Even after a bumper year of investor inflows, high yield bank loans underperformed high yield bonds in 2013. Flows into bank loans, a segment of the overall high yield fixed income market, were north of US$62 billion, and yet the total returns in the high yield bond market were better. Why didn’t all that love from investors translate into better returns?
Bank loans have a couple of relative structural disadvantages when compared to traditional high yield bonds, which can limit their potential for price appreciation. First, bank loans lack call protection. This is a measure of protection for the investor if the issuer decides to pay the debt off early (i.e., call the bond). High yield bonds can contain call protection that bank loans lack. Loan spreads have been flexing lower, and because of the strong demand, issuers are able to quickly call a loan within six months and reissue the loan with a lower spread, thus flexing the spread lower and limiting the ability of the investor to clip a high coupon. This results in a lower total-return opportunity for the investor. Bonds have much longer call protection, which gives an investor the ability to have price appreciation by clipping a coupon.
Second, bank loans are attractive to investors because many have a floating rate based on a spread above LIBOR; this can help in periods where interest rates are in flux. However, a majority of bank loans have a LIBOR floor. The LIBOR floor is the minimum LIBOR rate that the loan will use as a reference. Since most loans have LIBOR floors between 100 and 200 basis points, and since three-month LIBOR is currently around 25 basis points, LIBOR would have to increase by around 75 basis points before loan investors saw any benefit. A drastic move like that is unlikely in short-term rates currently, because while the Federal Reserve is beginning to taper, it’s vowed to keep short-term rates near zero through at least 2015. That could mark another full year of little to no price appreciation on bank loans.
How can one approach the loan-versus-bond trade-off in 2014? The best strategy is probably to combine the two. Loans are a potential lower-risk and lower-return investment alternative to high yield bonds; however, with the Fed moving long-term rates higher, the yield curve is steepening, which creates opportunity for high yield bond investors to gain price appreciation. A steeper yield curve enhances the price appreciation of fixed-rate bonds (especially those bonds with maturities less than five years) to the detriment of floating-rate loans, especially if the yield curve remains steep. During 2013, as the U.S. yield curve moved higher, not all points on the curve moved up by the same amount. The 10-year Treasury increased by around 121 basis points, the 5-year by about 99 basis points…and yet the 2-year only moved up by about 13 basis points. Bond investors are able to gain price appreciation as they roll down the yield curve, especially from five years to two years, clipping a high coupon and shortening their duration.
Something else to consider, high yield bonds don’t add interest risk to a portfolio because of their traditionally low correlation to movement in interest rates. Because high yield bonds trade on dollar price and have more credit risk embedded in their returns than investment grade bonds, the realized interest sensitivity of high yield bonds is typically much lower than what the duration alone would suggest. The correlation is even lower for short-duration high yield bonds, those with maturities less than five years, which makes this an attractive area within high yield.
So for 2014, consider spreading your high yield allocations between loans and short duration high yield bonds around to the benefit of your portfolio.
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