Based on discussions with economists, strategists, and other industry experts, the consensus view appears to be an inevitable rise in interest rates but with highly uncertain timing. In its most recent meeting minutes, the FOMC stated that it will keep the target fed funds rate at the current level until employment improves, inflation remains in check, and “other” market conditions comply. Such an opaque framework is unsettling. The timing and direction of interest rate movements, while nearly impossible to forecast precisely, has material implications for investment returns. Interest rate changes can affect equity markets but influence fixed income markets disproportionately— particularly when the change is unexpected. We recognize that there is a risk of rising rates, but given the headwinds facing the economy, we also understand that rates could persist at low levels for an extended period. Because our outlook for interest rates is rather ambiguous, we will contrast two credit instruments in a variety of interest rate environments: high yield bonds and bank loans. Our goal is to ascertain whether one, the other, or both are appealing investments in today’s environment.
The first step in our exercise will be to contrast the high yield bond market and the bank loan market. It will reprise the main conclusions drawn from the 2011 2Q Newsletter, “A Synopsis of the Bank Loan Market” (which we are happy to resend if requested). Once we have summarized the two asset classes, we will evaluate historical, current, and potential interest rate environments. Finally, we will analyze the behavior of the high yield market and the bank loan market in these different interest rate environments to determine whether we can make any sensible conjectures about the future.
Quick Review: High Yield Bonds vs. Bank Loans
High yield bonds and bank loans are undeniably nuanced, but both are generally classified within the same realm: high yielding credit instruments. Because both asset classes exhibit greater default risk than investment grade bonds, investors demand higher yields. Because both asset classes are senior to equity in the corporate capital structure, they exhibit lower volatility than stocks. For investors seeking greater yields than those offered by investment grade bonds but who are unable or unwilling to tolerate the volatility of equities, both high yield bonds and bank loans may appear interesting.
High Yield Bonds
The high yield bond market began to proliferate in the 1980s. The basic structure is simple: a company (the borrower) issues bonds that are purchased by investors (the lender). In return for lending money, investors are entitled to receive payments. These predefined payments are fixed and made regularly (semiannually) until the bond matures or is called by the company/borrower. Typically, the bond has an 8 or 10 year maturity, and is callable halfway to maturity (i.e. 4 or 5 years from issuance). The high yield bond market is large, well-established, and quite liquid.
The bank loan market, as it is currently structured, began to proliferate in the late 1990s and early 2000s. Its expansion coincided with the increased popularity of collateralized loan obligations (“CLOs”), which are bank loans that are pooled together and split into tranches with varying risk/yield profiles. Hedge funds, investment banks, and insurance companies were among the primary CLO investors.
The structure of basic bank loan is nearly as simple as a high yield bond: a company borrows money from a bank, which in turn, sells a portion of the loan to investors. In return for lending money, the bank and the investors are entitled to receive payments (pro-rata). Payments are made regularly (quarterly), but unlike a high yield bond, these payments are variable/floating and typically stated as a spread over a benchmark rate (LIBOR). Typically, the loan has a 5 or 7 year maturity, and is callable at its par value from day one. The bank loan market is private, which often translates into limited transparency and lower liquidity than the high yield bond market. Bank loans typically represent the senior-most portion of a company’s capital structure and are often accompanied by extensive covenant packages designed to protect the loan holder.
From the investor’s vantage point, the benefits of high yield bonds relative to bank loans include a knowable coupon rate, call protection for the first half of the bond’s life, and a highly liquid marketplace. The benefits of bank loans relative to high yield bonds include increased coupons in the event of rising interest rates, greater seniority in the event of default, and covenants designed to prevent destructive management behavior.
The Interest Rate Environment
As depicted in Chart 2, U.S. interest rates have been in secular decline for more than three decades. This has provided a welcomed tailwind for bond investors, particularly those invested in high grade bonds/Treasuries which are interest rate sensitive (as opposed to high yield corporate bonds which are credit sensitive). With investment grade indices exhibiting yields well below 2%, we are skeptical that this market can replicate the compelling risk/return it has achieved in recent decades.
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