Following a challenging 2015, many investors saw their portfolios bounce back last year as macro headwinds subsided and economic data turned increasingly positive. Today investors are anticipating that the new administration’s policies may lead to higher economic growth in the months ahead and are searching for opportunity.
Given that performance has improved for many asset classes, how might investors spot opportunities today? When markets have headed in the same direction, as has been the case through much of the past year, I tend to look for relative value opportunities, or instances where traditional relationships between asset classes may have diverged from their historical patterns. We may be seeing such an opportunity in the relationship between senior secured loans and high yield bonds today. Senior secured loans may offer a similar level of yield as high yield bonds for a potentially lower level of risk.1
Comparing high yield bonds and senior secured loans
It is worth taking note when yields on these asset classes converge as it may be because of technical pressures on the asset classes (relative fund flows, size and liquidity of the respective asset-specific markets, etc.), and not necessarily due to fundamental factors. While both senior secured loans and high yield bonds are similar in that they are used as financing by non-investment grade companies, it is also important to remember the differences between these asset classes, including their varying risk profiles.
- Senior secured loans are senior within a company’s capital structure, and therefore are first in line to be repaid ahead of bond and equity investors. They are also secured, or backed, by an issuer’s assets and offer a coupon that floats with interest rate movements. Remember, senior secured loans are 1) senior, 2) secured and 3) floating rate.
- High yield bonds have fixed-rate coupons and are often repaid after senior secured loans, or subordinated. As opposed to senior secured loans, high yield bonds are 1) subordinated, 2) unsecured and 3) fixed rate.
The main difference for investors is that, in exchange for assuming a higher level of risk compared to senior secured loans, high yield bond investors have historically demanded a higher yield.
A break from the norm
Since January 2010, high yield bonds’ average yield has been approximately 79 basis points higher than that of senior secured loans. For context, the yield differential between the two asset classes climbed to as high as nearly 300 basis points in January 2016.2 As of late February 2017, it had declined to just 2 basis points.2 In other words, an investor would receive approximately the same level of income from either asset class today despite their differing risk profiles.
While credit quality is always a key consideration, we are monitoring the yield differential between the two asset classes for any potential opportunities that may exist.
1 Bloomberg. High yield bonds are represented by the Bank of America Merrill Lynch U.S. High Yield Master II Index. Senior secured loans are represented by the Credit Suisse Leveraged Loan Index. Large cap stocks are represented by the S&P 500 Index. Small cap stocks are represented by the Russell 2000 Index. Investment grade bonds are represented by Bank of America Merrill Lynch U.S. Corporate Master Index.
2 As of February 13, 2017. J.P. Morgan based on the yield to worst on the J.P. Morgan High Yield Bond Index versus the yield to 3-year takeout on the J.P. Morgan Leveraged Loan Index.
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