Exhibit I: Yield vs. Duration is an XY Scatter chart with Yield to Maturity percentage on the y-axis and Years of Duration on the x-axis. The chart compares the US Loan Index and the U.S. high Yield index to various other fixed income sector indexes.
- Loans offer better value today than high yield bonds due to similar yields, minimal interest rate risk, and the benefits of being a secured lende
- Converging features of loans and high yield bonds call for new loan strategies that should benefit from an opportunistic inclusion of high yield bonds when attractively valued
- Converging features include credit quality, access to private financial information, and the secured collateral for bonds and loans
- Combined loan and high yield bond market is ~$2.6 Trillion with a 28% overlap in value. A skilled credit team with the ability to cover the full market and move between the loans and bonds of a single issuer allows for the best return opportunity to go into portfolios
- A strategy based on only high yield bonds or loans will limit the opportunity set as certain sectors favor one form of financing versus the other
- Floating-rate loans should be the ballast of a dynamic portfolio seeking to benefit from interest rate protection, lower historical volatility, and a significant history of producing more positive annual investment returns
The size of the floating-rate loan market today is approximately $1.3 trillion and growing, which is now the same approximate size as the High Yield (“HY”) bond market.1 Market size is just one measure of the strong convergence between these once very segmented markets. The growing convergence of loans and bonds is being driven by the continuing search for higher yields by investors, and the adoption of similar features across these asset types by borrowers. This trend will likely continue since once practices become generally accepted by market participants, those practices persist. As this convergence in HY credit continues, investors should consider enhancing their opportunity sets and contemplate floating-rate loan and bond investment allocations. A strategic approach anchored in floating-rate loans, combined with the opportunistic inclusion of HY bonds, offers significant potential benefits for clients. Loans today offer similar yields as HY bonds, almost no duration exposure (see Exhibit I), a broader opportunity set of both new credits and flexible positioning within the same credit’s capital structure, and the ability to execute faster in volatile market environments.
Floating-rate loans and HY bonds have been traditionally viewed as two distinct asset classes that combined to make up the “leveraged finance”2 segment of credit markets. Floating-rate loans offered protection from interest rate risk, a secured lien on assets, financial maintenance covenant protections for lenders, but no protection from loan repayment. In contrast, HY bonds had fixed rate coupons and a level of call protection from early repayment when interest rates declined, but the bonds were unsecured obligations with no financial maintenance covenants. In default situations, the secured lien position of floating-rate loans allowed for a priority in repayment, which resulted in significantly higher recoveries compared to unsecured HY bonds.3 In addition, the loan market was characterized as a private market with only confidential information available to investors and HY bonds were viewed as a public market.
The market looks vastly different today – and investors should be asking themselves whether their investment policies are flexible enough to keep pace with the changes by offering timely opportunities to seize the best values across the HY loan and bond universe. In 2020, the speed of the pandemic-induced economic shock, and subsequent recovery, did not provide investors much time to consider reallocating between loans and bonds, nor provide clear indications which market offered the better prospective value. At BBH, we are both valuation-driven, and bottom-up fundamental credit investors focused on capital preservation. Our process looks across all fixed income asset types (e.g., HY, investment grade, or structured products) and seeks to invest in the highest conviction opportunities that meet both our long-term valuation and fundamental credit criteria, whether in loan or bond format.
Elements of the convergence trend in floating-rate loans and HY bonds
The low levels of interest rates resulting from the policy responses to COVID-19 amplified the perpetual search for yield in fixed income markets. The leveraged finance sector became a more critical component of portfolios trying to earn higher returns. This resulting demand for higher fixed income returns drove yields on HY bonds to converge with floating-rate loans as seen in Exhibit I. With inflation concerns on the rise and nominal interest rates at multi-year lows, a portfolio with significant floating-rate loan exposure hedges interest rate risk. Moreover, adding the flexibility for HY exposure at appropriate valuations delivers a better approach to these converging markets in our view.
