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High Yield and Bank Loans: A Tale of Two Markets

Recent fundamental changes in the leveraged finance markets mean that actively managing credit exposure is more important than ever.

Major fundamental changes in the leveragedfinance markets since the financial crisis have resulted in improved creditquality in high yield bonds and greater dispersion in credit quality in bankloans. For investors today, this is a crucial development: In the later stagesof the business cycle, it’s more important than ever to distinguishbetween improving credits and weaker credits that are likely to underperformin an economic downturn.

We think these shifts in the leveraged finance markets underscore theimportance of active management in seeking attractive credits with improvingprospects and potentially avoiding pitfalls. It is also critical that creditportfolio managers have a thorough understanding of both asset classes sincerelative value opportunities between the two can be an important source ofboth alpha and total return.

The changing composition of leveraged finance markets

Historically, the bank loan market was much smaller than the high yield marketbut looked much like it in terms of industries represented − automotive,media, telecom and energy − although higher-risk issuers, such as highlylevered LBOs (leveraged buyouts) and those in sectors undergoing secularchallenges (such as newspapers and yellow pages) gravitated toward high yield.

Figure 1 shows a bar chart showing bank loan vs. the high yield market size, 1999 through 2018. Both forms of debt have grown over the time span, with high yield usually well outpacing bank loans. Yet in 2018, volume of bank loans slightly surpassed that of high yield debt for the first time during the period, with volume of around $1.1 trillion
Recently, however, the re-emergence of collateralized loan obligations (CLOs)as the main buyer of bank loans starting in 2012 has acted as a catalyst forrenewed growth in syndicated loans, and in 2018, the notional amount of loansoutstanding surpassed $1 trillion (see Figure 1). CLOs now hold almosttwo-thirds of the market (according to S&P LCD, as of 30 September 2018),and demand from loan mutual funds has also increased thanks to strong fundinflows in response to rising interest rates. 

By contrast, the high yield market in the U.S. has been shrinking modestlysince 2014. The majority of high yield issuance has centered aroundrefinancing as many new issuers, LBOs in particular, have been issuing in theloan market in response to stronger demand and the prepayment optionality itoffers them.

As a result of these shifts, the two markets look very different todaycompared with the pre-financial-crisis period. Notably, high yield has seengrowth in BB rated debt (referring to the debt itself, not the corporate orissuer rating) and a reduction in the amount of CCC rated debt, while the loanmarket has experienced an increase in B rated debt and a decline in BB rateddebt (see Figure 2).

Figure 2 shows two shaded graphs that chart the percentage of various ratings for high yield debt and bank loans, from 2006 to November 2018. High yield bond ratings improved slightly on average over time, with percentage of BB-rated debt gaining share of the market. Meanwhile, bank loan ratings had deteriorated, with lower-rated B-rated loans increasing by almost 10 percentage points of all leveraged loans in roughly the last four years 

Beyond the increase in B rated loans, a number of other changes in the marketshave also eroded overall credit quality in bank loans. The most important ofthese has been the increase in “covenant-lite” loans and“loan-only” issuers (to 80% and 70% of the market respectively,from about 20% and 59% in 2008, according to data from JPMorgan). With theformer eroding investor protections and the latter diminishing subordination– a layer of high yield bonds designed to absorb first losses and serveas credit protection for loan investors ‒ Moody’s forecasts a decline infirst-lien loan recoveries from over 70% historically to 60% in the future.

Why the composition and investor base matter

As the proportion of lower-rated issuers in the loan market increases, wethink investors should take notice. Single-B rated companies tend to haveweaker business profiles, more tenuous competitive positioning or insufficientdiversification compared with BB rated companies. Moreover, according toMoody’s, these companies also tend to be smaller and have more leveragethan their higher-rated peers.

We see three additional risks associated with loans from B rated issuers inparticular:

  • The single-B segment of the loan market has a high concentration of“loan-only” issues, based on data from JP Morgan. Recoveryvalues on loans without high yield bond subordination have historically beenlower than for those with high yield bonds beneath them.
  • Issuance of highly leveraged loans resulting from M&A(merger-and-acquisition) and LBO activity has increased topost-financial-crisis highs in 2018, according to BofA Merrill Lynch, andthese likely represent more risk than loans issued for general corporatepurposes or refinancing.
  • Single-B loans constitute almost half of the total leveraged loan market andare dominated by the technology, services, and healthcare industries, BAMLdata show. Both technology and services issuers typically lack hard assetsand, in the event of default, they have the potential for lower recoveryvalues as a result.

In addition, an incremental technical risk is likely to arise if a significantnumber of single-B loans are downgraded to CCC when the credit cycle turns.CLOs have been the primary buyers of single-B loans; estimates from CitiResearch, LPC, and Moody’s suggest approximately 70% of CLO holdingsconsist of single-B loans. Rating agencies typically require that when CCCholdings exceed 7.5% of assets, CLOs must begin marking those loans to marketrather than at face value, potentially activating an automatic deleveragingmechanism. With the average CLO already holding 4% in loans rated CCC orlower, the implications are clear: Downgrades of loans to single-B-minus orlower may result in sales of those loans, which could exacerbate decliningprices. Currently, issuers rated below single-B with a negative outlook (knownas the “weakest links”) are at their highest level since theinception of this metric in 2013 (source: S&P LCD).

Yet despite these concerns, the first-lien senior-secured status of bank loansshould continue to ensure that recoveries will, on average, remain higher thanin the high yield bond market, where much of the debt is unsecured andstructural protections in bond documentation have also been weakening.Additionally, bank loans secured with strong assets and supported with bondsubordination still offer potentially attractive risk-adjusted returnscombined with low duration.

Opportunities for active management

For investors, the impact of the changes in the leveraged finance markets istwofold. First, historical comparisons of valuations in and between the highyield and bank loan markets should take these changes into account. Second,managing credit exposure within these markets has become more important. 

Many single-B issuers, especially those with weaker business profiles, highleverage, and loan-only capital structures, could face challenges in servicingor refinancing their debt when the economy slows and contracts. Moreover,price declines for downgraded loans could be exacerbated by potential forcedselling by CLOs to meet the rating agencies’ collateral qualityrequirements.

Given this range of risk among leveraged finance credits, robust fundamentalcredit analysis is crucial to select borrowers with the business flexibilityand access to future capital to withstand economically volatile periods.Accordingly, we favor issuers in industries with stable or improving seculartrends, strong competitive positioning, strong asset coverage, andloan-and-bond capital structures.

In both markets, active managers with a deep bench of research analysts canconduct the fundamental credit research to identify and understand the risks.Choosing the investments that not only offer attractive return potential butalso potentially avoid the risks in today’s leveraged finance marketrequires expertise in both high yield and bank loan markets, which, despitetheir differences, are still inextricably intertwined.

The Author

Sabeen Firozali

Credit Strategist

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Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. 

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