Bridging the Divide Between High Yield and Bank Loans | Lord Abbett
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Fixed-Income Insights

While high yield has found more favor with investors recently, several factors could potentially shift the valuation gap to bank loans’ advantage.

Read time: 9 minutes

 

In Brief:

  • Differing flows in the U.S. high yield bond and leveraged-loan markets have contributed to a performance gap between the two assets. History suggests that such a setup could enable loans to close in on high yield bonds in the year ahead.
  • Apart from the valuation gap, prospects for either rising rates or a steepening yield curve that is indicative of some reflation at work could be a positive tailwind for loans.
  • On the flip side, investors should be aware of the structural changes in both the loan market and the composition of the buyer base over time. Ultimately an investor with a strategic mindset should focus less on these changes, but they could dictate sentiment and performance over the near term. 

 

Relative value between U.S. high yield and bank loans is an evergreen debate among leveraged finance investors, but even more notable today given the differing shape of recovery between the two since the March trough. We won’t offer a definitive view on owning one over the other here. At Lord Abbett, we invest for both strategies; we own leveraged loans in high yield bond portfolios—and own high yield bonds in loan portfolios. This is part of the broader story of our historical strength in multi-sector portfolios. The sector allocation-themes and process are the same for both asset classes, although there are constituent differences between the two. In this report, we endeavor to relay the factors that influence how we allocate risk between the two asset classes, and what could help, or hurt loans, in closing the performance gap.

Here's what helps support the argument for loans …

  • Valuation: History shows when loans trade at spreads as wide versus high yield bonds, as they do now, they see a relative performance momentum gain over the coming year.
  • Potential for a steeper yield curve: Loan-retail, mutual fund-flows follow rates, but even with the front end of the curve pinned close to the “zero bound” near term (and the benchmark London Interbank Offered Rate, or LIBOR, unlikely to climb), inflation expectations have rebounded strongly. Could we see a Treasury curve steepening or rate sell-off that drives inflows into loan funds as investors seek to cut rate duration in response?   
  • “Technicals” are recovering: Loan issuance is running at its slowest, year-to-date (through August 31) pace since at least 2015, and CLO (collateralized loan obligation) formation improved each month sequentially after March, as liability spreads have narrowed through the structure. 

…And here are some points to consider

  • The ratings differential: The loan market is dominated by B-rated issues, while high yield is mostly BBs. Recovery and default differentials between the two can level the playing field, but on the surface, it appears that on ratings alone, high yield looks better positioned.
  • A dominant investor type: CLOs are the primary investor category in the leveraged-loan market (with a nearly 60% ownership stake). Their investment behavior, with a nod to ratings as well as sensitivity to their own funding costs, play a role. However, CLOs’ longer-term investment horizon can create a more “permanent” source of capital versus high yield, where mutual funds are a larger share of the ownership pie.
  • Structural changes: “Loan-only” issuers have become a sizeable portion of the loan market. But the fall in leveraged buyout (LBO) financing this year and the recent shift by issuers to fund in the high yield bond market (on pace for record new issuance this year) could shift the skew. 

What is the historical tie between high yield and bank loan returns?

While some differences have emerged between the U.S. bank loan and U.S. high yield markets over the last several years, long-term monthly return data indicate they are still related, as shown in Figure 1. Over the last 10 years, the correlation between monthly returns of the two assets is about 81%. Year-to-date through August 31, high yield (as represented by the ICE BofA U.S. High Yield Constrained Index, or the HY Index) has returned 0.67%, versus a -1.51% return for loans (based on the Credit Suisse Leveraged Loan Index, or the LL Index). 

 

Figure 1. Leveraged-Loan and High Yield Returns Have Correlated Over the Long Term
Monthly returns, January 2010 – July 2020


Source: Bloomberg. Data as of July 31, 2020.
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

There are plenty of reasons for this relative performance of late, but the move lower in risk-free rates has resulted in more intense outflows for U.S. floating-rate mutual funds and exchange-traded funds (based on Lipper data), a technical factor pressuring the bank loan asset class on a relative basis. That partially explains the LL Index trading at a wider spread—and lower price—than the high yield market. Figure 2 shows that typically, when the loan market trades similarly wide of the high yield market, loans gain ground on high yield over the following 12 months. Indeed, loans outperformed high yield bonds by 50 basis points (bps) in August 2020 (1.50% vs. 1.00%), just as the two-year to 10-year U.S. Treasury curve steepened by 15 bps on the month.

