Off late most investors of below investment grade debt – be it leveraged loans or high yield bonds – are intently focused imageson three specific questions, two of which are fairly straight forward, while the third is more complex:

Q1. What is the state of the credit fundamentals and tangentially, what are current underwriting standards like?

A1. Solid and reasonable, respectively

Q2. What are valuations like in the market?

A2. The current and forecasted benign default environment is supportive of current valuations and spread levels; however, macro influences could lead to bouts of volatility

And finally, Q3. What is the relative value between high yield bonds and loans?

Well the answer to question three is nuanced at best and inconsistent at worst. This is because the answer can be approached from several vantage points. And, as best put by Oscar Wilde, “The truth is rarely pure and never simple.”

Both high yield bond and leveraged loan instruments are issued by investment grade credit quality companies. However, the instruments have very different coupon structures and call protection, making the evaluation of relative value not as simple as a straight yield or price comparison. Although many facets are taken into consideration, spread duration is ultimately the most important factor in assessing the relative value between leveraged loans and high yield bonds.

SO lets talk about Spread duration : Spread duration measures the anticipated price change given a 100 basis point move in spreads. Given that loans are callable, a loan trading at or above par has different spread duration depending on the direction of the spread move. As spreads tighten, the loan will not experience further upside appreciation, but if spreads widen, it will absorb the full brunt of the depreciation. However, high yield bonds typically have call protection, allowing them to trade at a higher price, with more room for capital appreciation even when the average price of the high yield market is at a premium. Admittedly, the current extreme high average price of high yield bonds does mean that high yield bonds also have more downside than upside spread duration (negative convexity).

Examining the current environment, the price behavior between loans and bonds in various spread and rate scenarios can be quite different and is dependent upon a variety of factors, including current price. We feel that active managers need to be nuanced in their evaluation of the relative risk and return between loans and bonds. With loans generally trading above par, the lack of call protection means that upside or capital appreciation is limited, which essentially makes the loan market a carry market. Said differently, if spreads continue to tighten from here, the loan market will not see the average dollar price move higher, because of the lack of call protection, loans will re-price to reflect the current market conditions (i.e. lower coupon; reinvestment risk). On the other hand, high yield bonds can still move higher.

 

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