Going into the second half of the year, interest rate risk remains a focus for investors as central banks progress towards a tighter monetary stance. In terms of asset allocation, conversations with clients and flow data confirm that investors have been piling into U.S. and European loans. And why not? Leveraged loans are a secured form of lending that offer a comparatively high credit spread, with the 3-year discount margin (a proxy for spreads to a theoretical call date) on the Credit Suisse Western European Leveraged Loan Index at 379bps as of 31 March, and minimal interest rate sensitivity given their floating rate coupons. This sounds like the answer for fixed income investors, but short duration high yield bonds might offer another solution.
When viewed through the lens of the high yield bond market, the fundamental rationale for owning European leveraged credit risk looks sound. Leverage continues to fall, interest coverage ratios have been improving and earnings have been solid. Yet, the characteristics of the bond market do not necessarily apply to loans. As mentioned above, leverage loans are typically senior (residing at the top of capital structure), secured with strong covenants, and have historically captured high recovery rates in an event of default. However, we have started to observe subtle, adverse changes in the credit characteristics of the loan market in comparison to the high yield bond market. In the former, new deals have come with more leverage and the use of loan proceeds has been more skewed to M&A and dividends than in the high yield bond market. The proportion of loan issuance with proceeds used for M&A and dividends for year-to-date as of 31 March was 69% compared with only 26% for high yield bonds.
While it is true that the loan market lends entirely on a secured basis and historically with stringent lending terms, the influx of capital to this segment (PE firms have amassed $1.7 trillion of ‘dry powder’ as of the end of 2017) has created a competitive environment resulting in weaker covenants. Consequently, there has been a growth in ‘cov-lite’ or even ‘cov-loose’ structures [Figure 1]. In other words, lender protections in the loan market now look a lot more like those in the bond market. What’s more, the European high yield bond market has seen its proportion of senior secured debt increase, growing from 10% in January 2007 to 27% in September 2017.
Arguably, all of these comparative strengths are reflected in an average rating for the European high yield bond market of BB-, while the average rating for the leveraged loan market is single B.
Away from the credit risk profiles of leverage loans versus high yield bonds, a key differentiating factor between the asset classes is prepayment risk. Unlike high yield bonds, leverage loans gives the borrower the option of early repayment. By contrast, while the majority of high yield bonds are callable, borrowers must observe a non-callable period of several years, typically, 2 to 5 years. From an investor’s perspective, prepayment risk creates uncertainty in the timing of expected cashflows.
Thankfully short duration high yield bond strategies offer an alternative to investors looking for higher yields with less sensitivity to rate moves. Such strategies consist of short duration fixed rate bonds, and floating rate notes (FRNs). High yield FRNs are typically secured and like loans, are hedged against underlying interest rate moves. They also benefit from call protection which is typically 1 to 2 years and similar to high yield bonds, they have significantly better liquidity than loans [Figure 2].
While leveraged loans offer investors income with protection against rising interest rates, some of the credit risks have increased. As such, short duration high yield is a viable alternative. Keep in mind that high yield bonds and loans are both leveraged and investors need to evaluate both interest rate risk and credit risk. If the aim is to decrease sensitivity to interest rates in a diverse portfolio that offers positive carry, then a combination of shorter dated European high yield bonds and FRNs may be an attractive alternative to achieve this.