Major fundamental changes in the leveraged
finance markets since the financial crisis have resulted in improved credit
quality in high yield bonds and greater dispersion in credit quality in bank
loans. For investors today, this is a crucial development: In the later stages
of the business cycle, it’s more important than ever to distinguish
between improving credits and weaker credits that are likely to underperform
in an economic downturn.
We think these shifts in the leveraged finance markets underscore the
importance of active management in seeking attractive credits with improving
prospects and potentially avoiding pitfalls. It is also critical that credit
portfolio managers have a thorough understanding of both asset classes since
relative value opportunities between the two can be an important source of
both alpha and total return.
The changing composition of leveraged finance markets
Historically, the bank loan market was much smaller than the high yield market
but looked much like it in terms of industries represented − automotive,
media, telecom and energy − although higher-risk issuers, such as highly
levered LBOs (leveraged buyouts) and those in sectors undergoing secular
challenges (such as newspapers and yellow pages) gravitated toward high yield.
Recently, however, the re-emergence of collateralized loan obligations (CLOs)
as the main buyer of bank loans starting in 2012 has acted as a catalyst for
renewed growth in syndicated loans, and in 2018, the notional amount of loans
outstanding surpassed $1 trillion (see Figure 1). CLOs now hold almost
two-thirds of the market (according to S&P LCD, as of 30 September 2018),
and demand from loan mutual funds has also increased thanks to strong fund
inflows in response to rising interest rates.
By contrast, the high yield market in the U.S. has been shrinking modestly
since 2014. The majority of high yield issuance has centered around
refinancing as many new issuers, LBOs in particular, have been issuing in the
loan market in response to stronger demand and the prepayment optionality it
As a result of these shifts, the two markets look very different today
compared with the pre-financial-crisis period. Notably, high yield has seen
growth in BB rated debt (referring to the debt itself, not the corporate or
issuer rating) and a reduction in the amount of CCC rated debt, while the loan
market has experienced an increase in B rated debt and a decline in BB rated
debt (see Figure 2).
Beyond the increase in B rated loans, a number of other changes in the markets
have also eroded overall credit quality in bank loans. The most important of
these has been the increase in “covenant-lite” loans and
“loan-only” issuers (to 80% and 70% of the market respectively,
from about 20% and 59% in 2008, according to data from JPMorgan). With the
former eroding investor protections and the latter diminishing subordination
– a layer of high yield bonds designed to absorb first losses and serve
as credit protection for loan investors ‒ Moody’s forecasts a decline in
first-lien loan recoveries from over 70% historically to 60% in the future.
Why the composition and investor base matter
As the proportion of lower-rated issuers in the loan market increases, we
think investors should take notice. Single-B rated companies tend to have
weaker business profiles, more tenuous competitive positioning or insufficient
diversification compared with BB rated companies. Moreover, according to
Moody’s, these companies also tend to be smaller and have more leverage
than their higher-rated peers.
We see three additional risks associated with loans from B rated issuers in
The single-B segment of the loan market has a high concentration of
“loan-only” issues, based on data from JP Morgan. Recovery
values on loans without high yield bond subordination have historically been
lower than for those with high yield bonds beneath them.
Issuance of highly leveraged loans resulting from M&A
(merger-and-acquisition) and LBO activity has increased to
post-financial-crisis highs in 2018, according to BofA Merrill Lynch, and
these likely represent more risk than loans issued for general corporate
purposes or refinancing.
Single-B loans constitute almost half of the total leveraged loan market and
are dominated by the technology, services, and healthcare industries, BAML
data show. Both technology and services issuers typically lack hard assets
and, in the event of default, they have the potential for lower recovery
values as a result.
In addition, an incremental technical risk is likely to arise if a significant
number of single-B loans are downgraded to CCC when the credit cycle turns.
CLOs have been the primary buyers of single-B loans; estimates from Citi
Research, LPC, and Moody’s suggest approximately 70% of CLO holdings
consist of single-B loans. Rating agencies typically require that when CCC
holdings exceed 7.5% of assets, CLOs must begin marking those loans to market
rather than at face value, potentially activating an automatic deleveraging
mechanism. With the average CLO already holding 4% in loans rated CCC or
lower, the implications are clear: Downgrades of loans to single-B-minus or
lower may result in sales of those loans, which could exacerbate declining
prices. Currently, issuers rated below single-B with a negative outlook (known
as the “weakest links”) are at their highest level since the
inception of this metric in 2013 (source: S&P LCD).
Yet despite these concerns, the first-lien senior-secured status of bank loans
should continue to ensure that recoveries will, on average, remain higher than
in the high yield bond market, where much of the debt is unsecured and
structural protections in bond documentation have also been weakening.
Additionally, bank loans secured with strong assets and supported with bond
subordination still offer potentially attractive risk-adjusted returns
combined with low duration.
Opportunities for active management
For investors, the impact of the changes in the leveraged finance markets is
twofold. First, historical comparisons of valuations in and between the high
yield and bank loan markets should take these changes into account. Second,
managing credit exposure within these markets has become more important.
Many single-B issuers, especially those with weaker business profiles, high
leverage, and loan-only capital structures, could face challenges in servicing
or refinancing their debt when the economy slows and contracts. Moreover,
price declines for downgraded loans could be exacerbated by potential forced
selling by CLOs to meet the rating agencies’ collateral quality
Given this range of risk among leveraged finance credits, robust fundamental
credit analysis is crucial to select borrowers with the business flexibility
and access to future capital to withstand economically volatile periods.
Accordingly, we favor issuers in industries with stable or improving secular
trends, strong competitive positioning, strong asset coverage, and
loan-and-bond capital structures.
In both markets, active managers with a deep bench of research analysts can
conduct the fundamental credit research to identify and understand the risks.
Choosing the investments that not only offer attractive return potential but
also potentially avoid the risks in today’s leveraged finance market
requires expertise in both high yield and bank loan markets, which, despite
their differences, are still inextricably intertwined.