In 2018, the rising interest rate environment heightened demand for loans which was met by issuance with looser restrictions and more “covenant lite” features that resemble the less restrictive structure of high yield bond offerings. The result makes the two instruments even less distinguishable. Issuers preferred to finance through the loan market, where demand for loans resulted in “bond like” financing, but still with the prepayability of loans. At the start of 2019, however, the supply/demand dynamics has reversed as a more dovish Federal Reserve has dampened the demand for loans and contributed to the shift in issuance from loans to high yield, exemplified by an increase in secured note offerings, a dynamic that further blurs the lines between loans and high yield. For example, TransDigm’s $3.8 billion offering, the largest secured note issuance ever, was issued instead of a loan to finance recent M&A.
Driven by the Fed’s dovish pivot, we have seen fixed rate high yield bonds outperform floating rate loans by over 3% through the first quarter. This relative underperformance is partially attributed to decreased collateralized loan obligation (CLO) demand and retail fund outflows, but also due to the spread tightening that has occurred in high yield as investors return to that asset class. Loan fund outflows totaled -$8.6bn YTD, versus high yield inflows of $14.5bn, driven by the rally in rates over the past few months.
Indeed, the differences in technical has recently resulted in the loan market yielding (to maturity) 6.9% compared to the high yield market yield of 6.3%. We have not seen a period where bank loans have yielded more than high yield bonds in many years. Further, we are now seeing senior secured loans yielding more than secured notes in some issuer capital structures. In other words, while both securities share in the same collateral, the loan is yielding more in large part due to the technical environment in each market. The ability to take advantage of such technical dislocations with a broader approach to the entire leveraged finance market may produce attractive risk-adjusted client outcomes over time.
As shown below, an increasing number of structures have inverted year to date (data as of 4/4), as evidenced by loans out-yielding their high yield secured bond counterparts. In fact, in some cases the technical is so dislocated that the secured loan yields more than unsecured bonds, a rarity. For example, both of the Bausch (Valeant) secured loans yield more (5.67% and 5.50%) than the secured note (4.65%) with which it shares collateral. In the case of Dell, the first lien loan yield (4.78%) is materially higher than Dell’s unsecured note (4.07%).
Clearly, the Fed’s pivot toward a more accommodative policy has driven a shift in both issuer and investor preferences, as evidenced by recent supply data and fund flows. This shift has created dislocations within the capital structure, allowing managers with flexible mandates to take advantage of relative value opportunities.
Risk Considerations: Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Bank Loans: Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times than other investments, which can make loans relatively illiquid at times. Leverage: When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the fund.
The S&P/LSTA Leveraged Loan Index is a daily total return index that uses LSTA/ LPC Mark-to-Market Pricing to calculate market value change. On a real-time basis, the index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included in the Index represent a broad cross section of leveraged loans syndicated in the United States, including dollar-denominated loans to overseas issuers.
The ICE BofAML US High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion. Eurodollar bonds, taxable and tax-exempt U.S. municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index.
The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges and they are not available for direct investment.
Collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.
This commentary is the opinion of Newfleet Asset Management. Newfleet provides this communication as a matter of general information. Portfolio managers at Newfleet make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.