If there was any question about it, the financial crisis of 2008 demonstrated to us all just how flawed the rating process is.  However, in the aftermath, it has also become clear that changing that ratings process is exceedingly difficult, if not impossible.  We have seen more stories hit this week that outline just how little progress has been made in trying to address the ratings agency model.

Several years ago when we wrote the first version of our New Case for High Yield, we discussed the problem we see with credit ratings:

Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions.

Credit ratings are not going away, as they are too ingrained in the system.  And frankly, we feel that is to our benefit.  We will take advantage of others who blindly rely on these ratings to make investment decisions or who have investment policies that restrict investing in certain ratings category; that has created the investment opportunity for us for years in the high yield market, and seems it will continue to going forward.

Investing in the leveraged loan market has been a popular strategy so far this year.  YTD, inflows into loans have totaled $23billion, well above the prior FULL YEAR record of $17.9billion seen in 2010.¹  This spike has been driven by a recovery in CLO (collateralized loan obligation) issuance and interest rate concerns.

Broadly looking at the leveraged loan market versus that of high yield bonds, we still favor high yield bonds.  First, we have spoken in the past about how much of the high yield market is constrained by call prices, but that is even more of an issue in the leverage loan space.  In the loan market, you largely don’t have the same sort of early redemption provisions with call prices at a nice premium to par, usually starting at $104 or $105.  Instead, a company would generally have to pay either $100 or $101 to redeem a loan early.  So, in an environment where an astounding 86% of the loan market (per the JP Morgan Leveraged Loan Index) trades at a price of par or higher², loans are even more return constrained by call prices.

Along these lines, we are seeing a massive amount of the loan market repricing/issuing, so realizing these early redemptions is a definite reality.  Year-to-date, we have seen $305billion in leveraged loans issued, surpassing the FY amount of $300.5billion seen in 2012, and on track to surpass the record issuance of $388billion seen in 2007.³

According to JP Morgan, 22% of the institutional leveraged loan market has re-priced year-to-date.⁴  Furthermore we are seeing loans getting re-priced just months after the initial deal priced.  And while all of this re-pricing hurts existing loan holders, it does help us as bondholders in the same structure because it lowers the interest cost on the debt ahead of us, allowing for further free cash flow generation.

Something else to keep in mind for those piling into the loan market: LIBOR floors.  Much of the demand for this asset class has been driven by interest rate concerns.  The concept is that leveraged loans have floating rates, so if there is a rise in rates, there would also be an immediate rise in your coupon income from these loans, providing an effective interest rate hedge/protection.  However, a huge portion of the loan market, especially on the newly issued loans, contains LIBOR floor provisions generally of at least 1% or higher.  3-month LIBOR, which is what loans are generally based on, is currently just under 0.30%.  So the reality is that we would need to see a pretty sizable move in rates before any benefit is realized to the “floating” rate income provided by the loans.  Second, it should be kept in mind that just because Treasury rates move, that doesn’t translate to a perfect move in LIBOR.

Finally, the leveraged loan market is often thought of as lower risk than high yield bonds.  In many cases that is true: in cases where a company’s capital structure consists of both loans and bonds, the loans would rank higher than the bonds in the event of a default.  But the problem is that not all capital structures have both loans and bonds.  Rather, with the strong market demand for loans over recent history, and the lower coupon payments that a company would have to pay in issuing loans versus bonds, we have seen companies turn to the loan market for funding of their entire capital structure. This means that a company can be just as or even more highly levered through a loan than another company is through a bond.  Absurdly, just because it is called a “loan” instead of a “bond” the holder would most likely get a lower coupon payment.  Additionally, we also saw a strong technical loan market back in the height of LBOs (2005-2007), making many of these high-leveraged LBO structures very loan heavy.  In fact, during that 2005-2007 period, LBO issuance accounted for 50% of the institutional leveraged loan market use of proceeds versus only 10% in the bond market.⁵  Many of these loans have just been amended and extended, so are still outstanding today.

As we consider the primary risk that we see in the credit markets—default risk—the default rate is actually currently higher in the loan space versus in high yield bonds, with an LTM default rate of 1.42% for loans and 0.93% for bonds.⁶  And as we look at risk going forward, we see the proliferation of “covenant-lite” (or lack of covenant protections for loans holders) as a definite negative development for future prospects in the loan space.⁷

So at the end of the day, we still favor the high yield bond market, focusing on the names that we feel still offer attractive yield and potential upside.  While there have been some concerns that demand has driven out opportunity in the high yield space, we see that as much more evident in the loan world.  In the high yield market, with the flexibility of active management, we are still finding attractive credits in an environment of low default risk.

¹  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Credit Strategy Weekly Update,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, May 10, 2013, p. 4.

²  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Credit Strategy Weekly Update,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, May 10, 2013, p. 5.

³  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Credit Strategy Weekly Update,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, May 10, 2013, p. 45.

⁴  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Credit Strategy Weekly Update,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, May 10, 2013, p. 5.

⁵  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Default Monitor,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, April 30, 2013, p.13.

⁶  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Credit Strategy Weekly Update,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, May 10, 2013, p. 48, 49.

⁷  Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, and Rahul Sharma, “Default Monitor,” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research, April 30, 2013, p.13.