High yield bonds and bank loans are two asset classes that are more alike than many investors realize. In the first part of this blog series, we discussed where each type of debt typically sits in a company’s capital structure, and why the flexibility to invest in both bonds and bank loans in a high yield portfolio can enhance the risk-adjusted returns of such a portfolio over time.
This week, we will be discussing the size and growth of the bank loan (aka leveraged loan) market, as well as other useful statistics, such as volatility measures, of loans as compared with high yield bonds.
As one can see from the graph below, the size of the bank loan market has grown exponentially over the past few decades. In fact, the bank loan market recently surpassed the size of the high yield bond market. Historically, traditional banks were the largest holders of bank loans (and hence the naming convention of the asset class). However, regulations adopted following the global financial crisis have made holding loans more “costly” for banks due to higher capital charges associated with such loans, which has resulted in a significant decrease in ownership of bank loans by banks. Institutional investors, such as DDJ, as well as Collateralized Loan Obligations (“CLOs”), stepped in to the fill the void and currently own a significant portion of bank loans outstanding.
Size and Growth of the Bank Loan Market
Financial Regulation has resulted in investors replacing banks
As institutional investors replaced traditional banks as major holders of bank loans, instances in which the same institutional investor owned two parts of an issuer’s capital structure – a bond and a bank loan – naturally increased. This reinforces the notion of why we believe that there is value in having a single team of analysts responsible for researching and recommending investments for both asset classes as opposed to having a team of analysts responsible for bank loans and another responsible for high yield bonds. In particular, by focusing on a deep understanding of the risks that affect a target company as a whole and not simply a particular bond or loan tranche, DDJ believes that its analysts are better equipped to identify the most attractive leveraged credit investment opportunities across the companies within their coverage universe. Below we have highlighted certain characteristics of each asset class:
Leveraged Credit Market Characteristics
As of September 30, 2019
Sources: Credit Suisse, BofA Merrill Lynch, JP Morgan
Market Characteristics: Bank Loans based on Credit Suisse Leveraged Loan Index; HY Bonds based on ICE BofA ML U.S. HY Bond Index
1Leveraged Loan yield and spread calculations based on an assumed 3-year life
2 All data as of 12/31/18. Bond default and recovery rate data represents 25-year annualized average. Overall loans and first lien loan default and recovery rate data represents 21-year annualized average. Second lien annualized average recovery rate is based on all available data, which dates back to January 1, 2008. Recovery rates are issuer-weighted and based on the price 30 days after default date. Default rates are par-weighted.
While the size of the bank loan and high yield bond markets today are comparable, loans tend to be higher rated, and are generally viewed by investors as less risky. This perception is largely due to the fact that loans are oftentimes secured by a first or second lien on the issuers assets and are more senior in the capital structure. As a result, any proceeds in a liquidation would flow to the holders of loans before any value is distributed to the holders of bonds; accordingly, the downside protection (in the case of adverse circumstances affecting the issuer) is greater. Also, while the default rates are similar between the two asset classes, as displayed in the table above, recoveries on first lien loans on average are much higher than bonds, which is one reason why investors in loans are willing to accept somewhat lower returns in exchange for the lower risk (and greater downside protection) associated with such investments.
Bank Loan Volatility
Another benefit of loans is that they tend to be less volatile than high yield bonds given that loans have limited exposure to interest rate movements and are generally safer due to their secured status and senior position in an issuer’s capital structure. As we observed from 2015 - 2017 when the high yield market sold off, loans proved to be a relative safe haven.
Volatility: High Yield Bonds vs. Bank Loans
Three-year Annualized Standard Deviation (%)
Calculated using monthly returns, rolled monthly
Source: eVestment Alliance
Since loans are typically situated higher than bonds in the issuer’s capital structure, it accordingly takes larger moves in the intrinsic values of the issuer to ultimately impact the potential for principal losses. Other drivers behind the lower volatility of loans include:
- If a company does enter bankruptcy or otherwise undergoes a restructuring, the loan typically should not trade down to the same extent as the bond;
- Since loans can typically be paid back at-or-just-above par at any time (as they have limited call protection), loans generally do not trade significantly higher than par; and
- Loans are floating rate instruments that are reset on a quarterly basis; as a result, they are not impacted by day-to-day interest rate moves to the same extent as high yield bonds, which have a fixed rate for life.
If you would like to learn more about the pros and cons of investing in leveraged loans as compared with high yield bonds, be sure to sign up to receive our weekly blog. In future posts, we will be elaborating on liquidity, covenants, lien examples and more.
FURTHER READING: Interested in reading the first blog in this series? Click here to read part 1 of Bank Loans: Enhancing the Risk/Return Profiles of High Yield Portfolios
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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