For fund manager Brian Juliano, protecting other people’s money is personal.
“My mother was a teacher then a secretary”, assures the co-manager of
PGIM Floating Rate Income
said. “My father was in the building.
Juliano, 43, credits his blue-collar background with a strong work ethic and helped him recognize the importance of risk control – what’s at stake when investing other people’s money.
His cautious approach is evident in his fund’s credit quality, which consistently outperforms its peers in Morningstar’s bank loan fund category. And it paid off. The 4.3% annualized return of the $1.5 billion PGIM fund (ticker: FRFAX) over the past decade exceeds 91% of its peers, and its expense ratio of 0.97% is also below the average. It carries a 2.25% charge, but this commission is waived at brokers such as Charles Schwab and Fidelity.
Now is an attractive time to invest in bank loans, which are debt securities issued by banks to corporate borrowers and whose yields rise and fall with interest rates. After hitting zero during the pandemic, interest rates can only go up, especially if an overstimulated economy triggers inflation, as many investors fear.
Although bank loans may benefit from rate increases, they suffer from credit risk. They are generally rated below investment grade or junk grade, so weaker loan originators may struggle to keep up with their payments as rates rise. In addition, many companies have borrowed heavily in recent years as rates have remained extremely low. In addition, many of the covenants of these loans – or loan conditions in case of financial hardship – have weakened as investors have become more hungry for yield and willing to accept more risk. That means the amount investors will recoup if a company fails is less than it once was — about 40 to 50 cents on a dollar, Juliano says.
“The market has moved away from the traditional protections offered by senior secured leveraged loans,” so investors should turn to high-quality assets and do “thorough credit research,” says -he. “You have to pick up the phone and talk to the [loan] dealers, the [company] management teams and private equity sponsors. You need to get as much information as possible about the [companies’] end markets and keep an eye on leverage and cash flow.
Most bank loan borrowers are not well-known blue chip companies, but are often small private companies, making it essential that analysts seeking them do their homework. Fortunately, a strong work ethic doesn’t just apply to Juliano. Three of its co-managers – Parag Pandya, Ian Johnston and Robert Meyer – are long-experienced credit analysts. A fourth co-manager, Robert Cignarella, specializes in high-yield bonds, in which the fund occasionally gets involved. They are supported by PGIM’s 40 credit analysts.
(PRU), of which PGIM is the investment management division, in 2000 as an accountant to help transform the private mutual insurer into a publicly traded company. (He previously worked at Deloitte and has an MBA in finance and accounting from New York University.) But he yearned to do something more challenging. “I had made contacts in our lending business, which was very young at the time,” he says. He transferred to the loans team in 2003 and began working on his secured loan obligations, or CLOs. Today, he leads PGIM’s US bank lending team and co-head of its US CLO business, which collectively oversees $30 billion in loan portfolios.
CLOs are pools of loans managed by managers – like PGIM – and are sold to institutional investors. Most CLOs struggled during the 2008 financial crisis, suffering defaults and collapsing with other forms of bundled debt like mortgage-backed securities. But PGIM’s conservatively managed CLOs handled the crisis well, says Juliano: “The big financial crash reinforced our view of our risk management techniques. This reinforced our view that we could launch a mutual fund product. PGIM Variable Rate launched in 2011.
Having a background in accounting helps analyze loans, especially “to flush out fraud and catch things that just don’t make sense,” says Juliano. For example, drug-testing firm Millennium Health issued $1.8 billion in debt in 2014, but PGIM avoided the sale after digging in its numbers, he recalls. “One of our research analysts asked [Millennium’s] management, ‘I don’t understand why your turnover is increasing like this. It does not mean anything. Can you help me understand? And the management team could not give a good answer. The following year, Millennium filed for bankruptcy and agreed to pay $256 million to settle allegations of medical misrepresentation.
Before investing in a loan, the PGIM team creates a risk model to see what would happen if its issuer experienced a 20% drop in revenue. But once they’ve done their homework, they’re willing to take risks. For example, they more than doubled their exposure to CLOs, from 5% towards the end of 2019 to over 13% in May 2020 during the pandemic slide. CLOs are designed as pyramids, with levels or slices of credit risk, and they only bought the highest CLO slices. (They will not buy CLOs managed by PGIM to avoid conflicts of interest.)
Even though CLOs are well-diversified, says Juliano at the time of the crisis last March, these highest-quality tranches were yielding much more than individual loans because they were trading at discounts of up to 20% from face value. loans.
By November, the value of the CLO allocation had recovered along with the rest of the market, and Juliano began selling them to buy individual loans again. In February 2021, the fund’s CLO weighting was only 1.5%.
Lately, the team has purchased floating rate preferred shares of major banks such as
(JPM), as they have high yields but good credit quality. Juliano also likes loans from companies in the process of being acquired, like the truck manufacturer
Navistar International (NAV), which is acquired by Traton Group, a
subsidiary company. The debt will be repaid at the closing of the agreement and the acquirers are incentivized to repay the investors in loans, which reduces the risk of default.
As always, Juliano tries to win by losing less.
E-mail: [email protected]