Bank Loans: Enhancing the Risk/Return Profiles of High Yield Portfolios, Part 1

Posted on October 23, 2019

High yield bonds and bank loans are more alike than many investors realize. Although there are meaningful differences between the two types of securities, from an investment perspective, we believe that these two asset classes should be viewed through the same lense. As we will expand on, we believe an investment manager that focuses on both segments together can create considerable value for a high yield portfolio. Furthermore, having one analyst team that focuses on both asset classes is the way to go instead of having separate specialists.

When a DDJ client portfolio purchases either a high yield bond or bank loan, such a portfolio is essentially lending money (i.e., a principal amount) to a company – either directly through a purchase in the primary market or otherwise by purchasing such an investment in the secondary market. The company issuing the debt may use the proceeds from such issuance to finance an acquisition of a company, make additional capital investments, or to declare a dividend to shareholders. In exchange, the company promises to make a periodic interest payment together with the full principal amount of the borrowing upon the instrument’s eventual maturity.

Here are a few representative capitalization structures utilized by companies.

Examples of "Loan Only" and "Loan and Bond" Capital Structures

Loan-and-Bond-NEAM-Chart

Typically, from an investor perspective, the least risky (and most senior) portion of the capital structure is the first lien bank debt.

  • Such debt is the first to get paid back (in any downside scenario, such as a restructuring); in this example, we will assume that this tranche represents 30% of the capital structure (a reasonable level for the types of companies frequently evaluated by DDJ).
  • In such instances, the intrinsic value of the company would have to shrink by 70% before the holders of the first lien bank debt experience any credit losses.
  • Because the first lien bank debt is the first to get paid back its principal amount, it is the safest loan in the capital structure and investors are paid the lowest interest rate accordingly.

Next, there is typically a junior piece of debt in the capital structure that may be a combination of a second lien term loan and/or an unsecured high yield bond. This additional debt typically represents 25% to 30% of the capital structure. When combined with the first lien, these two debt tranches represent roughly 55%-60% of the company’s capital structure. Thus, in theory, the intrinsic value of the company would have to shrink by 40% before the holders of this second tranche of debt would incur any credit losses (i.e., principal amount losses ). However, because these junior debt tranches are subordinate to the first lien tranche, they will bear a higher level of interest rate to compensate investors for the additional risk incurred.

A key takeaway is that irrespective of whether DDJ is evaluating the risk-reward of an investment in a bond or a bank loan, our approach will be the same. In a nutshell, we estimate a real-time, intrinsic value of an issuer, and then only invest when we believe the expected return on such investment (i.e., its yield) is attractive relative to the risk of such investment (i.e., the likelihood that the company’s intrinsic value does not cover the principal amount of the debt, and accordingly the investment incurs credit losses). Whether such investment is a bond or a loan is an outcome of DDJ’s bottom-up investment process designed to identify the most attractive investment opportunities across the capital structures of the companies that we analyze.

Many of DDJ’s clients allow us to allocate their high yield portfolio between bonds and bank loans. We believe that this flexibility is a key component in generating attractive risk-adjusted returns over time, as it enables us to essentially evaluate double the investable universe for these portfolios.   

This also gives us important tools to protect the portfolio from macro factors that we find nearly impossible to successfully predict. For example, by maintaining a significant allocation to bank loans, DDJ can effectively hedge some of the interest rate risk across its client portfolios. The interest rate accompanying a bank loan resets every quarter based on then-current rates, and thus their price is not impacted by changes in rates to the same degree as bonds (which pay a fixed, rather than floating, interest rate).

Lastly, because (first lien) bank loans typically sit atop the capital structure of an issuer and therefore are least likely to experience credit losses, they are generally the safest high yield asset class. Accordingly, an investment in bank loans can provide additional downside protection to a client’s portfolio while oftentimes only sacrificing minimal yield to achieve such safety.

Next week, we will dive into the size and growth of the leveraged loan market as well as the characteristics of loans versus high yield bonds. If you would like to be notified when we release new market insights, please let us know! Just complete the form on this page and we will deliver our insights to your inbox once per week.  

 

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