Sub-investment grade debt: Blended risk

Of all the changes in the sub-investment grade capital markets over the last decade, the blurring of the boundary between loans and bonds might have the most lasting impact. 

It has spurred consistent growth in multi-asset strategy funds on the buyside, through which leveraged loans and high-yield bonds are managed together in a single strategy. This has spurred demand for both. The traditionally very different instruments are increasingly being treated as one and the same.

To some degree, this has come about because of the convergence in investor protection that has taken place over 10 years of quantitative easing and a relentless search for yield. High-yield bonds have historically incorporated just incurrence covenants – covenants that are put in place at the time of the deal – while loans have also involved maintenance covenants as well, which must be complied with throughout the term of the loan. 

This was because loans were traditionally held by banks on their balance sheets and bonds were sold into the market. The latter were seen as riskier and lower down the capital stack than loans. 

Not so any more. The two instruments now often rank pari-passu in the capital structure, and the vast majority of leveraged loans now issued are covenant-lite, carrying just incurrence covenants (by May 31 last year, 77.4% of US leveraged loan outstandings were structured as such). Banks also syndicate them into the market like bonds rather than keeping them on balance sheet. 

Interchangeable

The two instruments are therefore now largely seen as interchangeable. And they are – in as much as they are both syndicated and sold to pretty much the same institutional buyers. 

The regulators don’t see it that way though. In early April, UBS fired its head of leveraged finance in the Americas, James Boland, for failing to inform superiors that a $250 million bond deal that the bank was working on for Ares Management had been reclassified as a loan (the case is currently in arbitration). 

This was important because leveraged loans are subject to regulatory guidelines and bonds are not. In 2013, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued guidelines stating that banks should not lend to corporates with leverage multiples of more than six times ebitda. UBS’s US operations fall under these guidelines. 

The Ares deal is understood to have been switched from a bond to a loan because the disclosure requirements of a bond could not have been met. 

High-yield bond disclosure requirements are usually limited to information that is publicly available, but leveraged loans have historically been private instruments. 

Other than this, the risk being syndicated to the market is pretty much the same, as, most likely, the buyers would have been. 

The purpose of the deal is not confirmed – issuers have tended to opt for high-yield bonds for refinancings and leveraged loans for leveraged buyouts.

Difference

There is, however, one very important difference between loans and bonds: loans are floating rate and bonds are fixed rate. This has stoked a surge in investor appetite for leveraged loans because floating rate instruments offer protection in a rising rate environment. 

There are signs, however, that as the prospect of further rate rises in the US recedes, appetite for the leveraged loan asset class might finally be impacted. Analysts at S&P Global Intelligence recently noted a rise in bond-for-loan takeouts to $12 billion: transactions that involve refinancing leveraged loans in the high-yield bond market are now taking place at their fastest pace since the first quarter of 2017. 

And retail investors – a key marker of broader sentiment, although they only account for 12% of the leveraged loan market and 24% of the high-yield bond market – pulled $23.6 billion from US loan funds between January and March this year. 

On April 16 the S&P/LSTA Leveraged Loan index had returned 6.76% year to date, while the ICE BAML US High Yield index had returned 8.59% in the same time.

The leveraged loan market is now more than $1 trillion in size. According to Citi, LPC and Moody’s, 70% of CLO holdings are single-B rated loans, so that means that there is an awful lot of risky paper in these vehicles. 

Moody’s recently highlighted a series of structural weaknesses in collateralized loan obligations, such as looser standards for amending indenture terms, weaker trading rules that are meant to limit risk taking, and collateral quality test adjustments that can worsen CLO risk profiles. 

Breather

If the leveraged loan market is now poised to take a breather, that is probably no bad thing.

With the Fed on hold for now, the pendulum of issuance seems to be swinging away from the loan market back towards high-yield bonds. This would go some way towards rebalancing the sub-investment grade debt market. 

It is also another illustration of how QE-driven investor demand for sub-investment grade products has crushed the idiosyncratic risk characteristics of loans and bonds under its weight. 

The decision to issue or buy loans or bonds seems to now boil down to an assessment of the chance of further rate hikes in a highly charged political atmosphere more than to the inherent nature of the instruments themselves.

If everyone in the market views leveraged loans and high-yield bonds as essentially different sides of the same coin, maybe the regulators should start to look at them that way too. 

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