengthening economy/ rising rates

Investment-grade bonds Low to high Low Low LowWeak economy/ falling rates

Non-investment-grade bonds

medium high medium highStrengthening economy/flat rates

In turn, the low correlation and diversification benefits have the potential to create a combined portfolio that offers attractive return and

yield with lower overall volatility than a 100% investment-grade portfolio (as shown in chart below).

pOTENTIAL TO hELp prOTEcT AND ENhANcE A hypOThETIcAL FIxED-INcOmE pOrTFOLIO

Source: DWS Investments as of 3/31/10. Past performance is historical and does not guarantee future results. Asset class representation: floating-rate loans, credit Suisse

Leveraged Loan Index, which is designed to mirror the uS leveraged loan market; investment-grade bonds, Barclays capital uS Aggregate Index, which represents domestic

taxable investment-grade bonds with average maturities of one year or more. Data is for illustrative purposes and does not represent any DWS fund. Index returns do not reflect

fees or expenses. It is not possible to invest directly in an index. performance over other time periods might not be as favorable. risk is measured by standard deviation.

Source: Deutsche Asset management.

2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0%

5.9%

6.0%

6.1%

6.2%

6.3%

6.4%

6.5%

6.6%

Ret

urn

Risk

100% investments-grade bonds

70% investment-grade bonds / 30% floating-rate loans

Investment-grade vs. senior secured loans (Feb.1992–March 2010)


One of the most attractive features of floating-rate loans is the

potential measure of protection they may provide from higher

interest rates. There are two main reasons behind floating-rate

loan performance during a higher-interest-rate environment.

First, the floating coupon associated with floating-rate loans.

Given that floating-rate loans reset their coupons payments every

30 to 90 days, they have minimal interest-rate, or duration, risk.4

Therefore, unlike fixed-rate instruments, which will experience

a decline in price as interest rates increase, floating-rate loans

will generally benefit from higher interest rates through higher

coupon and income payments with minimal impact to the price

of the loans. In short, the returns of floating-rate loans would be

expected to be higher during periods of rising interest rates given

the additional income that is being earned, while the returns of

traditional fixed-rate bonds would expected to be lower during

these periods.

The second component of loans that may potentially lead to

outperformance during rising-rate environments is that floating-

rate loans are impacted more significantly by deterioration of

general credit market or economic conditions. In general, their

returns are impacted positively during periods of improving

economic and credit conditions, which are also generally

associated with higher interest-rate cycles. The opposite is true

during economic downturns.

The chart below highlights the returns of floating-rate loans, short-

term bonds and intermediate-term bonds during periods in which

interest rates rose by one percentage point or more since 1992.

As would be expected, intermediate-term bonds with a high level

of interest-rate risk experienced the lowest returns (–0.08%) with

the highest volatility (3.68%). On the other hand, floating-rate

loans experienced significantly higher returns (10.27%) with less

risk (1.40%) over the same periods.

The risk higher interest rates may have on an investor’s fixed-

income allocation is important and that is many times overlooked

during portfolio construction. An allocation to floating-rate loans is

a compelling option to help investors seek a potential measure of

protection from higher interest rates.

pOteNtiaL prOtectiON FrOM hiGher iNtereSt rateS

pOTENTIAL BENEFIT OF FLOATING-rATE LOANS DurING rISING-rATE ENvIrONmENTS

Source: morningstar Inc., as of 12/31/09. Past performance is historical and does not guarantee future results. Asset class representation: Floating-rate loans, credit Suisse

Leveraged Loan Index; intermediate-term bonds, Barclays capital 5-7 year uS Aggregate Index, which with average maturities of five to seven years; short-term bonds, Barclays

capital 1-3 year uS Aggregate Index, which represents domestic taxable investment-grade bonds with average maturities of one to three years. Data is for illustrative purposes

and does not represent any DWS fund. Index returns do not reflect fees or expenses. It is not possible to invest directly in an index. performance over other time periods might

not be as favorable. volatility is measured by standard deviation. performance over other time periods might not be as favorable.

time period 10/93 — 10/94 1/99 — 1/00 5/03 — 5/04 6/05 — 6/06

One-year rise in interest rates 2.38% 2.02% 1.29% 1.21%

Floating-rate loan returns 13.35% 5.43% 8.30% 6.66%

Short-term bond returns 1.33% 2.85% 1.10% 1.96%

Intermediate-term bond returns –2.28% –0.91% –1.52% –0.37%

Average annual return

Short-term bondsFloating-rate loans Intermediate-term bonds

0%

4%

8%

12%

10.27% 2.27% –0.08%

Average volatility

Short-term bondsFloating-rate loans Intermediate-term bonds

0%

1%

2%

3%

4%

2.46% 1.40% 3.68%


pOteNtiaL prOtectiON FrOM hiGher iNFLatiON

Another attractive feature of floating-rate loans is the potential

measure of protection that they may offer from higher inflation.

While floating-rate loans do not have a specific imbedded

inflation hedge, their floating coupons may offer a measure

of protection from inflation. There are several reasons this is

the case, which we will discuss in more detail. First, inflationary

pressures tend to rise during periods of economic expansion,

which are also associated with higher interest rates.

As discussed in the previous section, a period of economic

expansion and higher interest rates tends to lead to

outperformance of floating-rate loans.

Given that inflation tends to move higher in these periods, loan

returns historically have increased during the same periods

in which inflation pressure take hold, as highlighted by their

high correlation to inflation in the chart below.

So while floating-rate loans may not have a direct inflation hedge

imbedded in their structure, there is potentially a measure of

protection from higher inflation because the environments in

which floating-rate loans tend to outperform are generally the

same environments that lead to higher inflation.

