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SENIOR LOAN MARKET UPDATE
Fourth Quarter 2010
MARKET PERFORMANCE
The senior loan market displayed strong performance during the fourth quarter
of 2010. Improving credit fundamentals and robust investor demand for the asset
class combined to drive senior loan prices higher. The S&P/LSTA Index ("Index")
was up 3.19% during the final quarter of the year, bringing the full year
return to an impressive 10.13%. The loan market return in 2010 was the second
highest performance year on record for the Index, following only the return in
2009 (+51.62%) which benefited from a strong rebound off the lows in 2008.
In the fourth quarter, the loan market gains were broad based with every
industry group posting positive results for the period. The
strongest-performing industries in the Index were Radio and Television
(+8.15%), Nonferrous Metals-Minerals (+4.64%) and Ecological Services and
Equipment (+4.58%). The worst-performing industries were Beverage & Tobacco
(+1.03%), Forest Products (+1.56%) and Food Products (+1.84%).
IMPROVING CREDIT QUALITY
Fundamental credit quality has come full circle. This is evidenced by the
senior loan market default rate, which has declined sharply from a peak of
nearly 11% in November of 2008, to 1.87% at year end 2010. The current default
rate is below the long-term average default rate for the asset class (3.75%),
and we anticipate that the default rate will remain relatively low in the
quarters ahead. First, the amount of leveraged loans maturing by the end of
2012 has been reduced through corporate actions to approximately $24 billion
from nearly $70 billion at year-end 2009. This reduction limits the universe of
loans with a potential catalyst (upcoming maturity) for default. The second
reason is improved corporate performance. The average year-over-year growth in
cash flows for senior loan market issuers has increased in each of the first
three quarters of 2010, and is expected to be strong in the fourth quarter as
well. During the third quarter of 2010 (latest data available), Index issuers
that report publicly grew cash flow an impressive 25.6% from one year prior.
With the prospect of continued growth in the U.S. economy, corporate
performance may well improve further. These improving financial results should
help increase a company's ability to service debt payments.
INCREASING INVESTOR DEMAND
Retail investors purchased $7.1 billion in senior loan mutual funds in the
fourth quarter, which represents a record quarterly inflow into the asset
class, according to Lipper FMI. For the full year, retail senior loan mutual
funds took in $16.2 billion in assets. This increase in investor demand
provided a supportive technical environment as retail senior loan fund managers
were net purchasers of senior loans. This demand helped support, and drive
higher, the average secondary market price of loans. The average loan price
within the Index increased over 6 points over the course of the year and ended
December at 93.6.
Of additional importance, investor demand for high-yield bonds was also strong
in 2010. The increased market liquidity allowed many companies to refinance
near-term maturities (either loans or bonds) in order to place them on a firmer
financial footing. This renewed market liquidity has greatly reduced the
universe of loan issuers with near-term maturities.
Investor demand for senior loans may continue to be strong in the periods
ahead. Investors may find the floating-rate nature of the asset class
attractive in a period when interest rates may move higher.
LOAN PRICES AND SPREADS
The average loan price in the market improved over the quarter from 91 to 93.6.
While loan prices have indeed improved significantly from nearly 60 in late
2008, we believe that the current discount to par remains attractive,
especially when coupled with the much improved default rate and the healthy
fundamental performance for corporations in the senior loan universe. In fact,
by historical standards, yields are attractive. According to Standard & Poors
LCD, the discounted spread to a 3-year average life is currently Libor plus
5.73%. This compares favorably to the average pre-credit crisis spread of Libor
plus 3.63% (period ending June 2007).
PORTFOLIO REVIEW
The portfolio performed well in the fourth quarter. For the three-month period
ending December 31, 2010, the Fund generated a market price total return of
7.39% and a net asset value (NAV) total return of 4.01%. The Fund's market
price return benefited in the period as the discount to NAV narrowed from
-7.46% at the beginning of the period to -4.32% at the end of the reporting
period. The Fund's NAV return for the fourth quarter outperformed the Index
return of 3.19% by 82 basis points. For the full year ended December 31, 2010,
the Fund generated a market price total return of 22.20% and a net asset value
(NAV) total return of 11.01%. As was the case in the quarterly period, the
Fund's market price return benefited in the period as the discount to NAV
narrowed from -13.20% at the beginning of the period to -4.32% at the end of
the reporting period.
On December 20, 2010, we announced that the Fund increased the monthly income
distribution to $0.06 per share from $0.055 per share. This represents an
increase of 9.09%. The increased income distribution reflects an increase in
coupons in the senior loan market. As of December 31, 2010, the Fund's
distribution yield at NAV was 4.93% (5.16% at market price).
