To say it has been a terrific year for investors in high yield bonds and leveraged loans is quite the understatement. High yield bonds saw typical yields drop from the high teens to about 8%, providing investors with a year-to-date total return in the 50% range, depending on the make-up of an individual investor’s portfolio. Leveraged loans, which are floating rate senior secured loans to high yield (i.e., non-investment grade) borrowers, provided their investors with similarly stellar returns that averaged over 45%. The main driver of these returns has been essentially a “return from the brink” in both the loan and bond markets, where debt instruments that were priced by panic-stricken investors for an “Armageddon scenario” as some commentators described it a year ago, have returned to prices that are now viewed as more rational in terms of the foreseeable risks.
To put this in perspective, at the end of last year bonds and loans issued by healthy companies that continued to pay interest and principal on time throughout the downturn were priced in the range of 55 cents to 65 cents on the dollar. This provided tremendous one-time gains for investors in the United States, Canada and elsewhere who got into the market at that time and rode the prices back up to the current range of 90 cents to par.
Is the Ride Over?
Everyone seems to agree that the “easy money” has been made, so the questions facing high yield investors now are: Is there additional money still to be made and, if so, how much? Investors in other asset classes are facing the same question, since not only equities, but investment grade bonds as well, have rewarded their holders with gains in the 20% range so far this year. Neither asset class approaches the stratospheric heights of the high yield debt arena, but 20% returns are not too shabby, especially for investment grade corporate bonds, which never experienced the near-panic conditions that prevailed in the leveraged finance market last year. So the question remains: Where does an investor reinvest his or her winnings, whether from bonds, stocks or loans? Or is there additional upside – albeit perhaps somewhat restrained, compared to recent experience – for those willing to let their bets ride?
To view chart click here (.pdf).
Compared to What?
Any discussion of the attractiveness – or not – of various asset classes has to be set in a context that considers the alternatives. So the question is not only whether high yield debt remains a good investment going forward, but also if so, “compared to what?” The range of possible investment scenarios facing investors in the next year or so is a broad one. It ranges from perennially dour writer Jim Grant’s surprisingly bullish outlook (sharp bounce back from a deep downturn) to the “new normal” anticipated by PIMCO’s Bill Gross that foresees the classic football ground game of “three yards and a cloud of dust” applied to investing (i.e., where investors will work very hard to make single digit returns). In addition, there are numerous “doom and gloomers” who would view even Gross’s “new normal” as overly optimistic. Since our crystal ball is no clearer than anyone else’s, all we can do is evaluate the various alternative scenarios to see what the impact on loan and bond investors might be under each one, and how that scenario might compare to alternative investment opportunities.
First let us turn to the expected absolute returns that debt investors might expect going forward. To help create “what if” scenarios with respect to various levels of default, spreads, LIBOR, yields, price discounts to par, etc. readers may wish to use the DBRS Loan/Bond Return Model, first introduced in December 2008, in our article Fire-Sale Prices Could Mean “Equity Returns” for Loan Investors. At that time, the credit markets were pricing in default scenarios even worse than those experienced in the 1930s during the Great Depression. As pointed out earlier, markets have now climbed back – way back – from that abyss and the question at hand is how much additional upside still remains.
Turning to the loan market, let us assume that new leveraged loans are being made at plus or minus 400 basis points (actual spread would depend on credit rating – double-BB or single-B), LIBOR floors of perhaps 200 basis points and original issue discounts of 200 basis points to be amortized over five years. Based on these assumptions, without factoring in any credit losses, a leveraged loan portfolio would yield about 6.5% annually, a far cry from the roughly 20% yield (before credit costs) that a similar portfolio would have yielded a year ago.
The challenge to investors is that a 20% yield provided them with a lot more room to be wrong in estimating future credit costs than today’s 6.5%, which leaves little margin for error. If we assume long-term trends reassert themselves and we experience average historical default rates of 3% per year with 50% recovery, then that yield drops to 5%. There was a time when leveraged loans, with their good collateral protection and floating rates that eliminated duration and interest rate risk, were considered a stable asset that would attract investors with a 5% yield, but it remains to be seen whether “Great Recession”-chastened investors will be similarly attracted.
Some leveraged loan fund managers will argue that the upside is actually brighter than that, since investors entering the asset class now are buying into existing portfolios that are already marked to market, and whose price is typically in the 90 cents on the dollar range. So that just because new loans are being sold close to par, the existing inventory remains marked down, albeit not nearly as much so as earlier this year. They would also argue that the credit problems in the existing portfolios have already been identified, with the offenders weeded out, written off and/or sold. If we consider these factors, and widen the discount to 10% on, say, two-thirds of the portfolio, lower the default rate by two-thirds to 1% annually, and shorten the holding period to account for seasoned loans having less time remaining to maturity, our yield pops up to the 8% to 9% range.
Applying similar assumptions to the high yield bond market, we get largely similar results, although yields are slightly (1% to 2%) higher, which may or may not offset the additional risks of being junior in recovery to loan investors, and having to bear the interest rate risk that loan investors avoid via floating rates.
How attractive are single-digit returns?
So it comes down to a choice about how attractive an investor feels about the post-recession prospect of single-digit returns. Here are some (but hardly all or even most) of the possible scenarios:
- If you believe that the years ahead will be rocky for the economy and the companies within it, because of the effects of reduced consumer spending, higher taxes, rising interest rates to fight off higher inflation from deficit spending, and a generally challenging environment for corporate profits, then a single-digit return from owning corporate debt may appear more attractive and less risky than owning the equity of the same cohort of companies (this is consistent with the “new normal” view).
- If you have a brighter view of economic prospects, you may feel that a single-digit return on corporate debt may be insufficient compared to the equity returns that should accompany such an economic upturn (consistent with the “sharp bounce” view).
- If you have a brighter view of economic prospects but believe that the stock market has already anticipated the economic recovery with its recent rise, then you may feel that it might be pushing one’s luck to expect a continued rise in equities given all the economic uncertainties (consistent with a “restrained bounce” view).
- If you are of a more draconian “gloom and doom” persuasion, then neither approach will be very satisfying, since you clearly would expect higher than normal defaults going forward, which would bring the return on corporate debt – bonds and/or loans – down to the low single digits or worse, in which case you don’t want to be in corporate debt at all (neither do you want to own those companies’ equity).