The protection of financial maintenance covenants in loan credit agreements had separated floating-rate loans from HY bonds historically. The emergence of “covenant-lite” loans, or loans issued without financial maintenance covenants, resembling how HY bonds are marketed, has eroded this once important loan market distinction. The lack of financial maintenance covenants has now reached almost 90% of new issue loans6 and is accepted as standard practice by loan market investors. In fact, it reached a point where loan market data services no longer update certain covenant tracking datasets due to the ubiquity of the practice.7 From the HY bond aspect, the convergence trend can also be seen in the growth of “144A-for-Life” 8 bond issuance, or bonds that will never be registered with the Securities and Exchange Commission. This type of HY bond issuance has increased from less than 20% of the market ten years ago to over 65% today.9 Issuers of 144A-for-Life bonds do not have an obligation to publicly release their financial information and 31% require that investors access private data sites to review bond information. This dynamic of shielding financial data from public view is similar to how the loan market operated for decades. Lastly, the HY bond market saw an increased issuance of bonds with secured liens through 2020 and continuing into 2021, which corresponds to a standard lien in a loan structure. Secured bonds comprised 32% of HY bond issuance in 2020, or the second highest percentage since the Global Financial Crisis back in 2009. Today, approximately 22% of HY bonds are secured, which is a level last experienced back in 2013.10
Benefits to a dynamic strategy
A more dynamic approach to loans and bonds provides investment teams with an enhanced opportunity set for finding attractive values. The combined leveraged finance market is approximately $2.6 trillion by market value spread across approximately 1,060 loan, 645 bond, and 365 issuers of both types of debt. Also, the breakdown of industry sector weightings differs between loans and bonds as certain industry sectors tend to prioritize capital raising in either loan or bond form to meet the specific circumstances of the industry. For example, the largest industry sector in the loan market is the more stable Technology and Software sector at 15.5%, while in the bond market the more volatile Energy sector is the largest at 12.5% (see Exhibit III). An adaptive investing approach provides credit teams the flexibility to move between the loans or bonds of a single issuer depending on where the most attractive value resides. If analytical resources are being expended on the bottom-up fundamental credit analysis of a business and its capital structure, the portfolio should be able to invest in the most attractive potential return opportunity, regardless of whether that debt obligation is in loan or bond format.
Exhibit III: Industry Sectors exhibits a percentage-based pie chart of the Loan Market industry sectors and a percentage-based pie chart of the High Yield Bond Market industry sectors.
For example, there is significant overlap between the loan and HY markets. Approximately 28% by value, and 18% by number, of borrowers issue debt in both the loan and bond markets (see Exhibit IV).
Exhibit IV: Overlap of Loan and Bond Issuers is a percentage-based nested doughnut chart. The two rings compare issuers of loans, issuers of bonds, and issuers of both loans and bonds. The inner ring is in terms of number of issuers and the outer ring is in terms of market value of issuance.
Companies often seek to access both the loan and bond capital markets when borrowing needs increase. For instance, the average loan tranche size of an issuer exclusively in the loan market is less than half the size of a loan tranche issued in conjunction with HY bonds.12 The smaller loan tranche size means there are more individual credits to choose from in the loan market with yields about 100bps higher than larger loan-and-bond issuers (see Exhibit V).
Exhibit V: Average Loan Tranche Size by Issuer and Yield Differential Between Sizes is a combination bar chart and line chart. The lines graph the Average Loan Tranche size of Loan-only issuers and of Loan & Bond issuers. The bars graph the basis points of Yield Differential between the issuance of Loan-only issuers and the Loan & Bond issuers.
With the two asset types converging – why anchor the strategy in floating-rate loans? The low level of interest rates induced by the Federal Reserve’s policy response to COVID-19 makes duration risk a primary concern. The floating-rate nature of loans helps protect portfolios from interest rate risk and provides stability to returns. Furthermore, although floating-rate loans offer less capital appreciation potential than bonds, as most loans trade close to par given the ability of borrowers to prepay the loans at any time, the loan market has a significant history of producing more positive annual investment returns than any other segment of the fixed income markets (see Exhibit VI). The loan market also has historically lower correlations with other asset classes than HY. For example, the 15-year correlations of both loans and HY with investment grade credit are 0.41 and 0.59, and with equities is 0.63 and 0.74, respectively.13 It is for these reasons we believe a strategy anchored in floating-rate loans, with the opportunistic inclusion of HY when valuations are appropriately attractive, is a potentially better investment approach to compound returns and offset risk.
Exhibit VI: Floating Rate Loan Annual Returns is a bar chart of the annual returns, since 1997, of Floating Rate Loans. It also has a bar for the year-to-date 6.30.2021 return.
