Bank Loans: Enhancing the Risk/Return Profiles of High Yield Portfolios, Part 3

Posted on November 14, 2019

This week, we continue with our third and final educational piece on high yield bonds and bank loans. In the first two parts of this blog series, we discussed where each type of debt typically sits in a company’s capital structure; the size and growth of the bank loan market; useful statistics with respect to each asset class (such as volatility measures); and why the flexibility to invest in both asset classes can enhance the long-term risk-adjusted returns of a high yield portfolio. Links to these blog posts are available at the bottom of this page.

While high yield bonds and bank loans are more alike than many investors realize, there are some important differences between the two asset classes, some of which are detailed in the table below:Differences between Bank Loans and High Yield Bonds

“Bank Loans” characteristics are based off of the Credit Suisse Leveraged Loan Index.
“High Yield Bonds” characteristics are based off of the ICE BofA Merrill Lynch U.S. High Yield Index.  Data as of 9/30/19.

Let’s start at the top and touch on the each of these characteristics in more detail.

  • Coupon – Bank loans have a floating rate coupon reset every three months (generally 3-month LIBOR), while the interest rate for bonds is fixed. As a result of the floating rate nature of its coupon, bank loans have limited exposure to changes in interest rates.
  • Seniority – Loans tend to be safer than bonds issued by the same issuer because they are typically the most senior portion of a company’s capital structure (and oftentimes secured with a lien on all or substantially all of the company’s assets). In the event of a downside scenario such as a restructuring, investors in such loans are generally paid back first.
  • Tenor – On average, loans have shorter maturities than high yield bonds. Because of the floating rate nature of bank loans coupled with their limited call protection, the actual tenor of a loan can be even shorter in the event that the company re-prices or refinances the loan prior to maturity.
  • Call protection -
    • Bonds generally have a period of 3-4 years after issuance in which the company is not allowed to pay back – or “call” – the debt. This is known as “hard” call protection.
    • After the “hard call” period expires, the issuer usually must pay a premium to par (e.g., 103% of face value) in order to call their bonds. The ability of the issuer to call their bonds at a premium to par is often referred to as “soft” call protection.
    • Bank loans, on the other hand, typically have limited call protection. Companies usually have the ability to pay back loans at a slight premium to par (e.g., 101% of face value) for a short period after issuance (such as one year), after which time, there is no penalty for an issuer to call its loans prior to maturity.
  • Duration – Since bank loans have a floating rate structure, with a coupon that resets each quarter, the duration of any bank loan is approximately three months. High yield bonds generally have a fixed coupon that does not change over the life of the bond, thereby resulting in a higher duration (and thus considerably more price sensitivity to changes in interest rates).
  • Trading – Both bank loans and high yield bonds each trade in the over-the-counter market, rather than on an exchange. A bank loan can be just as liquid as a high yield bond – and in fact, sometimes larger, first-lien bank loans are more liquid (as measured on an as-traded basis) than comparable high yield bonds.  Similar to bonds, the liquidity of such loans varies based on several factors, including the size of the issue, the performance of the company, and the degree of concentration of the holders of the loan.
    • However, unlike bonds, there is no TRACE data available for loans. TRACE is a system maintained by FINRA that reflects the prices and sizes at which transactions occurred in the secondary market for certain types of fixed income securities, including high yield bonds. This system enables market participants to monitor the commissions (i.e., spread) earned by their trading counterparties and, as a result of such transparency, increases the ability of a manager to achieve best execution for its clients.
    • Given less transparency in secondary market trading of bank loans relative to high yield bonds, DDJ believes that a trading team with significant experience trading bank loans is crucial to achieving best execution.
  • Settlement – The settlement process is much faster and streamlined for high yield bonds as compared with bank loans.  High yield bonds take two business days to settle via a centralized repository (DTC), while bank loans take an average of 15 business days to settle  in what remains a particularly manual process that requires a substantial back office infrastructure. However, as a result of improvements in the efficiency of bank loan settlements, such timeframe has continued to decrease over time.
  • Covenants – Bank loans can have both maintenance covenants and negative covenants. Maintenance covenants require the issuer to comply with certain financial covenants (e.g., not exceed a specified leverage level or fall below a certain interest coverage ratio as of each designated reporting period). Negative covenants restrict the issuer from engaging in certain activities that may otherwise harm the debtholder (e.g., paying certain dividends, issuing more debt, etc.).  In recent years, the percentage of bank loans issued without maintenance covenants has increased significantly with such loans being commonly referred to as “covenant lite”. The covenants included in a “covenant lite” loan closely resemble those included in a high yield bond.
  • Information – Generally speaking, bank loans are more likely to be issued by private companies than high yield bonds. The amount of information available to investors in private companies (as compared with public companies, which have more rigorous disclosure requirements) can be substantial.  For bottom-up, fundamental investors like DDJ, this increased level of information can be very beneficial.
    • When evaluating a new loan issuance, DDJ often has access to consulting reports during our due diligence process, which include in-depth data illustrating how the business operates, allowing us to get a better understanding of the key risks of the business.
    • Management teams of private companies can also be more willing to discuss in detail the business, key customers, suppliers and forward outlook. Access to such management, which may be obtained by virtue of holding the company’s bank loans, is helpful not only to learn about the actual company, but to better understand the overall industry and apply such information to other investments that we have/are evaluating in that industry.

 


FURTHER READING: Interested in reading the first two parts of this series?
Part 1 is available here

Part 2 is available here


 

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