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Revisiting Bond vs Loan Relative Value
Opportunities to capture additional yield by moving up in quality are uncommon for fixed income investors, but that’s the dynamic at play today in leveraged credit. Leveraged loans have historically offered lower yields relative to high yield bonds in exchange for the senior position in the capital structure. But over the last several months, Treasury yields have moved decisively lower, resulting in a duration-driven rally that has helped high yield outpace leveraged loans for the year.
Meanwhile, as high yield bonds have rallied, lower Treasury yields have translated into headwinds for floating-rate structures like leveraged loans, causing yields and valuations between high yield bonds and loans to diverge. For investors that can invest in both securities, a unique setup exists where leveraged loans offer a superior tradeoff between yield and duration risk.
Exhibit 1: The Case for Leveraged Loans
Bonds vs. Loans: Yields and Spreads
Source: ICE BofA/Credit Suisse. As of 31 Aug 2021. High Yield bonds represented by the ICE BofA US High Yield Index; leveraged loans by the Credit Suisse Leveraged Loan Index. Bond yields are computed on a yield to worst basis; loans on 3-year takeout. Bond spreads computed on spread to worst basis; loans on a discount margin to 3-year takeout. ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Credit Suisse Leveraged Loan Index tracks the investable market of US dollar denominated leveraged loan market. Credit ratings typically range for quality from AAA (highest) to D (lowest) and are subject to change. The ratings apply to underlying index constituents. Past performance is not a reliable indicator of future results.
Across the credit spectrum, leveraged loans are offering yield and spread premiums to corporate bonds of similar quality. BB and single-B loan yields provide 40bps advantage over similarly rated corporate bonds. And on a spread basis, discount margins for BB and single-B loans are more than 60bps wide of valuations for similarly rated bonds (Exhibit 1). Though an imperfect exercise due to compositional differences between high yield bond and loan indices, historically speaking, when spreads have diverged to such extremes, loans have tended to outperform bonds over the next 12 months (Exhibit 2).
Exhibit 2: At Current Valuations, Loans Have Historically Outperformed Bonds Over the Next 12 Months
Bonds vs Loans: Spread Difference and Forward 12-Month Returns Difference
Source: ICE BofA/Credit Suisse. As of 31 Aug 2021. High Yield bonds represented by the ICE BofA US High Yield Index (spread to worst); leveraged loans the Credit Suisse Leveraged Loan Index (discount margin 3-year takeout). Past performance is not a reliable indicator or guarantee of future results.
Consider, too, the growing asymmetry between high yield bonds and leveraged loans. A large portion of the high yield market now trades at levels that limit the potential for further price appreciation—even if interest rates were to rally further. At the end of August, more than 85% of high yield bonds were trading at a premium to par compared to just 11% of loans. Current valuations suggest high yield bonds have less ability to absorb a pickup in volatility—whether it’s interest rates or credit related. Sub-4% coupons are increasingly common among newly issued high yield bonds. Taken together with tight spreads, a 50bps upward move in interest rates would be enough to wipe out a year’s coupon for many of these deals. Put another way, limited capital appreciation potential for high yield bonds is another reason to favor leveraged loans. Because of their floating feature, leveraged loans not only provide insurance against rising rates but still provide compelling total return potential at current valuations.
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