“Rule 144A is therefore very valuable to issuers, as it reduced the cost of capital by improving the liquidity of the institutional secondary market for privately placed bonds.”
– Andrew Ross, CFA, Director, Portfolio Specialist
Not familiar with 144A bonds? You’re not alone. Given the growth of bonds issued via Rule 144A (“the Rule”) and their increased importance in the high yield market, we thought it would be informative to provide a brief overview of Rule 144A and the bonds issued under this rule.
This blog is an excerpt from an in-depth thought piece that DDJ published on Rule 144A in 2018, “144As – A Large But Often Misunderstood Segment of the High Yield Market”. The blog includes some key points and a few updated data points from the original white paper, but for those who wish to take a deeper dive on the subject, including a more detailed description of Rule 144A, you can find the original paper here.
Rule 144A permits underwriters (and their assignees) to resell unregistered securities immediately after their issuance to large institutional investors. Rule 144A also applies to secondary market trading of private placements (i.e., securities not registered with the SEC) and allows the resale of securities issued via the rule to qualified institutional buyers (“QIBs”) without any applicable holding period requirement being met prior to the occurrence of such sales.
The rule enables QIBs to trade Rule 144A bonds with one another as frequently as SEC registered bonds can be traded amongst broader market participants. Prior to the enactment of Rule 144A, a private placement was typically significantly less liquid than an SEC registered security, primarily due to resale restrictions, and in particular, a two-year holding period requirement before such security could be sold absent another exemption from registration. This holding period applied to all market participants, including QIBs.
As a result, bonds issued in private placements were much less liquid than registered bonds, and therefore issuers could expect to pay a higher interest rate to compensate investors for lower liquidity when selling a bond issued via a private placement compared with an SEC registered security. Rule 144A is therefore very valuable to issuers, as it reduced the cost of capital by improving the liquidity of the institutional secondary market for privately placed bonds. Although SEC registered securities may still benefit from a liquidity premium, the size of such premium has decreased significantly as the 144A market has grown.
144A Bonds in the High Yield Market
Bonds issued via Rule 144A have become a significant – and growing – portion of the high yield market and represent meaningful holdings across many DDJ-managed funds and accounts.
The exhibit below illustrates the growth in 144A bonds in the high yield market using the Bloomberg Barclays U.S. Corporate High Yield Index as a proxy for the high yield market. 144A bonds now represent more than half of the outstanding bonds in the U.S. high yield market based on principal amount outstanding. In addition, as shown on the second chart below, this outcome is not the result of a disproportionate number of smaller 144A issues, as the number of issues for both 144A and non-144A issues in such index is in-line with the difference in principal amount outstanding displayed in the first chart below.
Source: Barclays; Based on month-end data from January 2010 through August 2020; high yield market represented by Bloomberg Barclays U.S. Corporate High Yield Index
DDJ expects that the growth of 144A issuances in the high yield bond market will continue. As a result of such growth, the 144A high yield bond market has matured and now more closely resembles the broader high yield bond market, particularly from an investor participation and a liquidity perspective.
Investing in 144A high yield bonds used to be in part about capturing a “liquidity premium”; today, the ability to invest in 144A high yield bonds significantly broadens the investment universe from which DDJ can source attractive investment opportunities on behalf of our clients, irrespective of whether or not such a liquidity premium exists in any particular instance. Given current market dynamics, DDJ believes that investors seeking exposure to high yield should embrace investing in Rule 144A issuances as a meaningful component of such an investment strategy.
DDJ Capital Management is a privately held investment manager for institutional clients that specializes in investments within the leveraged credit markets. Since our inception in 1996, DDJ has sought to generate attractive risk-adjusted returns for our clients by adhering to a value-oriented, bottom-up, fundamental investment philosophy. DDJ has extensive experience investing in securities issued by non-investment grade companies within the lower tier of the credit markets, including high yield bonds, bank loans and other special situation investments.
The information and views expressed herein are provided for informational purposes only, and do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. The inclusion of particular investment(s) herein is not intended to represent, and should not be interpreted to imply, a past or current specific recommendation to purchase or sell an investment. Any projections, outlooks or estimates contained herein are forward-looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses carefully before investing with DDJ.
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