 

Figure 2. For Bank Loans, History Suggests Current Spreads Versus High Yield Could Be Followed by Outperformance Over the Next 12 Months

Forward 12-month performance difference of loans versus high yield bonds and spread difference of loans to high yield bonds, November 2012–August 2020

Source: Loans = Credit Suisse Leveraged Loan Index (discount margin). High Yield = ICE BofA US High Yield Constrained Index (spread to worst). Data as of August 31, 2020.
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

What is the backdrop for today’s relative cheapness in loans?

Since the pivot by the U.S. Federal Reserve (Fed) in January 2019 from a tightening to an easing bias, floating-rate product flows have come under pressure, as noted earlier (see Figure 3). While loans are a long-established credit product, you can clearly see the relationship between changes in rates (fed funds in this case, with similar patterns if you look at LIBOR, 10-year U.S. Treasury yields, and the like) and loan-retail, mutual fund-flows. In response to market volatility in the fourth quarter of 2018 and the ensuing Fed shift to easier monetary policy in early 2019, loans flows reversed.

 

Figure 3. Bank Loan Fund Flows Decreased in Tandem with Fed Rate Cuts in Early 2020
Flows for U.S.-registered high yield and leveraged-loan mutual funds, January 2017–May 2020

Source: Lipper FMI. Data as of May 31, 2020.

Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Since the end of the Fed’s hiking campaign, high-yield, retail mutual fund-flows are net positive (“I’m happy owning duration,” the high yield investor might say) versus deeply negative for loans (“I want to avoid watching coupons drift lower”). You can see the price differential that has opened up between the HY Index and the LL Index overall, as well as by rating category (see Figure 4). 

 

Figure 4. The Leveraged-Loan Index is Trading at Its Biggest Discount to High Yield Bonds Since Late 2010

Leveraged-loan (LL)/high yield (HY) price differential for indicated rating categories (left axis); prices for broad leveraged-loan and high yield indexes (right axis), December 29, 2017–July 31, 2020

Source: Bloomberg. Data as of July 31, 2020.

Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

We think it’s notable that the “fallen angels” (issues that have dropped below investment grade, which are largely non-call, constrained bonds) of this cycle have helped propel BB-rated bonds in high yield to an index price above $104.67 as of August 31, while BB loans are around $96.88. This is the largest price gap between BBs of the two markets over the last 10 years. 

What are the other tailwinds outside of valuation that could drive loans?

As shown in Figure 5, there is a growing gap between inflation expectations and similar tenor Treasury yields. If those expectations on inflation gain traction, we’ll likely see a steepening yield curve (further assuming the Fed keeps short-end rates pinned near zero, as Fed Chair Jerome Powell suggested last month); steepening has historically been supportive of flows into loan product. Loans historically have served as a favorable way to play reflation, particularly if you believe the market is underestimating the strength and timing of a U.S. economic rebound. 

 

Figure 5. A Growing Gap Between Inflation Expectations and 10-Year U.S. Treasury Yields
Data for the period August 27, 2019–August 26, 2020

Source: Bloomberg. Data as of August 26, 2020. A 10-Year Zero Coupon Inflation Swap is a maturity-specific hedging instrument designed to transfer, or “swap out,” inflation risk from one party to another.

Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The downgrade wave appears to have passed, as shown in Figure 6. This, along with the potential that we are nearing a peak in the default rate for loans, could engender more confidence, particularly with a ratings-sensitive buyer base of CLOs. 

 

Figure 6. Rating-Agency Downgrades of Loans Have Decreased Markedly Following the March-April Market Turmoil
Rating agency actions (monthly) on bank loans, January 2020-July 2020

Source: S&P LCD. Data as of July 31, 2020.

 

Looking at other indicators, despite a robust August, loan issuance has moderated YTD (with cumulative volume the lightest since at least 2015, per Credit Suisse) and the forward loan. net new issue-calendar looks light. Meanwhile, CLO formation has rebounded (see Figure 7) – there was no CLO formation in March, but the monthly volumes increased sequentially from April through July (albeit with an August lull), just as they did in early 2016 after the 2015 energy-market washout.   

 

Figure 7. CLO Formation Has Rebounded from the March 2020 Drought
Newly formed collateralized loan obligations by month, January 2014–August 2020

Source: S&P Market Intelligence. Data as of August 31, 2020.

