High yield bonds remain more attractive than leveraged loans
There are times when the leveraged loan market can provide attractive investment opportunities, but now is not one of them.
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The leveraged loan market has traditionally been a route for institutional investors to gain sub-investment grade credit exposure, with a different risk/return profile to that available in high yield bonds. There are two main reasons why investors are typically drawn to leveraged loans1.
The traditional appeal of leveraged loans over high yield bonds
Sensitivity to interest rates: Due to their floating rate mechanism, leveraged loans are viewed as a good investment during periods of rising interest rates or when short-term rates are expected to rise.
If short-term rates are rising, the interest rate on the loan will increase and provide the investor with a higher yield and ultimately a higher return. Because the coupon is periodically reset to a predetermined spread level over LIBOR (typically every three months), leveraged loans are floating rate instruments.
Therefore, they have minimal interest rate duration – an attractive feature in a rising rate environment.
Recovery rates in the event of default: The majority of the leveraged loan market is comprised of first-lien secured obligations. Such corporate liabilities sit at the top of the capital structure of companies which have issued debt. Senior unsecured bonds, subordinated debt, preferreds and equity capital all rank lower than the secured obligations.
Therefore, in the event of a default, recovery rates are generally higher for secured loans than they are for high yield bonds. In fact, over the past five years through May 2017, the average recovery rate for US first lien loans was 70% compared to an average recovery rate of only 40.8% for US senior unsecured bonds, according to Moody’s2.
To many investors, leveraged loans seem to provide attractive income in a rising rate environment with limited downside risk, relative to high yield bonds, due to their higher position in the capital structure.
Are those reasons compelling today?
Sensitivity to interest rates: There is no doubt that loans have less interest rate sensitivity than high yield bonds. Yet, for loans to produce more attractive returns, short-term rates need to rise considerably due to their lower coupon income. Although leveraged loans are typically priced off 3-month LIBOR, which doesn’t move in lockstep with the Fed Funds rate, these two short-term rates do move closely over most time periods.
Short-term rates are expected to rise at a measured pace over at least the next one-to-two years. The floating rate component of the loan may be unlikely to reward investors for the foregone income versus fixed-rate high yield bonds, which tend to provide higher yields than loans.
As a result, we believe that in today’s environment leveraged loans may have limited benefits. Importantly, leveraged loans provide less call protection than high yield bonds. So, if an investor times the interest rate move incorrectly, they can be penalised. If interest rates decline and/or credit spreads tighten, the company that had issued a leveraged loan can re-price or re-finance it at virtually any time at the new, lower rates.
High yield bonds have better call protection which means they have the ability to appreciate further in price than loans can in a stable or improving market environment.
Recovery rates in the event of default: The argument regarding higher recovery rates has become less compelling over the last few years.
Understandably, many investors are willing to sacrifice some return in exchange for the added protection they receive for owning a security that is higher in a company’s capital structure.
However, while loans are prioritized over unsecured bonds in a default situation, the overall credit quality for loans has been deteriorating over the last few years and investors are not protected as much as they once were.
Increased demand for loans has contributed to stronger negotiating power by issuers during the new issue process and investors have been willing to accept weaker covenants than they had in the past.
After having comprised less than 5% of the leveraged loan market prior to 2007, these “covenant-lite” loans now constitute 75% of the entire loan market3. So, while loans may in fact be higher in the capital structure, the leveraged loan asset class overall no longer necessarily provides the same level of safety as it has in the past.
Chart: Covenant-lite index weighting as a percentage of overall leveraged loan market
Source: JP Morgan, Schroders July 2017
In addition, the proportion of the high yield market that is comprised of issuers that only have loans and no bonds in the capital structure has risen steadily since 2007 from 40% to 49%. This is important because if an issuer only has loans outstanding, then there are no bonds below it in the capital structure to cushion the loan in the event of a default.
High yield bonds are a better solution, especially in today’s market environment
Sensitivity to interest rates: While many investors consider buying loans because they are concerned about rising short-term rates, the fact is that high yield bonds have historically posted strong returns and have done better than other fixed income alternatives during periods of rising rates.
There are two main reasons for this: (1) greater coupon income tends to mitigate price erosion and (2) periods of rising rates tend to correspond with an improving economic environment, rising corporate profits and stronger fundamentals, all of which lead to lower default rate expectations, which are positive for the high yield sector.
Recovery rates in the event of default: As mentioned above, one of the reasons why investors prefer loans to bonds is because of their higher position in the capital structure. However, if expectations for defaults are low, as they are today, then investors should not be as focused or concerned about how they would fare in the event of a default.
Global default rates have fallen to 3.3% for the 12-month period ending May 31, 2017. This is well below the long-term average of 4.4% and below the peak reached last year of 4.8% where 80% of the defaults were in the commodity-related sectors.
The credit quality for the overall high yield issuer universe has actually been improving over the last year and we believe that this trend is set to continue in the coming year.
There are times when the leveraged loan market can provide attractive investment opportunities, but loans are unlikely to be able to achieve investors’ goals in the current market environment, in our view. Instead, we believe that investors should consider maintaining exposure to high yield bonds.
High yield is an asset class that has historically produced strong returns even during periods of rising interest rates and where current expectations for defaults are at some of the lowest levels that we have seen in many years.
Indeed, high yield bonds have solidly outperformed loans during the first half of 2017, with a +5.00% total return for the global high yield index versus the +1.85% return for leveraged loans4.
Before making a final decision about the asset allocation between high yield bonds and leveraged loans, investors should evaluate the fundamentals, technicals and valuations provided by each market.
1. The term “leveraged loan” may be used interchangeably with “high yield loan,” and the official definition according to S&P LCD is as follows: A leveraged loan is a commercial loan provided by a group of lenders. It is first structured, arranged, and administered by one or several commercial or investment banks, known as arrangers. It is then sold (or syndicated) to other banks or institutional investors. S&P LCD includes a loan in their leveraged loan universe if (1) it is rated BB+ or lower and it has a spread of LIBOR +125 or higher and (2) is secured by a first or second lien. ↩
2. Recovery rates are based on the Moody’s universe of rated companies. Recovery rates are measured by debt prices which are taken immediately prior to distressed exchanges or 30 days after non-distressed exchange defaults. Source: Moody’s Monthly Default Report, May Default Report, 8 June 2017.↩
3. Source for covenant-lite loan issuance volumes and share of the total leveraged loan market: JP Morgan, 12 July 2017.↩
4. The total returns for each asset class for the first half of 2017 reflect the Barclays Global High Yield exCMBS exEMG 2% Issuer Capped Bond Index, USD hedged , and the JP Morgan Leveraged Loan Index. ↩