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.

Conclusion

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.

Past Articles

Article #1:  Is It Time to Invest in Leveraged Debt?

Article #2: Leveraged Debt Investment Alternatives

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

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.

For more information, contact:

If you liked this blog you may enjoy reading some of our other blogs here.

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

For more information, contact:

 

If you liked this blog you may enjoy reading some of our other blogs here.

Is it Time to Invest in Leveraged Debt?

In the week ended January 11, 2018, retail investors poured $2.65 billion into the high yield bond market.  Was this a good idea?

The chart below describes the historical yield experience investors have enjoyed (sometimes endured)  through their investments in leveraged debt.

Leveraged debt includes all below investment grade (“junk”) debt obligations of large issuers including corporations and certain governments. They are called below investment grade because the issuers have issued large quantities of debt, face significant operational problems or both.  Rating agencies assess the likelihood these issuers will default and assign credit ratings ranging from “BB” (good junk) to “B” (questionable junk) to “CCC” (risky junk).

The chart above shows that credit risk premiums were close to historic lows in early January. 

The chart above presents credit risk premiums by rating category over a period of more than 20 years.  The credit risk premium is the compensation in excess of treasury yields received by investors for investing in corporate debt.  To create a simple example, an investor in a the Merrill Lynch BB rated bond index on January 5, 2018 would expect to earn:

  Credit Risk Premium + Treasury Bond Yield = Expected Return

                  1.99%           +      2.40%           =   4.39%

The yield on 7 year US Treasury bonds on January 5 was 2.40% (we assumed the average term to maturity on bonds in the index approximates 7 years).  When we add the credit risk premium on “BB” rated bonds of 1.99%, we obtain an expected return of 4.39%.  In the case of an individual bond, the expected return might also be described as the yield to maturity.

The chart above shows that credit risk premiums on below investment grade debt vary widely during the course of the business cycle.  During good times, investors are calm and do not require large credit risk premiums.  During tough times, investors are fearful and expect much larger returns for putting cash to work in risky investments.  Since the contractual rate of interest on a bond is fixed, an increase in the required return is reflected in the price at which the bond trades in the secondary market. 

In an extreme case, if the required return (treasury yield + credit risk premium) on a bond with a 5.0% contractual interest rate increases to 20.0%, the bond’s price changes as follows:

  5.0% coupon / 20.0% required return = 25

In this example, the bond’s price would fall by 75% to 25 cents on the dollar.

The low points of the graph above represent moments when bonds are expensive (unattractive) relative to their long term average prices and the high points on the graph represent moments when bonds are inexpensive (attractive).

The chart below converts the credit risk premiums described in the first chart into approximate historical prices.  For simplicity, we calculated prices assuming the average high yield bond in each index had a remaining term to maturity of seven years and paid an annual cash coupon of 7.0%. 

This chart reflects the fact that leveraged debt investment prices are subject to significant changes in value over time.  Because these investments are subject to high degree of risk, investors should exercise caution when investing in them.

The next six articles in this series provide important background information regarding the leveraged debt markets (Article #2) and guidance regarding when to invest and how to structure investments in leveraged debt (Articles #3 through #7).

Outlook and Conclusions

The last broad correction in leveraged debt began in the third quarter of 2007, more than 40 quarters ago.  Credit risk premiums are nearing their all time lows and structural market changes could make it difficult to every reach previous lows (see Article #3).

We do not anticipate a significant correction in the leveraged debt markets in 2018 but we believe that, as of early January 2018, leveraged debt investments presented modest return potential with significant risk of future loss.  Timing is important to successful investment in leveraged debt. 

Active investors who vigilantly monitor economic and market conditions will likely be able to wring further gains from this increasingly dry market.  Passive investors may find that the risks presently outweigh the rewards.

Coming Articles

Article #2:  Leveraged Debt Investment Alternatives

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.

For more information, contact:

If you liked this blog you may enjoy reading some of our other blogs here.