High yield bonds have been a big winner for investors who “kept the faith” and held onto their portfolios through the financial crisis. But what’s an investor to do now, when financial writers, economists and commentators are all pointing out – quite correctly – the danger of owning fixed-rate bonds when interest rates, eventually, are sure to rise?
Traditionally the classic investment choice has been presented as bonds vs. stocks. But this is a false choice. Investors should really be asking about debt vs. stocks. Corporate debt, once we remove the interest rate bet that is an inherent element of a fixed rate bond, is a very attractive asset for long-term investors seeking steady returns. When you combine corporate debt with floating, adjustable rates (the opposite of the fixed rate bet) so your coupon grows as interest rates rise (unlike bonds whose value drops) then you have an instrument that (1) pays a steady predictable return, and (2) acts as a hedge against rising inflation and interest rates.
Such an investment would achieve many of the purposes for which investors own stocks, and in an uncertain period where economic, political and fiscal uncertainties make the outlook for equities unpredictable, might be far less volatile.
Of course, there is such an instrument, which hedge funds and institutional investors have known about for years. It’s a corporate loan, often referred to as “senior secured floating-rate corporate debt.”
Bonds: Debt With “Interest Rate Bet Attached”
When we buy a bond, we are making two very distinct investment bets: We are betting that the company will pay the principal and interest on its debt (the credit bet), and that interest rates will stay the same or go down (the interest rate bet).
During periods of dramatic shifts in interest rates – like the last 30 years, when long-term bond rates fell from the mid-teens to just above 2%, boosting bond prices substantially – the return on the embedded interest rate bet can overshadow the return on the credit bet. But with interest rates hovering just above zero, thoughtful bondholders know that they face a highly skewed risk/reward outlook in the future, with the embedded interest rate bet more likely to be a millstone than a bonus in the years ahead.
But corporate debt does not have to mean bonds, with their embedded interest rate bet. Corporate loans – senior, secured, floating-rate debt instruments issued by the same cohort of companies that issue high-yield bonds – are (1) a safer, more effective way to invest in corporate credit than high-yield bonds, and (2) an investment that will actually benefit from rising interest rates because of their adjustable rate coupons, instead of losing value as bonds do when rates rise.
Loans vs. Bonds: Big Difference in Credit Risk and Protection
Many financial writers lump high-yield bonds and senior, secured loans together in describing their credit profile and risk of loss. While both are issued by non-investment grade companies (i.e. firms rated double-B-plus and below, which includes the great majority of all rated companies), they are quite different in terms of investor protections and likelihood of repayment in bankruptcy:
- Bonds are unsecured, and in many cases, legally subordinated to other senior debt
- Loans are senior obligations, and almost always secured by collateral (the assets – tangible and intangible – of the borrowing company)
- When a company defaults and goes into bankruptcy, secured lenders are often paid in full, with an average repayment of about 70%, and corresponding loss of 30% (i.e. 100% minus the 70% average repayment)
- Bondholders don’t do as well, being further behind in the queue and having no collateral, so their average recovery is about 40%, which means their average loss is 60% (or worse if the bond is “subordinated” and even further behind in the queue than merely being “unsecured”).
This difference in loss severity between loans and bonds makes a big difference in the amount of credit loss suffered by a portfolio of high-yield bonds versus a portfolio of loans. A simple example will demonstrate this. Suppose there are two portfolios, one with senior secured loans, the other with high-yield bonds, and each experiences defaults of 4% of the instruments (i.e. loans or bonds, respectively) in their portfolios. Applying the historical averages cited above, the loan portfolio suffers an average loss of 30% on each of its defaulted loans, so its overall portfolio loss is:
4% X 30% = 1.2%
The bond portfolio suffers an average loss of 60% on each of its defaulted bonds, so its overall portfolio credit loss is:
4% X 60% = 2.4%
This analysis actually understates the loan portfolio’s advantage because loans, besides having the advantage of higher repayments in bankruptcy, actually experience default at a slightly lower rate as well. That’s because some companies that run into financial difficulty will husband their limited cash flow by continuing to service their senior secured loans, even while defaulting on their junior debt (bonds, etc.).
Comparing Returns: Bonds vs. Loans
Any comparison of returns of high-yield bond portfolios and loan portfolios should be net of credit losses. This means taking the gross return each portfolio is paid for taking credit risk and reducing it by the amount of credit losses, as described above. But before we can do that, we have to strip out, from the bond portfolio return, the portion of the coupon that is attributable NOT to taking credit risk, but to the “interest rate bet” that is an integral part of the instrument.
This is simple to do. Assume a 10-year high-yield bond with a coupon of, say, 8%. We know that the 8% coupon compensates the investor for both the risk (1) of the borrower defaulting in payment and (2) that interest rates will rise over 10 years and reduce the market value of the bond.
We also know that an investor who wants to take a “pure” risk of interest rates rising over 10 years, stripped of any credit risk, can purchase a 10-year US treasury bond and earn about 2.5% more than they would if they bought a 3-month Treasury bill. So if we subtract the 2.5% 10-year interest rate risk premium from the 8% coupon, we get 5.5%, the amount the high-yield investor is being paid for taking the pure credit risk of the borrower defaulting.
Loans currently have coupons ranging in the 6% to 7% range, which comprises a “spread” usually between 400 and 500 basis points, plus a base rate of 3 month LIBOR (the “London Inter-Bank Offered Rate” an inter-bank money market rate). Since 3 month LIBOR, like other short-term rates, is currently hovering slightly above zero, new loans are being written with minimum LIBOR “floors” of 1.5% to 2%, to ensure a minimum coupon. Older loans traded in the secondary market are discounted to offset their lack of a minimal LIBOR floor.
So we see that loans, having no inherent interest rate bet to dilute their coupon, provide yields of 6% and higher, whereas bonds, once we subtract the 2.5% interest rate bet premium, often yield less than that. When we subtract credit losses, which as discussed earlier are generally twice as high for high-yield bonds than for loans, the advantage for loans becomes even greater.
This is a simplified version of an analysis with a lot of variables. But the basic advantage of loans holds at all levels of default – it increases the higher the default rate – and as the yield curve steepens and the “cost” of the interest rate bet increases. The point isn’t to “prove” that loan funds are a better investment than high-yield bond funds. (The author is an avid investor in both.) It is rather to encourage investors to move beyond the “bond vs. stock” paradigm and to analyze more carefully the advantages of corporate debt generally, especially the floating rate variety, at a time when we’re coming off a once-in-a-lifetime 30-year interest rate decline, and facing a future that might be very different. What loans offer – a basic return, net of interest cost, in the range of 5% or slightly more, plus the additional yield pick-up when and if interest rates and inflation rise – strikes me as awfully “equity-like,” albeit without much of the angst and volatility that typically accompanies equity investments.
Investing in floating rate debt is easier than ever. Most of the vehicles for doing so efficiently are closed end funds and load-bearing open-end funds. (Fidelity has one of the few no-load funds in the floating-rate loan space. For a list of closed-end funds, click here and screen for “senior loan” funds; note the wide variation in fees and premium/discounts.)
Disclosure: Author owns Eaton Vance and Fidelity floating-rate loan funds, and a number of Fidelity, Vanguard, Pimco and Third Avenue high-yield bond funds.