Another positive and unique aspect of the loan market is that approximately 64% of it is owned by Collateralized Loan Obligations (“CLOs”). CLOs are structured-product vehicles that raise capital to invest in a pool of floating-rate loans for a fixed term of years. The capital raised by CLOs at issuance is captive and cannot be redeemed by investors in periods of market volatility. This unique characteristic, of having the largest investors in floating-rate loans be captive capital vehicles, should provide greater long-term stability to the loan asset class in episodes of widespread market redemptions compared to the HY market that has no such equivalent buyer base (see Exhibit VII). Interestingly, CLOs have also begun to add small buckets in their structures for the purchase of HY bonds to boost returns when valuations are attractive.14
Exhibit VII: Industry Investors exhibits a percentage-based pie chart of U.S. Loan Market Investors by sector type and a percentage-based pie chart of U.S. High Yield Bond Market Investors by sector type.
We tested the performance of a flexible loan investment strategy based on the principles described above versus a loan-only approach. Starting with the loan index, we added exposure to HY following the quantitative recommendation of our proprietary valuation framework.15 As an illustration, consider the simple rule of implementing one-half of the overall recommended allocation to HY. That is, if the valuation framework recommends 60% of overall exposure to HY at a point in time, our flexible strategy becomes 0.5 x 60% = 30% HY and 70% floating-rate loans. In our example, the flexible strategy outperforms the loan index by about 70bps, producing a 10-year average annual total return of 5.15% versus 4.44% for loans. In addition, the flexible strategy improves the Sharpe ratio to 0.91 versus the loan index at 0.83 (higher than the 0.88 of HY, as seen in Exhibit VIII.) Moreover, as the economy strengthens and the Federal Reserve contemplates tapering asset purchases, we believe loans are the better ballast in a portfolio with the better risk-reward proposition in the leveraged finance sector. As a reminder, the annualized returns for loans and HY in the 3-year period 2013-2015, containing the “Taper Tantrum,” were 2.57% versus 1.64%, respectively.16
|10 Years||Loans + HY||Loan Index||HY Index|
|Excess Return vs.Loans||0.71||N/A||1.79|
|This hypothetical example is for illustrative purposes only.
Past Performance is not a guarantee of future results.
Data as of May 31, 2021
Source: BBH Analysis
The convergence in the leveraged credit markets is here to stay and will likely progress further. Asset allocators and individual investors should be considering additional flexibility in investment strategies as a response to these changes. At BBH Investment Management, we believe that the traditional approach of segregating loans and HY bonds in separate strategies stifles return potential for clients and may unintentionally concentrate credit risk. It is suggested that a below investment grade credit strategy anchored in floating-rate loans, with a meaningful HY bond capacity that can be utilized when valuations warrant, offers many compelling benefits going forward. Loans are offering equivalent yields as bonds currently, a hedge against rising interest rates, and should continue to provide better downside protection in a credit event. At BBH, we apply the same disciplined bottom-up credit approach to all our investments and remain committed to investing only in durable credits when they are available at attractive prices. Multi-asset flexibility in fixed income is an ingrained part of our everyday valuation and fundamental credit process. Please give us a call to discuss our well-established investment process and capabilities, or any of the topics contained in this commentary.
1 Represented by the JPMorgan Leveraged Loan Index and the JPMorgan Global High Yield Index.
2 “Leveraged Finance” traditionally refers to any debt that is rated below investment grade.
3 Moody’s Annual Default Study 1990-2020: Recovery rates at the time of default were 69% for senior secured floating-rate loans, 58% for senior secured bonds.
4 “Fallen Angel” is a market colloquialism to describe a credit that is downgraded from a previous investment grade rating of BBB- or better to a HY rating of BB+ or below.
5 Bloomberg Barclays U.S. Corporate Investment Grade Index.
6 S&P LCD reports that covenant-lite loans are 89% of all broadly syndicated institutional loans.
7 S&P LCD stopped updating multiple covenant tracking statistics after 2019 when new-issue covenant-lite loans reached 85% of new issue volumes.
8 “144A for Life” is a market colloquialism to describe securities that are issued pursuant to an exemption from registration under the Securities Act of 1933 and these securities do not contain rights for bondholders to demand the issuer register the bonds within a proscribed time period.
9 Barclays and BBH Analysis.
10 Barclays and BBH Analysis.
11 JPMorgan and BBH Analysis.
12 JPMorgan and BBH Analysis.
13 JPMorgan and BBH Analysis.
14 The so-called “Volcker Rule” was modified October 1, 2020 to allow for non-loan assets in CLO portfolios.
15 Represented by the Credit Suisse Loan Index and the ICE BofA Cash Pay High Yield Index.
16 Represented by the Credit Suisse Loan Index and the ICE BofA Cash Pay High Yield Index.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
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