Do you still like credit risk? If so, you may want to look at high-yield bonds or leveraged loans.
Both markets have held up remarkably well so far this year. While rising interest rates have clobbered both investment-grade and emerging market bonds, high-yield debt in the form of bonds and loans has performed well.
Prices have fallen with the rest of the bond market recently, but the Bloomberg Barclay’s U.S. Corporate high-yield index had a total return of 1.05 percent through Oct. 11. Floating-rate leveraged loans remain the hottest segment of the fixed-income market. The Credit Suisse Leveraged Loan index was up 4.46 percent through Oct. 11. High-yield funds are experiencing outflows this year, but cash continues to pour into leveraged loan funds.
The strength of the U.S. economy is driving performance in both markets.
“The rest of the world is having a hiccup, but the U.S. economy is in great shape,” said Elaine Stokes, a portfolio manager and fixed-income strategist for asset manager Loomis Sayles. She thinks tax cuts and government spending will continue to drive growth in the U.S. economy. “It’s late in the cycle but still too early to get out of high-yield debt.”
Stokes believes that the U.S. economy will remain strong, but not so strong that the Federal Reserve picks up its pace of monetary tightening. She expects a rate hike this month and gives 50/50 odds on another in December. “We’re still on a very slow pace towards higher interest rates,” she said.
The 6.6 percent yield on the high-yield index remains attractive when you consider alternatives. But sharply rising rates don’t help. That’s the main reason the market has shifted dramatically toward leveraged loans. With floating rates pegged to the three-month LIBOR, leveraged loans made to non-investment-grade companies protect against rising interest rates. They also retain seniority in the capital structure over bonds.
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“Interest rates are going up, and if you’re in fixed income, there aren’t a lot of good places to go,” said Michael Terwiller, a portfolio manager at investment firm Resource Alts. “I would prefer being in loans with floating rates at the top of the capital structure than in high-yield bonds.”
Doug Peebles, CIO of fixed income at Alliance Bernstein, thinks that bank loans are not what they seem and that investors should be wary. “Loans are the easiest elevator pitch in the markets now,” he said. “They’re senior secured, and they have floating rates.
“I understand why they’re being sold, but senior secured doesn’t mean good credit quality,” Peebles added. “There is deep credit risk involved with these loans.”
Peebles also doesn’t think that leveraged loans live up to their promise of higher income in a rising rate environment. The reason is that loans are callable, and when demand is as strong as it has been for the last year, companies regularly refinance on better terms even as rates are rising. Last year 73 percent of loans were refinanced. That results in lower returns for investors, said Peebles.
Like many others, he also believes the risks of leveraged loans could be much higher this cycle. For one thing, loan covenants — the terms that protect the interests of lenders — have never been weaker. Prior to the financial crisis, approximately 20 percent of loans — i.e., the best credits — were labeled “covenant lite” because of their lesser protections.
Now 80 percent of the market is covenant lite. The looser terms may not make them any more prone to default — in fact, it makes them less so in the short term — but the recoveries for lenders if they do hit the wall could be a lot less than the historical 70 percent to 80 percent average.
Companies are, of course, tapping the torrid demand for floating-rate loans, often to finance mergers and leveraged buyouts. According to Moody’s research, the market has grown to nearly $1.5 trillion this year, surpassing the high-yield bond market, which is actually now shrinking.
There has been a notable lack of high-yield bond issuance this year, particularly by lower-quality CCC issuers. “There’s no data that shows lower credit quality for loans, but I’ve got a hunch that the riskier deals are getting financed with bank loans,” said Peebles.
Stokes, for one, is not overly concerned with the weakening covenants on bank loans. “It happens every cycle,” she said. “I don’t see it as dramatically different this time around.” But she is worried about the liquidity of leveraged loans. “We favor high-yield bonds,” Stokes said. “They have better carry [income] and much better liquidity than bank loans.”
Liquidity may eventually be the biggest issue for investors in leveraged loan funds, which now manage over $152 billion in assets as of Sept. 30, according to Morningstar.
Loan funds present a classic liquidity mismatch. They invest in illiquid loans that are notoriously hard to sell, but offer daily redemptions to fund investors. If and when the market turns, funds could be forced to sell into falling markets. “The price drops could be bigger than people expect,” said Peebles.
Terwiller, who invests in leveraged loans, agrees that liquidity could be an issue. “It’s a hugely underappreciated risk in the market and most people don’t know they’re running it,” he said.
Terwiller plans to take advantage of the situation. His unconstrained 40 Act fund allows him to invest wherever he chooses and to lever up the fund by as much as 30 percent. It also provides only quarterly redemptions to investors. That could help him weather panics in the market and even potentially buy assets at fire-sale prices.
“It gives us options,” said Terwiller. “If we think the sell-off is going lower, we can sell into it, or we can use leverage to buy when others are selling.
“The return potentials could be huge.”
The risks are pretty huge, too.
Both high-yield bonds and leveraged loans are priced to near perfection, with credit spreads still hovering at historic lows. They are a bet on the U.S. economy and that it will be another year or two before the cycle turns.
You don’t want to be in either market when the downturn comes.