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Senior loans offer competitive returns to high yield investors with less risk

Larry Holzenthaler
Investment Strategist/Analyst, Symphony Asset Management
Two escalators
A common observation recently seen in the below investment-grade corporate credit market has been the relatively similar yields produced by both senior loans (“loans”) and high yield bonds (“bonds”). Historically, the yield on loans is lower than the yield on bonds which is reflective of the lower risk profile that loans offer relative to bonds. Today, however, the yield on loans and bonds are roughly identical. There are both fundamental and technical reasons for this convergence. Despite similar yields on both assets, high yield bond funds have seen consistent inflows this year as retail investors, in particular, have continued to allocate money into these funds while reducing their exposure to loans. At this point they should arguably be doing the opposite as senior loans are now offering similar levels of return with less risk than high yield bonds.

Comparing loans and high yield bonds

Despite some important differences, senior loans and high yield bonds are quite similar. Both asset classes are issued by companies with below investment-grade ratings and, as a result, each respective index will reveal many of the same names. In many cases, companies issue a combination of both loans and bonds in an effort to minimize the issuer’s weighted average cost of capital. The main underlying risk to both assets is default risk by the issuer. Since both correlate positively with equities and less so with “traditional” fixed income, spreads and yields in both asset classes tend to track each other somewhat closely.

Despite these similarities, however, loans are typically senior in the capital structure and typically enjoy a first lien on the issuer’s assets (in effect the “mortgage on the house”) while bonds in general are often unsecured. The increased level of seniority and security of loans has typically meant that investors get paid less to own loans relative to high yield bonds as they’re assuming less risk.

Converging yields
Recently, however, the yields on senior loans and high yield bonds have converged. While this could be attributed to a mispricing of risk caused by inflows into high yield funds and outflows from loan funds, there are other fundamental factors to consider as well.

Chart 1


It is commonly cited that the reason for this convergence is technical in nature. High yield mutual funds and ETFs have had consistent inflows year to date, which have caused prices to rise amid strong demand. Meanwhile, loan mutual funds and ETFs have had outflows. This argument that technicals have caused the dislocation is partially true, and one of the reasons that loans trade “cheap” to high yield. However, there are also fundamental drivers at play.

Fundamental drivers
One such driver is the growth of so-called “loan-only” or “loan-heavy” capital structures. Loan-heavy capital structures are issuers who have funded a disproportional amount of their debt in the loan market versus high yield. As a result, they have more senior debt and less subordinated debt. Loan-only capital structures are the extreme as these issuers do not have any debt at all beneath their loans. Loan-oriented financing packages are largely the result of demand patterns seen over the last several years where the demand for loans by investors seeking floating rate income outstripped the demand for high yield. This resulted in issuers tilting their financing needs towards the loan market where the demand was stronger and more consistent. While this has partly reversed in recent months as high yield demand has been stronger than loans, the market today is dominated more by loan-only and loan-heavy capital structures than in the past.

The market today is dominated more by loan-only and loan-heavy capital structures than in the past.

 
Chart 2
Chart 3
More senior loans, and less subordinated debt (high yield bonds), in a capital structure gives senior lenders (loan investors) less buffer to absorb potential losses in the event of default or restructuring. While data has been somewhat limited over the last several years, as defaults and restructuring scenarios have been held in check, a clear pattern has emerged: loan-only capital structures have seen lower recovery values at the loan level than issuers that have high yield bonds beneath their loans.
Chart 4

As volatility has picked up in recent months, corporate credit continues to exhibit strong defensive characteristics while loans have proven more resilient.

 
Ratings migration
Another trend that has led to converging yields between senior loans and high yield bonds has been the negative ratings migration in the senior loan market. In particular, the senior loan market has grown significantly in the B-rated part of the market relative to BB-rated (higher quality) loans. In particular, B3 (or B-)-rated loans, the lowest rating above CCC/Caa, have driven this growth. This is not a coincidence as the Collateralized Loan Obligation, or CLO, buyer base has significantly increased over the past several years. CLOs, which are asset-backed securities “backed” by a pool of loans, have limited ability to own CCC-rated debt as collateral. However, they have much more flexibility to own loans rated B3/B-, which are rated just one notch higher. Yet CLOs also have a need for higher yielding assets to produce attractive returns for their investors. As a result, the market has seen a boom in new loans rated B3/B- as they often have higher yields yet qualify, albeit barely, for broader ownership by CLOs seeking to maximize the spread and yield.
Chart 5


Chart 6
This is a different scenario for high yield bonds as the market for BB-rated bonds has grown relative to B-rated bonds, the opposite of what has happened in the loan market.
Chart 7


While loan credit metrics have arguably deteriorated relative to high yield bonds over the last several years, loans should still be considered the lower risk investment on a broad basis. Even recently, loans have exhibited lower volatility than high yield bonds as a result of their shorter duration, shorter maturity profile and senior secured position in the capital structure. So, for investors in broader high yield bond investments, loans may offer an attractive opportunity to receive similar yields with less volatility.

Loans offer less downside risk than high yield during risk-off trades
As volatility has picked up in recent months, corporate credit continues to exhibit strong defensive characteristics while loans have proven particularly resilient. Going forward, we believe this relationship should continue as loans offer more seniority, security and a shorter maturity profile which typically results in lower volatility relative to high yield.
Chart 8


Conclusion

Although risks in the loan market have grown, the seniority, security and shorter maturity profile still tends to make loans a less risky and less volatile asset relative to high yield bonds in today’s market. This is particularly important given the later stages of an economic cycle as investors are looking to de-risk wherever possible, yet don’t want to sacrifice yield and returns. The relative value opportunity between loans and high yield offers investors just that: the ability to lower risk while maintaining a similar yield and return profile. For investors following the herd into high yield and out of loans, a better strategy might be to take the contrarian view and look at loans as a relative value play versus high yield. In a market where much of the “easy money” has been made, loans offer a compelling investment opportunity to reduce risk without reducing return potential.
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