Can Leveraged Debt Retest Low Premiums?
This article continues the discussion started in Article #1, “Is It Time to Invest in Leveraged Debt?” and Article #2, “Leveraged Debt Investment Alternatives.” Article #3 addresses the question of whether or not the leveraged debt market has reached its cyclical peak and if credit risk premiums can narrow further from present levels
Can high yield bond credit risk premiums continue to narrow from present levels?
It’s a significant question. Bonds provide returns to investors in two forms: 1) payment of the contractual rate of interest and 2) capital gains or losses. Credit risk premiums seldom remain constant for any length of time; they continually trend up or down. The chart below illustrate that cycles of decreasing credit risk premiums generally continue for a period of years and that cycles of increasing risk premiums can play out over a period of just a few months.
Thus, the question of whether credit risk premiums can continue to decrease from present levels is very important. If they can continue to decrease, high yield bonds are likely to provide attractive returns for several more quarters, perhaps even a year or two.
The chart above showed that credit risk premiums are nearing their all time lows. The answer to the question of whether or not high yield credit risk premiums can return to their all time lows lies in part in the leveraged loan market.
In Article #2 of this series, we explained that leveraged bank loans and high yield bonds are the two primary leveraged debt investment instruments. Many leveraged debt investors will allocate money to the loan or bond markets depending on which asset class offers more attractive risk/reward relationship. The chart below illustrates that the leveraged bank loan market is not presently retesting its all time lows from 2007.
Explaining the difference
The previous chart raises another important question – how can high yield bond credit risk premiums be approximately 1.0% from their all time lows when the credit risk premium on leveraged loans is almost 2.0% higher than its historic lows? The table below illustrates the significance of this difference.
As we discussed in Article #2, bonds are riskier than senior secured loans. As a result, the credit risk premium on “B” rated high yield bonds prior to and including the historic low was 171 basis points (1.71%) higher than the average on comparably rated loans (5.06% – 3.35%). Today, the credit risk premium on “B” rated loans (4.03%) is higher than it is on “B” rated bonds (3.39%). Credit risk premiums on bonds since 2009 have been very similar to what they were prior to the great recession but credit risk premiums on loans have been very different.
The reason the high yield market has essentially returned to pre-2008 norms while loans have not reflects the fact that the market for leveraged bank loans is far more dependent on the securitization as a source of capital to fund loan investments than the bond market. Roughly half of all new leveraged bank loans are purchased into the investment portfolio’s held by Collateralized Loan Obligations (“CLOs”).
Recall that mortgage loan securitizations (“CDOs”) were the epicenter of the financial crisis and recession that took place in 2008 and 2009. In response to the mortgage loan crisis, new rules were put in place to reduce the risks created in the securitization markets. This affected not only the mortgage loan CDOs but also commercial loan CLOs.
The new rules increased the equity risk exposure CLO managers were required to retain and restricted many of the freedoms the CLO markets previously enjoyed despite the fact that CLO’s performed well during the this period.
The chart above shows that the blended credit risk premium on the average new CLO in 2017 was almost three times larger than the blended credit risk premium on new CLO’s in 2007. The chart below shows that credit risk premiums on the AAA rated tranches of new CLOs have begun to decrease only recently, indicating that the CLOs which funded prior to 2017 had even higher funding costs.
The chart above shows that the average credit risk premium for AAA rated CLO obligations decreased 30 basis points (0.30%) in 2017. This indicates that the credit risk premiums of CLO’s created prior to 2017 are generally 170 basis points (1.70%) or more. This increase in CLO funding costs is a primary factor which has caused credit risk premiums on leveraged bank loans to remain stubbornly high relative to similarly rated high yield bonds.
This brings us back to our original question. Can the high yield bond market retest the all-time low credit risk premiums it experienced in 2007?
In our view, the answer to this question is probably not. Leveraged bank loans are a good substitute asset for high yield bonds. Thus, if bond yields get too low, investors are well advised to move their investments to loans so that they can get higher yields for similar risk.
In January, credit risk premiums on high yield bonds were significantly lower than their long term averages and they were nearing the all time lows experienced in 2007.
If the funding cost of CLOs continues to tighten as it did in 2017, bank loan credit risk premiums could decrease further – this would enable additional decreases in bond credit risk premiums. The magnitude of the decrease in CLO funding costs in recent months suggests that bonds could appreciate further before reaching their next cyclical peak.
The structural changes in the market for leveraged bank loans which occurred after the financial crisis of 2008 and 2009 make it unlikely that credit risk premiums on high yield bonds will return to their 2007 lows in the foreseeable future. The significance of this is that we anticipate high yield credit risk premiums are unlikely to decrease more than an additional 100 basis points from January 2018 levels.
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
Data Sources for the Article
The data presented in this article was obtained from the Federal Reserve Bank of St. Louis (ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield B Option-Adjusted Spread [BAMLH0A2HYB], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A2HYB, January 8, 2018) and from the Leveraged Commentary and Data news service provided by Standard and Poors Corporation.
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