The portfolio is weighted toward those industries which we believe will benefit
from continued economic and corporate credit improvement. Moreover, our
rigorous credit process tends to favor those industries exhibiting greater
defensive characteristics. The largest industries in the portfolio at the end
of the fourth quarter remained the same as the previous quarter with
Healthcare: 10.99%, Media: 10.13%, Diversified Consumer Services: 7.75% and
Chemicals: 6.14%. These industries may have hard assets, which may benefit
investors as loans tend to be senior secured which may provide for better
recoveries in the event of a default.
The primary market of new senior loan issuance was strong in the fourth
quarter, with $70 billion in issuance. With the robust primary market providing
ample supply of good credits with attractive economics, we have been able to
reposition the portfolio at a measured pace, to higher-yielding holdings.
The portfolio exhibits a significantly higher credit quality when compared with
the Index. Over 60% of the portfolio is rated BB- or better by Standard &
Poor's, compared to only 44.3% for the Index. Moreover, concentrations by both
industry and borrower are well below portfolio limits, reflecting our belief
that, after credit selection, diversification is the best way to guard against
loss.
In the fourth quarter, we significantly improved the diversification in the
portfolio. The number of positions increased from 148 to 188 and the average
position size declined from 0.68% to 0.50%. The largest portfolio position was
Reynolds Consumer Products Holdings, Inc., at 1.59% of the portfolio.
OUTLOOK
The story for senior loan investors has been one of continued improvement. As
seasoned managers, we have been working diligently to capitalize on the current
market opportunities by performing rigorous credit research and seeking to
identify what we believe to be excellent risk-adjusted return opportunities. In
accordance with the stated objectives in the prospectus, we're focused on
credit quality and improving yield. Our portfolio strategy is to balance the
goal of high current income with portfolio risk. While we expect the Fund to
continue to be of high credit quality, we believe there are compelling
opportunities in the market today that may marginally reduce the overall
portfolio's weighted average credit rating, but that we believe will improve
the portfolio yield and ultimately enhance the risk/reward profile of the
portfolio. We expect that even with these potential enhancements, the credit
quality of the portfolio would continue to be superior to that of the Index and
many peer funds within the senior loan closed-end fund category. In providing a
competitive rate of income to shareholders, we will focus our attention on
those issues that provide the greatest relative value, or risk-adjusted return.
The First Trust Leveraged Finance Investment Team is optimistic about the
outlook for the senior loan market. With loan prices trading, on average, below
par, defaults trending lower, and credit quality generally strong, we believe
investors with an intermediate time horizon will be rewarded by investing in
the senior loan asset class as current market conditions appear to offer
investors a compelling value. Moreover, should interest rates begin to increase
in the future, the Fund should benefit given the floating-rate nature of the
senior loan assets.
Sources: S&P LCD, Bloomberg, First Trust
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They do not address the suitability of securities or the suitability of
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advice.
INVESTMENT MANAGER
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First Trust Advisors L.P. ("First Trust") was established in 1991 and is
located in Wheaton, Illinois. First Trust offers customized portfolio
management using its structured, quantitative approach to security selection.
As of November 30, 2010, First Trust managed or supervised $39.65 billion in
assets. The First Trust Leveraged Finance Investment Group began managing the
First Trust Senior Floating Rate Income Fund II (previously called the "First
Trust/Four Corners Senior Floating Rate Income Fund II") on October 13, 2010.
The experienced professionals comprising the First Trust Leveraged Finance
Investment Group currently manage approximately $515 million. The group's
experience includes managing senior secured floating-rate corporate loans in
both the U.S. and Europe, managing high-yield debt and corporate restructuring
expertise. The group has managed institutional separate accounts, commingled
funds, structured products and retail funds.
PORTFOLIO MANAGEMENT TEAM
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WILLIAM HOUSEY, CFA o SENIOR VICE PRESIDENT, SENIOR PORTFOLIO MANAGER
Mr. Housey joined First Trust Advisors L.P. in June 2010 as Senior Portfolio
Manager and has nearly 15 years of investment experience. Prior to joining
First Trust Advisors L.P., Mr. Housey served as Executive Director and
Co-Portfolio Manager at Van Kampen Funds, Inc., a wholly-owned subsidiary of
Morgan Stanley. Mr. Housey has extensive experience in portfolio management of
both leveraged and unleveraged credit products, including senior loans,
high-yield bonds, credit derivatives and corporate restructurings. Mr. Housey
received a BS in Finance from Eastern Illinois University and an MBA in Finance
as well as Management and Strategy from Northwestern University's Kellogg
School of Business. He also holds the Chartered Financial Analyst designation.
SCOTT D. FRIES, CFA o VICE PRESIDENT, PORTFOLIO MANAGER
Mr. Fries joined First Trust Advisors L.P. in June 2010 as Portfolio Manager of
the Leveraged Finance Investment Team and has over 15 years of investment
industry experience. Prior to joining First Trust Advisors L.P., Mr. Fries
served as Co-Portfolio Manager of Institutional Separately Managed Accounts for
Van Kampen Funds, Inc., a wholly-owned subsidiary of Morgan Stanley. Mr. Fries
received a BA in International Business from Illinois Wesleyan University and a
MBA in Finance from DePaul University. He also holds the Chartered Financial
Analyst designation.