 

What are the potential challenges?

Inflation expectations are climbing, and the yield curve has started to steepen ever so modestly. Both developments appear to have prompted investors to take a second look at bank loans, even with the Fed funds rate target expected to remain at 0-0.25% for the foreseeable future. But there are some notable caveats that investors should keep in mind—along with some important context: 

  1. The issue of a ratings differential. First, there is a ratings-profile difference, as Figure 7 shows—U.S. high yield is dominated by BBs, while the leveraged-loan market, as captured by the LL Index, is dominated by Bs. Does this matter? On one hand, every cycle is different but loss-given default1 of a B-rated loan or a BB-rated unsecured bond, could be considered to be reasonably close, given the default and recovery differentials between those two cohorts (first lien loan recovery has typically been about 30 basis points higher than unsecured bonds over the long term, but Bs default more frequently than BBs). 

 

Figure 8. Comparing the Ratings Composition of High Yield and Leveraged-Loan Benchmarks
Ratings composition of the indicated indexes as of August 2020

Source: Bloomberg. Data as of August 31, 2020. US HY=ICE BofA U.S. High Yield Constrained Index. CS LL=Credit Suisse Leveraged Loan Index. NR=Not rated.
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

  1. A ratings sensitive investor base. As noted earlier, CLOs hold over 60% of the leveraged loans in the market. Given their structural considerations in a rising default-rate environment, they have de-risked by exiting low single B’s and CCCs to attempt to limit their potential future CCC exposure below certain prescribed limits. Recent behavior has suggested less ratings sensitivity for these buyers of late, as downgrades have subsided, but it still plays a role. 
  2. Structural changes in the loan market. It’s true that the proportion of the loan market that is from ‘loan-only’ issuers has been growing (Figure 8). Again, there is some debate between loan investors on how much this matters, but broadly speaking, loan-only issuers have less subordination below them to absorb losses than would a capital structure that has the same amount of total debt, but bonds subordinate to the loans. That’s one reason investors today expect loan recoveries to be lower than they have historically been—perhaps even ‘bond-like’ in particularly top-heavy, loan-only capital structures. (Incidentally, many high yield bond investors expect unsecured bond recoveries to be lower through this cycle than they have been historically as well.) However, we would note that based on data from S&P LCD, the share of outstanding loans without any debt cushion (subordinate second liens, debt other than high yield bonds, etc.) hasn’t grown to the same extent; in fact, it has remained little changed (at around 26%) over the past three years. 

 

Figure 9. Loan-Only Issuers Have Accounted for the Majority of the Loan Market for Some Time
Data (monthly) for the period January 2007–August 2020

Source: JP Morgan. Data as of August 31, 2020. Loan-only capital structures typically include loans and equity; a typical loan-and-bond structure features loans (which sit atop the capital structure), bonds subordinate to those loans, and equity.

 

There are many facets to examine when assessing the relative value—and future performance prospects—of leveraged loans versus high yield bonds. As long-seasoned investors across the leveraged finance market, we believe both asset classes provide opportunity. Nonetheless, history suggests the current trailing performance gap of loans to bonds could narrow, an outcome further enhanced by the potential rise of interest rates and investors’ collective view of reflationary themes.  We believe Lord Abbett’s multi-sector expertise is well positioned to be tactical and proactive in management of leveraged credit, even with the fog of uncertainty likely to persist in the coming months. 

 

1Loss-given default refers to capital loss due to unrecovered loss from a bankruptcy.

 

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. The principal risks associated with bank loans are credit quality, market liquidity, default risk, and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

There is no guarantee that the floating-rate loan market will perform in a similar manner under similar conditions in the future.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described above.

Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

A basis point is one one-hundredth of a percentage point.

A collateralized loan obligation (CLO) is a single security backed by a pool of loans, collected into a marketable instrument via process known as securitization. CLOs are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts. 

discount margin (DM) is the average expected return earned in addition to the index underlying, or reference rate of, the floating-rate security.

Spread-to-worst is the difference between the yield-to-worst of a bond and yield-to-worst of a U.S. Treasury security with a similar duration. The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated, leveraged-loan market.

The ICE BofA U.S. High Yield Constrained Index tracks the performance of U.S. dollar denominated, below-investment- grade, corporate debt publicly issued in the U.S. domestic market.

ICE BofA Index Information:
Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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