FLOATING-rATE LOANS OFFErED pOSITIvE cOrrELATION TO INFLATION (FIvE-yEAr pErIOD ENDED 3/31/10)

Source: morningstar, as of 3/31/10. Past performance is historical and does not guarantee future results. Asset class representation: inflation, uS Bureau of Labor Statistics,

cpI All urban; floating-rate loans, morningstar Bank Loan category; commodities, morningstar Natural resources category; short-term bonds, morningstar Short-Term Bond

category; large-cap equities, morningstar Large Blend category; uS TIpS, morningstar Inflation protected Bond category; intermediate-term bonds, morningstar Intermediate-Term

Bond category. This data is for illustrative purposes and does not represent any DWS fund. It is not possible to invest directly in a category. correlation refers to how securities

or asset classes perform in relation to each another and/or the market. A 1.0 correlation indicates that two security types move in exactly the same direction. A –1.0 correlation

indicates movement in exactly opposite directions. A zero correlation implies no relation in the movements. correlation over other time periods might not be as favorable.

Inflation

Floating-rate loans

Commodities

Short-term bonds

Large-cap equities

US TIPS

Intermediate-term bonds

–0.10 0.01 0.12 0.23 0.34 0.45 0.56 0.67 0.78 0.89 1.00

1.00

0.47

0.27

0.12

0.11

0.11

–0.08


cONcLuSION

Our research finds that floating-rate loans have the potential to provide several potential benefits when added to a fixed-income portfolio’s allocation.

1 l DIvErSIFIcATION OppOrTuNITy

First, floating-rate loans may potentially offer attractive diversification opportunities when added to a traditional investment-grade bond

portfolio. This is highlighted by the low correlation between the two investments. This low correlation may lead to lower volatility of a

combined floating-rate loan/investment-grade bond portfolio relative to an investment-grade-only portfolio (see pages 11–12 for details).

2 l pOTENTIAL INTErEST-rATE rISK hEDGE

Second, floating-rate loans present investors with a tool to help hedge the interest-rate risk that threatens traditional bond asset

classes. While past performance is historical and does not guarantee future results, during any period from 1992 to 2009 when interest

rates increased by one percentage point or more, floating-rate loans provided the highest return compared to short-term bonds and

intermediate-term bonds (see pages 13 for details).

3 l pOTENTIAL INFLATION rISK hEDGE

Third, floating-rate loans present investors with a tool to help hedge inflation risks that threaten a traditional bond assets classes. This is

highlighted through the high correlation between inflation and floating-rate loan returns (see page 14 for details).

as discussed in the paper, the floating-rate loan market experienced numerous transformations since its inception. it has grown

to become a fully developed asset class in size, scope and liquidity and now attracts multiple investor types. Given the growth

of today’s floating-rate loan market and the opportunities floating-rate loans may provide investors, we believe floating-rate

loans will become a more prevalent part of retail investors’ asset allocations moving forward.

© 2010 DWS Investments Distributors, Inc. All rights reserved. pm102742 (05/10) r-16953-1 FLOATING-WhITE

DWS Investments Distributors, Inc.222 South riverside plaza chicago, IL 60606-5808www.dws-investments.com [email protected] (800) 621-1148

NOT FDIC/NCUA INSURED MAY LOSE VALUE

NO BANK GUARANTEE NOT A DEPOSIT

NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

DWS Investments is part of Deutsche Bank’s Asset management division and, within the uS, represents the retail asset management activities of Deutsche Bank AG, Deutsche Bank Trust company Americas, Deutsche Investment management Americas Inc. and DWS Trust company.

OBTAIN A PROSPECTUS To obtain a summary prospectus, if available, or prospectus, download one from www.dws-investments.com, talk to your financial representative or call (800) 621-1048. We advise you to carefully consider the product’s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest.

NOteS1 Source: morningstar, Inc., as of 3/31/10. rankings and ratings are historical and do not guarantee future results. class S shares of DWS Floating rate plus Fund were ranked

as follows in the morningstar Bank Loan category: one-year, 33/134 funds; three-year, not available; five year, not available; 10-year, not available; since inception on 6/28/07,

7/100 funds. rankings are based on a fund’s total return with distributions reinvested. rankings of other share classes may vary. 2 LIBOr (London Interbank Offered rate) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market.3 credit quality is a measure of a bond issuer’s ability to repay interest and principal in a timely manner. rating agencies assign letter designations such as AAA, AA and so

forth. The lower the rating, the higher the probability of default. 4 Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates.5 percentages in parentheses represent percentages of the fund’s market value as of 3/31/10. Securities referenced do not represent all of the securities purchased or sold by

the fund, may or may not be profitable, and should not be construed as a recommendation of any specific security. current and future portfolio holdings are subject to risk. 6 Fair value is the estimated value of all assets and liabilities of an acquired company used to consolidate the financial statements of both companies.7 mark to market is a measure of the fair value of accounts that can change over time, such as assets and liabilities. mark to market aims to provide a realistic appraisal of an

institution's or company's current financial situation.8 Eaton vance Floating rate Advantage Fund: www.eatonvance.com, Two International place, Boston, mA 02110. van Kampen Senior Loan Fund: www.vankampen.com,

1 parkview plaza, Suite 100, p.O. Box 5555, Oakbrook Terrace, IL 60181.9 correlation refers to how securities or asset classes perform in relation to each another and/or the market. A 1.0 correlation indicates that two security types move in exactly

the same direction. A –1.0 correlation indicates movement in exactly opposite directions. A zero correlation implies no relation in the movements.

Past performance is no guarantee of future results. The opinions and forecasts expressed herein by the fund managers do not necessarily reflect those of DWS

Investments, are as of 3/31/10 and may not come to pass.

the evolving market for floating-rate loansnews.morningstar.com/pdfs/dws_floating_rate.pdf ·...

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