Major fundamental changes in the leveragedfinance markets since the financial crisis have resulted in improved creditquality in high yield bonds and greater dispersion in credit quality in bankloans. For investors today, this is a crucial development: In the later stagesof the business cycle, it’s more important than ever to distinguishbetween improving credits and weaker credits that are likely to underperformin an economic downturn.
We think these shifts in the leveraged finance markets underscore theimportance of active management in seeking attractive credits with improvingprospects and potentially avoiding pitfalls. It is also critical that creditportfolio managers have a thorough understanding of both asset classes sincerelative value opportunities between the two can be an important source ofboth alpha and total return.
The changing composition of leveraged finance markets
Historically, the bank loan market was much smaller than the high yield marketbut looked much like it in terms of industries represented − automotive,media, telecom and energy − although higher-risk issuers, such as highlylevered LBOs (leveraged buyouts) and those in sectors undergoing secularchallenges (such as newspapers and yellow pages) gravitated toward high yield.
By contrast, the high yield market in the U.S. has been shrinking modestlysince 2014. The majority of high yield issuance has centered aroundrefinancing as many new issuers, LBOs in particular, have been issuing in theloan market in response to stronger demand and the prepayment optionality itoffers them.
As a result of these shifts, the two markets look very different todaycompared with the pre-financial-crisis period. Notably, high yield has seengrowth in BB rated debt (referring to the debt itself, not the corporate orissuer rating) and a reduction in the amount of CCC rated debt, while the loanmarket has experienced an increase in B rated debt and a decline in BB rateddebt (see Figure 2).
Beyond the increase in B rated loans, a number of other changes in the marketshave also eroded overall credit quality in bank loans. The most important ofthese 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 theformer eroding investor protections and the latter diminishing subordination– a layer of high yield bonds designed to absorb first losses and serveas credit protection for loan investors ‒ Moody’s forecasts a decline infirst-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, wethink investors should take notice. Single-B rated companies tend to haveweaker business profiles, more tenuous competitive positioning or insufficientdiversification compared with BB rated companies. Moreover, according toMoody’s, these companies also tend to be smaller and have more leveragethan their higher-rated peers.
We see three additional risks associated with loans from B rated issuers inparticular:
- The single-B segment of the loan market has a high concentration of“loan-only” issues, based on data from JP Morgan. Recoveryvalues on loans without high yield bond subordination have historically beenlower 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 topost-financial-crisis highs in 2018, according to BofA Merrill Lynch, andthese likely represent more risk than loans issued for general corporatepurposes or refinancing.
- Single-B loans constitute almost half of the total leveraged loan market andare dominated by the technology, services, and healthcare industries, BAMLdata show. Both technology and services issuers typically lack hard assetsand, in the event of default, they have the potential for lower recoveryvalues as a result.
In addition, an incremental technical risk is likely to arise if a significantnumber 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 CitiResearch, LPC, and Moody’s suggest approximately 70% of CLO holdingsconsist of single-B loans. Rating agencies typically require that when CCCholdings exceed 7.5% of assets, CLOs must begin marking those loans to marketrather than at face value, potentially activating an automatic deleveragingmechanism. With the average CLO already holding 4% in loans rated CCC orlower, the implications are clear: Downgrades of loans to single-B-minus orlower may result in sales of those loans, which could exacerbate decliningprices. Currently, issuers rated below single-B with a negative outlook (knownas the “weakest links”) are at their highest level since theinception of this metric in 2013 (source: S&P LCD).
Yet despite these concerns, the first-lien senior-secured status of bank loansshould continue to ensure that recoveries will, on average, remain higher thanin the high yield bond market, where much of the debt is unsecured andstructural protections in bond documentation have also been weakening.Additionally, bank loans secured with strong assets and supported with bondsubordination still offer potentially attractive risk-adjusted returnscombined with low duration.
Opportunities for active management
For investors, the impact of the changes in the leveraged finance markets istwofold. First, historical comparisons of valuations in and between the highyield 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, highleverage, and loan-only capital structures, could face challenges in servicingor refinancing their debt when the economy slows and contracts. Moreover,price declines for downgraded loans could be exacerbated by potential forcedselling by CLOs to meet the rating agencies’ collateral qualityrequirements.
Given this range of risk among leveraged finance credits, robust fundamentalcredit analysis is crucial to select borrowers with the business flexibilityand access to future capital to withstand economically volatile periods.Accordingly, we favor issuers in industries with stable or improving seculartrends, strong competitive positioning, strong asset coverage, andloan-and-bond capital structures.
In both markets, active managers with a deep bench of research analysts canconduct the fundamental credit research to identify and understand the risks.Choosing the investments that not only offer attractive return potential butalso potentially avoid the risks in today’s leveraged finance marketrequires expertise in both high yield and bank loan markets, which, despitetheir differences, are still inextricably intertwined.