Market analysts are beginning to point out that – absent the long-term interest rate “bet” embedded in fixed rate bonds – corporate loans outperform high yield bonds as pure credit investments.
Portfolio managers and market commentators have traditionally approached investment strategy as a choice between stocks and bonds, while we have argued that it deserves a more nuanced view. Since bonds contain an embedded bet that interest rates will either remain flat or go down, in assessing their returns over time you have to separate out the return an investor receives for taking credit risk from whatever return they get – plus or minus – from that bet on the direction of interest rates.
My premise – and that of many others active in the credit markets – has been that corporate loans, which are senior, secured and have adjustable rates, provide a higher and more dependable return as a credit instrument than high yield bonds, especially once the impact of the interest rate bet is removed (see here).
A Barclay’s Capital chart, published by Randy Schwimmer of Churchill Financial in his weekly review On the Left, makes the point very clearly (see here). It shows how high yield bonds have lagged the return on loans considerably during the past year, once you remove the effect of the run-up in Treasury bond prices. Since the run-up in Treasuries represents the “pure” return on taking interest rate risk, the remaining return is what investors receive for taking credit risk alone.
This has big implications for investors – especially high yield bondholders – trying to decide what to do going forward. If a big portion of the return we have enjoyed over the past year or so (I say “we” because the author is a holder of both high yield bonds AND senior secured loans) has been due to the once-in-a-generation drop in interest rates to current levels, then it stands to reason we won’t be enjoying that high-octane boost to our returns in the future. In fact, if and when interest rates turn back up, that will be a big drag on bond returns, rather than a boost.
That means investors in high yield DEBT – loans as well as bonds – should be basing their decision on what the return on taking credit risk is likely to be for each instrument, going forward, and not be influenced by what sort of extra juice the decline in interest rates may have provided in the past.
As a pure credit instrument, the loan asset is far superior to the bond, since it ranks ahead of bonds in default or bankruptcy, and is secured by real assets rather than being unsecured and, in some cases, legally subordinated, as most high yield bonds are. (During the depths of the credit crisis, some high yield bonds were secured, in order to induce investors to buy them, but that was largely short-lived.) As a result of their greater protection and higher recoveries, loans historically have experienced less than half the credit losses as high yield bonds.
Better credit, higher yields
Ironically, despite their better credit performance, loans yield about the same – at equivalent levels of credit risk (i.e. double-B, single-B, etc.) – as bonds stripped of their interest rate bet return component. In other words, if a 10-year bond pays 8%, but 2% of that is the payment for taking a 10-year interest rate “bet” (and we know it is, if the “risk free” 10-year Treasury bond yields just over 2%), then the bond-holder is being paid 6% (i.e. 8% minus 2%) for taking the credit risk of the issuer. An equivalent loan probably yields about 6%, with no interest rate “bet” because the rate is floating and resets every three months. Since credit costs, whatever they turn out to be in absolute terms (0.5%, 1%, 2%..........etc. depending on default rates) will always be lower for loans than for bonds, because loans recover more than bonds at whatever the default rate, then from a pure credit return standpoint, loans are the better buy.
But there’s more. Since loan coupons are priced off a floating base rate (usually 3-month LIBOR), loans will provide a hedge against rising interest rates (the opposite of bonds, whose value will drop as rates rise.) So just as fixed-rate bonds were a very smart investment to hold during the 30 year secular drop in interest rates (and inflation) from the mid-teens in the early 1980s to close to zero now, floating rate loans will likely benefit big-time if the next few decades see a rise in rates and inflation as our government wrestles with financing its huge projected deficits.
“Equity yields” anyone?
If you take away the interest rate bet, corporate debt with a predictable 5-6% return looks pretty attractive in an environment where equity returns have been highly volatile and the economic future seems to be fraught with uncertainty. But a major attraction of equity, which induces many conservative long-term investors to hold their breaths and buy stocks despite the risks, is the belief that it is the only way to hedge against inflation and rising interest rates. And compared to “fixed income” bonds, it is. But floating rate loans, with a predictable yield of 5 or 6 percent, plus floating rates that effectively hedge against rises in interest rate and inflation, look a lot like an “equity return” to me.
Readers have asked for possible ways to invest in floating rate loans. This screen from ETF Connect, the guide to closed end funds, allows you to click on “senior loans” to obtain a list. [Editor's Note: The screen turns up the following corporate loan closed-end funds: BGT, BHL, BSL, EFR, EFT, EVF, HCF, FCT, FRA, FRB, JFR, JRO, NSL, PHD, PPR, TLI, VTA, VVR.]
Disclosure: No specific stocks mentioned; author does own a number of HY bond and loan funds, including Eaton Vance, Black Rock, Fidelity, Nuveen, Third Avenue and PIMCO.