These exceptional new issuance volumes were driven by a resurgence in refinancing activity as borrowers opportunistically reduced the cost of debt outstanding. The significant increase in refinancing activity in 2016 and early 2017 contrasted with the previous three years, which saw consecutive declines in the refinancing share of total new issue volume. Refinancing historically averages 43 percent of total new-issue volume across high-yield corporate bonds and bank loans. In 2016 and the first quarter of 2017, however, it totaled 52 percent and 66 percent of volume, respectively. Issuers in oil and gas, services and leasing, and cable industries represented a combined 32 percent of all refinancing volume since January 2016.
Refinancing activity and strong demand from institutional investors and mutual funds have pushed yields much lower, particularly for high-yield bonds. As of the end of March, high-yield corporate bonds yielded 50 basis points less than loans, compared to an average spread over loans of 110 basis points between 1992 and 2016. In light of this relative value proposition, we favor loans over high-yield corporate bonds. Loans’ seniority in the capital structure and secured status also make them attractive, as we have noted in past reports. We also favor bank loans’ floating coupons, which are benchmarked to the three-month London Interbank Offered Rate (Libor), since we believe that Libor will rise more quickly than markets are pricing in. Nevertheless, loan investors must be mindful of elevated call risk in light of heavy refinancing activity.
Refinancing risk can be managed more easily in bonds, as they are often quoted on a yield-to-worst basis, allowing investors to set appropriate return expectations. High-yield bonds also have better call protection than loans—typically five years at issuance. In contrast, loans can be called at any time, though issuers pay a small premium if they are called within the call protection period.
We believe refinancing activity will be a key performance driver in the bank loan market in 2017, and potentially into early 2018. Given that call activity generally reduces the spread over Libor an investor earns on the loan, adjustments should be made to current spreads and return expectations over the next five to seven years.
Drivers of Refinancing Activity
A refinancing transaction occurs when a loan issuer retires an existing loan with proceeds of a new loan issued in the primary market. This is typically motivated by the issuer’s ability to reduce borrowing costs due to an improvement in market conditions. Refis can be accompanied by other changes to the loan terms, such as an elimination of a Libor floor, an extension of the life of the loan, or an increase in the size of the facility. Refinancing activity rises when loans trade above par in the secondary market, as this implies that investors are willing to accept a lower yield than when the loans were issued. These conditions are prevalent in today’s market.
Loans are often quoted based on a yield to maturity or a three-year yield, which assumes that the loan will be refinanced in three years. If the loan is trading at a discount, the yield includes gains expected to occur as the loan price converges to par. In our view, a theoretical three-year yield estimate seems unrealistic in the current environment given that the average life of loans repriced since the second quarter of 2016 was only 17 months.
Newly originated loans now typically carry six–12 months of soft call protection, which means the borrower must pay a premium—often 1 percent, but sometimes 2–3 percent of the par value—to voluntarily call the loan within the protection period. Given this limited protection, investors should look to the primary market first in search of attractive loan opportunities before risking paying above par in the secondary market. However, primary market issuance has not been strong enough to meet the incremental demand from collateralized loan obligation (CLO) originations and bank loan mutual fund inflows. S&P LCD data indicate that the shortage of institutional loan supply has totaled $84 billion since the second quarter of 2016, an average of $7 billion per month. This has pushed buyers into the secondary market.
With the backdrop of insufficient primary market supply relative to visible inflows, buyers become price takers from sellers in the secondary market. The Loan Syndications & Trading Association reported that the median price of secondary loan trades exceeded 100 percent of par in September 2016 and has remained above that level ever since. Strong investor demand has resulted in over 70 percent of loans in the Credit Suisse Leveraged Loan index being quoted at prices above par as of the end of March.
Approximately 40 percent of loans in the Credit Suisse Leveraged Loan Index maturing after 2017 are no longer call-protected. Of those loans for which we could obtain a price, 47 percent were trading above par, and 8 percent were trading above 101 percent of par, putting the call option in the money (meaning the loan’s price was above the strike price of the call option). If the borrower calls the loan at some point this year, a recent buyer might clip a coupon or two but would lose the premium paid. Any reinvested proceeds would subsequently be invested in the new loan at a lower spread. Market forces may cause the new loan to also trade at a premium above par, as has been the case recently, but this outcome should not be expected.