Leveraged Debt Investment Alternatives
Leveraged Debt Outlook Vol 2
This article continues the discussion started in Article #1, “Is It Time to Invest in Leveraged Debt?” and describes the primary debt types that trade in the leveraged debt markets
What is leveraged debt?
Leveraged debt is the financial obligations of large businesses and certain governments whose credit ratings do not qualify as “investment grade.” These obligations take the form of both leveraged bank loans and high yield bonds. Because they are large obligations of large issuers, they are syndicated to investors and may be purchased or sold in secondary markets, much like those for stocks and investment grade bonds. Common characteristics of leveraged bank loans and high yield bonds are described below.
Characteristics of leveraged bank loans
- Floating rate coupon (contractual interest rate)
- Commonly senior secured
- Some benefit from financial covenants
- Retail investors can gain exposure through mutual funds and ETFs
- Experience significant price volatility over the course of the business cycle
- Meaningful risk of bankruptcy and principal loss but less principal risk than for high yield bonds
Characteristics of high yield bonds
- Fixed rate coupons
- Commonly unsecured
- Limited benefits from financial covenants
- Retail investors can gain exposure through mutual funds and ETFs and through direct ownership (not recommended due to high trading costs)
- Significant cyclical price volatility
- Meaningful risk of bankruptcy and principal loss
Leveraged debt background
Leveraged bank loans and high yield bonds are most commonly created to finance acquisitions of large businesses or other transactions by private equity firms. These acquisitions are frequently financed with a combination of bank loans and bonds; as a result there is a large overlap of corporate issuers in the leveraged loan and high yield bond markets. Loans and bonds offer different advantages to borrowers. By investing in the secured claims of the issuer, loan investors take less principal risk than high yield bond investors. As a result, nominal high yield bond coupons tend to be larger than nominal bank loan coupons. Because they take more principal risk, high yield bond prices in the secondary market tend to be more volatile than loans’.
Advantages of investing in leveraged bank loans
- They offer large, current, floating-rate coupons (more than LIBOR + 1.75%)
- The floating rate coupon shields investors from losses in the event inflation and interest rates begin to rise and thereby simplifies portfolio management
- Senior secured status means that bank loan investors will get the best recovery of all investors in the event of the obligor’s bankruptcy. It is common for bank loan investors to recover 100% of their investment despite significant impairment losses at junior levels of the issuer’s capital structure (secured obligations obtain a recovery prior to unsecured obligations)
- Second-lien loans provide investment opportunities with more risk and larger coupons
- Leveraged bank loans trade in a secondary market which is normally reasonably liquid
- Some leveraged bank loans benefit from financial covenants which enable lenders to reprice loans if the borrower fails to meet agreed minimum financial performance targets
- Broad downturns in the market can be reasonably anticipated enabling alert investors to take steps to hedge or reduce their risk
- Loan market corrections and recoveries tend to precede the equity market’s
- Moments of market illiquidity are moments of market inefficiency – finance theory teaches us that inefficient markets create economic opportunity for the astute
Disadvantages of investing in leveraged bank loans
- Institutional investors use extensive leverage to finance their investments in leveraged bank loans – this has a twofold impact:
- Significant selling pressure can arise when investors who have borrowed money to purchase leveraged bank loans receive margin calls
- The secondary market can become very illiquid during broad market corrections
- Aggressive lending, especially in the latter stages of a long period of strong demand, can lead to principal losses, even on first-lien secured bank loans
- Limited cost to call loans results in frequent demand for interest rate reductions from corporate issuers when economic conditions are favorable
- Significant price volatility over the course of a business cycle relative to other classes of fixed income investments can give investors a sense of motion sickness
- Cannot be directly acquired by retail investors but there are many ways for retail investors to gain exposure to the asset class – specifically through mutual funds and ETF’s
Advantages of investing in high yield bonds
- They offer large, current, fixed-rate coupons
- High yield bonds are much more expensive to refinance than loans; as a result investors experience much lower demand for interest rate reductions from corporate issuers than loan investors
- High yield bonds trade in a secondary market which is normally reasonably liquid
- Broad downturns in the market can be reasonably anticipated enabling alert investors to take steps to hedge or reduce their risk
- Investors focused on high yield bonds tend to use less leverage than loan investors; this helped to mute bond volatility somewhat relative to loans in the bear market of 2008 and 2009
- Bond market corrections and recoveries tend to precede the equity market’s
- Moments of market illiquidity are moments of market inefficiency – finance theory teaches us that inefficient markets create economic opportunity for the astute
- High yield bonds may be purchased by retail investors but transaction costs associated with purchasing odd-lots (less than $100,000 of a specific issue) of bonds make this option unattractive for many; there are other ways for retail investors to gain exposure to the asset class – specifically through mutual funds and ETF’s
- High yield bond exposure can be hedged by shorting bonds but the cost of carry on short positions is not insignificant
Disadvantages of investing in high yield bonds
- High yield bonds absorb a disproportionate share of principal losses relative to leveraged bank loans in the event of the issuer’s default.
- Aggressive lending, especially in the latter stages of a long period of strong demand, can lead to principal losses when the business cycle turns
- Significant price volatility over the course of a business cycle relative to other classes of fixed income investments can give investors a sense of motion sickness
- Absence of collateral increases risk of principal loss on default
- Absence of financial covenants creates no opportunity to reprice the bonds during periods of poor business performance
Conclusion
Both leveraged bank loans and high yield bonds offer meaningful compensation to investors but they also offer significant amounts of investment risk. Investors who understand the risks inherent in these investments can take steps to manage the risk they underwrite. Investors who cautiously underwrite their investments in leveraged debt preserve their ability to take advantage of the market in its moments of illiquidity. This creates the opportunity to earn significant economic profits through the credit cycle.
Past Articles
Article #1: Is It Time to Invest in Leveraged Debt?
Coming Articles
Article #3: Can Leveraged Debt Retest Low Premiums?
Article #4: Signs That It’s Time to Sell Leveraged Debt
Article #5: Signs That It’s Time to Buy Leveraged Debt
Article #6: The Appeal of Investing in Distressed Debt
Article #7: Investment in Leveraged Debt through the Business Cycle
Thereafter: Updates regarding important market statistics with current commentary
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