INVESTOR RELATIONS
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GREGORY OLSEN, CFA o SENIOR VICE PRESIDENT, PORTFOLIO SPECIALIST
Mr. Olsen is a Senior Credit Analyst and Portfolio Specialist for the Leveraged
Finance Investment Team at First Trust Advisors. He has 17 years of investment
experience, most recently as Executive Director and Portfolio Specialist in
leveraged finance for Morgan Stanley/Van Kampen. Mr. Olsen received a B.S. in
Business Administration from Illinois Wesleyan University and an MBA with a
concentration in finance from DePaul University. He holds the Chartered
Financial Analyst designation and is a member of the CFA Institute and the CFA
Society of Chicago. His professional experience is concentrated within the
credit markets including senior secured loans, high yield bonds, and
convertible securities.
CAUTION REGARDING FORWARD-LOOKING STATEMENTS
This commentary contains certain forward-looking statements within the meaning
of the Securities Act of 1933, as amended, and the Securities Exchange Act of
1934, as amended. Forward-looking statements include statements regarding the
goals, beliefs, plans or current expectations of First Trust Advisors L.P.
("First Trust" or the "Advisor"), taking into account the information currently
available to it. Forward-looking statements include all statements that do not
relate solely to current or historical fact. For example, forward-looking
statements include the use of words such as "anticipate," "estimate," "intend,"
"expect," "believe," "plan," "may," "should," "would" or other words that
convey uncertainty of future events or outcomes.
Forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause the actual results, performance or achievements of
First Trust Senior Floating Rate Income Fund II (the "Fund") to be materially
different from any future results, performance or achievements expressed or
implied by the forward-looking statements. When evaluating the information
included in this market update, you are cautioned not to place undue reliance
on these forward-looking statements, which reflect the judgment of the Advisor
and their representatives only as of the date hereof. We undertake no
obligation to publicly revise or update these forward-looking statements to
reflect events and circumstances that arise after the date hereof.
PERFORMANCE AND RISK DISCLOSURE
There is no assurance that the Fund will achieve its investment objectives. The
Fund is subject to market risk, which is the possibility that the market values
of securities owned by the Fund will decline and that the value of the Fund
shares may therefore be less than what you paid for them. Accordingly, you can
lose money by investing in the Fund.
Performance data quoted represents past performance, which is no guarantee of
future results, and current performance may be lower or higher than the figures
shown. For the most recent month-end performance figures, please visit
www.ftportfolios.com or speak with your financial advisor.
The Fund is subject to various risks, including: Credit Risk, Senior Loan Risk,
Lower Grade Debt Instruments Risk, Interest Rate Risk, Discount From or Premium
to Net Asset Value Risk, Leverage Risk, Restrictive Covenants and 1940 Act
Restrictions, Secondary Market for the Fund's Shares, Limited Secondary Market
for Senior Loans, Lending Portfolio Securities, Demand for Senior Loans,
Unsecured Loans and Subordinated Loans, Short-Term Debt Securities, Investments
in Equity Securities Incidental to Investment in Senior Loans, Illiquid
Securities, Non-U.S. Securities, Management Risk, Strategic Transactions,
Reinvestment Risk, Inflation Risk, Regulatory Changes, Market Event Risk, and
Anti-Takeover Provisions.
Lower grade debt instruments are commonly referred to as "high yield" or "junk
bonds" and are considered speculative with respect to the issuer's capacity to
pay interest and repay principal. Investing in lower grade debt instruments
involves additional risks than investment-grade debt instruments. Lower grade
debt instruments are securities rated Ba1 or lower by Moody's or BB+ or lower
by S&P, comparably rated by another NRSRO or, if unrated, of comparable credit
quality. These lower grade debt instruments may be come the subject of
bankruptcy proceedings or otherwise subsequently default as to the repayment of
principal and/or payment of interest or be downgraded to ratings in the lower
rating categories (Ca or lower by Moody's, CC or lower by S&P or comparably
rated by another NRSRO). Issuers of lower grade debt instruments are not
perceived to be as strong financially as those with higher credit ratings, so
the securities are usually considered speculative investments. These issuers
are generally more vulnerable to financial setbacks and recession than more
creditworthy issuers which may impair their ability to make interest and
principal payments. Lower grade debt instruments tend to be less liquid than
higher grade debt instruments.
FOR ADDITIONAL INFORMATION, CALL JEFF MARGOLIN, SENIOR VICE PRESIDENT AND
LOSED-END FUND ANALYST, AT 630-915-6784.
FIRST TRUST
www.ftportfolios.com
