Many institutional investors view their high-yield bond and leveraged loan allocations separately. We believe this is a sub-optimal practice. In separating these asset classes, the investor bears the responsibility to identify and evaluate what may be subtle risk/reward changes in each class and execute appropriate weighting adjustments to their portfolios.
In the search for overall portfolio alpha, taking on both credit and liquidity risk in the high-yield bond and leveraged loan markets can offer attractive risk/reward opportunities.
We view non-investment-grade bonds and loans as essentially the same species cohabiting in the high-yield universe. Importantly, both instruments are legally structured as contractual obligations of issuers with recurring interest payments and a maturity date at which time the principal becomes due.
A bond may have structural characteristics that elevate its safety to that of, or even above, a loan. In our view, the bank loan market is often simply an extension of the high-yield bond market, i.e., a step up on the issuer's “quality curve.”
Both high-yield bonds and leveraged loans may offer adequate breadth for institutional participation and significant yield along with current income to the extent investors choose to receive (and not reinvest) interest payments. The two markets are also similar in terms of credit quality with both carrying below-investment-grade average ratings. Each also includes a range of debt instruments in terms of credit quality and liquidity across a wide spectrum of industry sectors. The investment horizon for each class is similar as well. While bonds typically have longer maturities, loan maturities are almost as long and average over five years.
That said, there are two main differences between bonds and loans: the first is market oversight and pertains to liquidity; the second is economic and relates to the method used to calculate the particular instrument's interest rate.
First, unlike bonds, which are deemed securities under applicable securities laws, bank loans are private obligations that are typically not viewed by the U.S. legal system as securities or regulated as such. While bonds are generally considered more liquid and transparent, bank loan trading, on the contrary, is more manually intensive and places greater operational demands on managers than bond trading.
While bank loans overall might not enjoy the same degree of liquidity as high-yield bonds, numerous loan issuances now have an identical degree of trading liquidity as their high-yield bond counterparts. In our view, the standardization of the trading and settlement processes surrounding bank loans has enabled more institutional investors to play in this segment. As the loan market continues to mature, we anticipate syndicated loans in particular will comprise an increasingly large portion of an investor's fixed-income asset allocation.
Second, compared to bonds, which are most often issued with a fixed coupon, interest payments for loans are almost always based on the London interbank offered rate — a floating rate that can vary daily. The interest rate for loans is established as a spread over LIBOR and is reset on a regular basis, typically quarterly. In addition, a key feature of the asset class is that many loans contain a provision that limits the LIBOR rate from declining past a certain absolute level. Currently, most leveraged loans have a LIBOR floor of between 1% and 1.5%.
Given the cyclicality of credit cycles, “plain vanilla” high-yield bonds are sometimes unattractive due to tight spreads vs. Treasuries that may not adequately compensate investors for absorbing the elevated default risk over other fixed-income securities.
Recent events in the high-yield bond market demonstrate how a manager, by dynamically shifting the weighting of bonds and loans within a fixed-income portfolio, could have helped protect fixed-income investors against losses but still generated attractive relative returns.
Taking a passive, or even traditional, high-yield bond investment approach in a rising interest rate environment might hurt investors.
A prudent strategy in the current fixed-income environment may be to move away from interest rate beta exposure as rates are expected to rise, and instead aim to protect capital and maintain liquidity while seeking alpha-generating opportunities. To achieve this goal, investors need to provide their high-yield bond managers with a flexible mandate that enables them to nimbly shift weightings between bonds and loans depending on then-current market conditions.
For example, this year until June, high-yield bonds outperformed loans. In May, both high-yield bonds and leveraged loans set highs for the year, returning 5.77% and 3.65% year-to-date, respectively. To a passive investor, high yield was clearly the asset class in which to be invested. However, credit managers saw a dangerous trend developing months earlier.
The yield of high-yield bonds and bank loans over the last several years highlights the unstable relative value relationship between the two, further illustrating the need for the flexibility to allocate between the two asset classes.
The spread between the yield-to-worst offered by high-yield bonds and the comparable yield offered by loans compared to both the long- and short-term spread averages, or “bond premium,” represents the incremental reward that investors receive by taking the increased risk associated with investing in bonds rather than loans. While in the period from January 2007 to August 2013 the premium has averaged 104 basis points, or 1.04%, according to J.P. Morgan, since January 2010 this premium has averaged roughly 76 basis points.
In mid-November 2012, however, the bond premium dropped below its short-term average and has remained there ever since. In January 2013, the premium fell into negative territory, meaning high-yield bonds were yielding less than loans. In fact, during such times when the “bond premium” is negative, investors are essentially being penalized by receiving a lower yield while nonetheless taking on the extra risk associated with bonds compared with bank loans.
In the beginning of 2013, when the “bond premium” was negative, the prudent move was to tactically shift out of risky bonds into relatively safer loans offering comparable (and in some cases even superior) yields. To do so, however, would have required a flexible mandate that enabled a manager to shift from bonds to loans.
Ultimately, the “bond premium” returned to positive territory in May 2013, and has since migrated toward its short-term average. This relative value shift came at the expense of bonds, as the bond market experienced a significant correction while loans declined only slightly. Specifically, in the month of June, the BofA Merrill Lynch U.S. High Yield index lost 2.6% while the Credit Suisse Leveraged Loan index declined only 0.55%. Comparatively, more duration-sensitive credit fared worse, with investment-grade bonds losing 2.8% and emerging market sovereigns down 4.3%.
Putting this information into performance terms, if an investor held a passive portfolio allocated 50/50 between high-yield bonds and loans in 2013 that mirrored the holdings of the respective indexes, it would have returned 2.14% before fees through the end of June. However, if that investor instead had reduced the allocation to bonds in early January while the bond/loan spread differential shown above was near zero or below, the resulting performance would have been weighted more heavily toward loans, which outperformed bonds by 135 basis points through June (2.81% vs. 1.46%), all the while reducing risk.
Furthermore, while outperforming the broader high-yield bond market by including an allocation to loans was certainly desirable in early 2013, the risk reduction impact of a broader mandate cannot be emphasized enough. Bank loans are generally safer investments than bonds as loans are more senior in the capital structure (and therefore subject to less default risk). Additionally, they typically come with a security interest in the issuer's assets, and may include both restrictive as well as financial maintenance covenants that provide lenders with rights to accelerate repayment of capital if the borrower takes an impermissible action or otherwise does not perform at the level set forth in the underlying contract. These terms provide loan holders superior capital protection to the extent a company is required to restructure or reorganize its balance sheet.
Some bank loan arrangements also provide investors with more detailed information on company performance statistics, which can be invaluable when conducting issue-level research to make a buy/sell/hold decision.
The relationship between bank loans and high-yield bonds this year represents a microcosm of the importance of an unconstrained investment concept. Thus far in 2013, an actively managed strategy with the flexibility to shift between bonds and loans had the potential to outperform a passive strategy using either approach alone. Moreover, the timing of bond/loan market movements was relatively swift, which presented a significant challenge to the decision-making capabilities of institutional investors.
Scott McAdam is a director at DDJ Capital Management LLC, Waltham, Mass.