Why Leveraged Loans Are Closing In on Junk Bonds

Art by Qieer Wang

The once ho-hum bank loan is gaining ground among speculative credits. In the volume sweepstakes for below-investment-grade financing, leveraged loans are relentlessly closing the gap with high-yield bonds.

Thanks in part to their more flexible, floating-rate structure—a plus as interest rates rise—these loans are increasingly the debt instrument of choice for American corporate speculative debt issuers. Some 60% are used for mergers and acquisitions, which lately are on a tear. Amid a burst of US economic growth, spurred by the new federal tax cuts, such companies are increasingly opting for leveraged loans, which have another advantage (for issuers) over high-yield bonds: cheaper coupons.

Leveraged loans, so-called because the banks are lending to highly indebted companies, have come a long way. In 1998, the loans were dwarfed in volume by junk bonds, as high-yield paper also is known, by a 7 to 1 ratio. Loans first began a heady expansion in the M&A-happy years before the financial crisis, almost reaching parity with junk bonds, but then shrank as deals did.

As the economic recovery took hold, loans began their current surge. By 2010, loans were about half the size of junk. As of mid-year 2018, the amount of outstanding leveraged loans stood at a par value of $1.04 trillion, versus $1.28 trillion for junk bonds. The dollar volume of loans has enlarged by 12% from 12 months before, while the bonds are about the same.

“This late in the economic cycle, with so much [government] stimulus, boards of directors are asking themselves how they can take advantage” by expanding via acquisitions, said Jim Schaeffer, the deputy CIO at Aegon Asset Management, who also co-heads public fixed-income. “And more of them are turning to leveraged loans” to make that happen.

Underlying this trend is the transformation of bank loans into tradable assets, which caught on during the 1990s. These days, institutions are eager buyers of this bank debt, even though its yields trail junk’s average, now about 6.5%, by 0.75 percentage point. Enticed by the loans’ flexibility—in particularly their floating rates, which high-yield bonds don’t feature—institutions ranging from insurers to hedge funds lately are snapping up the loans.

The loan market has major support from securitization, allowing banks to sell their loans to sponsors of collateralized loan obligations (CLOs). Formed by such financial heavyweights as BlackRock, Credit Suisse, and Prudential, CLOs now control two-thirds of the leveraged loan market, according to LCD, an offering of S&P Global Market Intelligence.

These asset pools “have been a big catalyst for the loan market,” said Frank Ossino, senior portfolio manager at Newfleet Asset Management. The result: Loans are less of a retail product than is junk, whose prices often track the gyrations of stocks.

The upshot for loans is better price stability. “Due to that institutional buyer base, loans are less volatile,” noted Gautam Khanna, senior portfolio manager at Insight Investment.

Individual investors can invest in leveraged loans through floating-rate mutual funds. In perhaps a sign of the times, Lipper data show that loan funds have a $16 billion net inflow of investments this year—largely thanks to rising rates, a study by Newfleet said—while high-yield funds have suffered a $30 billion outflow.

Certainly, junk will remain a big part of the financial landscape, particularly with M&A. They have been central to the leveraged buyout (LBO) scene since Michael Milken’s day, and have fewer restrictions than loans, hence bonds tend to be easier to restructure if bad times befall an issuer.

Deals commonly contain both loans and junk, and have since the 1980s LBO era. This dual arrangement gives the capital structure more diversification, with loans providing interest-rate protection and bonds the chance of more capital appreciation. The mix is tilting toward loans, however.

Tellingly, a Blackstone Group-led buyout of the Thomson Reuters data business called Refinitiv is made up of far more loans than bonds. Announced in September, the deal has $9.25 billion in loans and $4.25 billion in bonds. This transaction, the largest leveraged buyout of 2018, gives Blackstone and its partners a 55% stake in Refinitiv. There are several tiers of bonds and loans—the biggest junk stratum has an 8.25% coupon and the biggest leveraged loan one is 3.75 percentage points over Libor, which currently means an interest rate of 6.19%.

From issuers’ and investors’ perspectives, the growing popularity of leveraged loans, compared to high-yield bonds, can be explained this way:

For Borrowers. Obviously, corporate issuers like loans’ lower rates, which holds down their interest outlays. Beyond that, loans are callable from the get-go, a flexibility that is appealing to companies. If interest rates dip, and issuers wants to refinance, then it is easy.

Bonds, on the other hand, typically aren’t callable for three to five years. LBO operators often want to sell their acquisitions around three years after the deal, so they are boxed in with bonds, said George Goudelias, head of leveraged finance at Seix Investment Advisors.

For Investors. The floating rates, at least at a time that rates are ascending, is comforting. Loan payments will keep up with the market. Further, once a recession hits, pushing many speculative-grade companies into default or bankruptcy court, loans offer better protection for investors than bonds.

The reason: Loans are secured debt and rank higher in the credit spectrum than bonds do. Thus, chances are investors will tend to come out better. How much better? Moody’s data indicate that investors historically have recovered 77% of a leverage loans value, and junk bonds about half that. A word of caution: The credit-rating agency warns the increased issuance has led to a decline in loan credit quality, and the recovery rate might slip to 61%.

The bright side, Aegon’s Schaeffer pointed out, is that loan covenants—limitations on what issuers can do—are a lot less constraining these days for many loans and bonds. “Covenant lite,” he added, “will buy them time,” giving managements more leeway to fix problems before defaulting.

To be sure, once rates stop climbing and M&A flags, loans will lose some of their desirability. Right now, though, as their volume keeps growing, time is on leveraged loans’ side.