The Sand Continues to Shift in High-Yield Bank Loans

Ashish Shah

Investors continue to pour money into funds that invest in high-yield bank loans, reciting the numerous perceived advantages of this asset class. But investors’ thirst for loans is encouraging borrowers to be aggressive, and the risks seem to be rising. Here are three commonly cited benefits of high-yield bank loans, and our take on why they may not hold true.

“Since loans are higher than bonds in a company’s capital structure, I’ll be able to recover more of my investment if the company goes bankrupt.”

That’s seems like a nice idea, but specific loans may not have that advantage. The term to watch out for is “covenant-lite.” Bank loans have traditionally offered lenders the protection of written covenants that require the borrower not to exceed a certain level of debt; lenders can negotiate a higher interest rate or even a restructuring if the company exceeds the limit. Covenant-lite loans don’t provide that protection.

More than 50% of loans offered today are covenant-lite, almost double last year’s percentage, as the display below shows. Why such a huge increase? In part, it’s due to record issuance of collateralized loan obligations (CLOs). Companies are increasingly tapping the high-yield loan market rather than the high-yield bond market to gain attractive terms on loans. Issuance of Hogh-Yield, Covenant-Lite Loans Has Increased Dramatically

The leveraged loan market is dependent on CLO investors for demand. CLOs represent roughly 45% of current leveraged loan buyers, according to Fitch Ratings. And as CLOs are increasingly allowed to hold bigger percentages of covenant-lite loans, CLO demand for covenant-lite loans increases even further.

“Since bank loans pay floating-rate coupons, they’ll beat bonds if interest rates rise.

Here’s the secret—many bank loans are issued with a “floor,” and their coupon rates are now structured to float only after interest rates have risen above a specified benchmark by a certain amount. Often, the floor is 1% above the London Interbank Offering Rate, or LIBOR.

The idea of sacrificing yield in exchange for floating income may have seemed like a good idea before the Federal Reserve said it would keep rates low for quite a while. But as long as the Fed doesn’t change its mind, the floating-rate loan seems less appetizing.

“I’ll get a better yield on high-yield bank loans than I could anywhere else.”

The reality is that the stated coupon on high-yield loans is declining. Borrowers can repay the lender anytime they want at the loan’s face value, often to take out a new loan with a lower coupon rate. That’s just what’s happened as rates have dropped. In the last two months, 15% of high-yield loans were refinanced, reducing the coupon rate by more than 1% on average.

Why aren’t investors seeing the shortfalls in the perceived benefits of high-yield loans? Because lower coupon rates have not stood out during the recent market and economic upturn. But these loans could tumble as much as high-yield bonds in a major downturn. When this happened in 2011, bank loans provided only half the upside of bonds, but all of the downside.

What can investors do differently? One place where they can find less interest-rate risk and a healthy yield is in short-duration high-yielding bonds. We think these bonds provide a better sense of what you’re likely to earn and how long the income stream will last.

Bank loans have their place in a diversified portfolio, but before you buy, do the research and understand exactly what you’re getting.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

Ashish Shah is Head of Global Credit at AllianceBernstein.

4 comments

  1. Scott Vineberg

    Helpful observations. Based on the % of loans being issued as covenant-lite, what inning of the credit cycle do you think we are in? Or has QE altered the credit cycle as we know it?

    • Ashish Shah

      Based on corporate behavior, I believe that we are somewhere in the fifth or sixth inning–which means there are probably around 18 months to two years left untl the peak. As you know, timing to peak is tough to do, as it is a function of investor behavior. For the most part, we have still observed investor discipline, but as noted we””ve begun seeing a weakening of that disicipline. In general, the quality of outstanding high yield today is far superior to what we saw in 2007.

  2. Ashish,
    How do these differ from “floating rate senior loans”- and
    your thoughts on these. And does alliance bernstein
    have a mutual fund that uses these.
    “OOSYX” is from Oppenhemier we are looking at.
    thank you.

    • Ashish Shah

      The loans I refer to in the article are the same as “floating-rate senior loans.” We currently and in the past have allocated to senior loans in our portfolios, but we are selective about which ones we choose. We look for solid companies that are issuing loans with good structures.

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