The Sand Continues to Shift in High-Yield Loans
Investors continue to pour money into funds that invest in high-yield bank loans, reciting the numerous perceived advantages of this asset class. But investors’ thirst for loans is encouraging borrowers to be aggressive, and the risks seem to be rising. This article will look at three commonly cited benefits of high-yield bank loans, and our explanation of why these three suppositions may not necessarily hold true.
Supposition 1: “Since loans are higher than bonds in a company’s capital structure, I’ll be able to recover more of my investment if the company goes bankrupt”.
Response: The first supposition seems like a nice idea, but specific loans may not have that advantage. The term to watch out for is ‘covenant-lite’. Bank loans have traditionally offered lenders the protection of written covenants that require the borrower, often a corporate treasury, not to exceed a certain level of debt. Lenders can sometimes negotiate a higher interest rate or even a restructuring if the company exceeds the limit, but covenant-lite loans don’t provide that protection, which is why you should watch out for the phrase.
More than 50% of loans offered today are covenant-lite, almost double last year’s percentage, as the Figure 1 graph below shows. Why such a huge increase? In part, it’s due to record issuance of collateralised loan obligations (CLOs). Companies are increasingly tapping the high-yield loan market rather than the high-yield bond market to gain attractive terms on loans.
Figure 1: High-yield Covenant-lite Loans Have Increased Dramatically: Treasurers Should Be on Guard.
Source: Standard & Poor’s (S&P) and AllianceBernstein.
The leveraged loan market is dependent on CLO investors for demand. CLOs represent roughly 45% of current leveraged loan buyers, according to Fitch Ratings. And as CLOs are increasingly allowed to hold bigger percentages of covenant-lite loans, CLO demand for covenant-lite loans increases even further.
Supposition 2: “Since bank loans pay floating-rate coupons, they’ll beat bonds if interest rates rise”.
Response: Here is a ‘secret’ that actually most treasurers and finance professionals – if not all investors – should be aware of: namely, that many bank loans are issued with a ‘floor’, and their coupon rates are now structured to float only after interest rates have risen above a specified benchmark by a certain amount. Often, the floor is 1% above the London Interbank Offering Rate (Libor).
The idea of sacrificing yield in exchange for floating income may have seemed like a good idea before the US Federal Reserve said it would keep interest rates low for quite a while. But as long as the Fed doesn’t change its mind, the floating-rate loan seems less appetising.
Supposition 3: “I’ll get a better yield on high-yield bank loans than I could anywhere else”.
Response: The reality is that the stated coupon on high-yield loans is declining. Borrowers can repay the lender anytime they want at the loan’s face value, often to take out a new loan with a lower coupon rate. That’s just what’s happened as rates have dropped. In the last two months, 15% of high-yield loans were refinanced, reducing the coupon rate by more than 1% on average.
Why aren’t investors seeing the shortfalls in the perceived benefits of high-yield loans? Because lower coupon rates have not stood out during the recent market and economic upturn. But these loans could tumble as much as high-yield bonds in a major downturn. When this happened in 2011, bank loans provided only half the upside of bonds, but all of the downside.
Conclusion
What can investors do differently? One place where they can find less interest-rate risk and a healthy yield is in short-duration high-yielding bonds. We think these bonds provide a better sense of what you’re likely to earn and how long the income stream will last.
Bank loans have their place in a diversified corporate treasury or investment portfolio, but before you buy, do the research and understand exactly what you’re getting.