High-Yield and Bank Loan Outlook: Tight Spreads Call for Caution

The faith-based rally that kicked off 2017 lost steam in March as investors’ expectations for fiscal easing were marked to market. As “Trump trades” continue to unwind, and the Federal Reserve (Fed) raises rates further to contend with a tightening labor market, we expect to see investors take more chips off the table unless we see more concrete legislative progress on fiscal policy in Washington. Given that high-yield bonds spreads have been tighter only 34 percent of the time since 1986, the sector appears vulnerable to spread-widening.

Bank loans continue to look more attractive than high-yield corporate bonds, offering 50 basis points higher yields when measured to maturity. However, yield-to-maturity measures can be misleading in periods of high refinancing volumes, as refis reduce issuers’ borrowing costs at the expense of investors’ spread income. In this report, we discuss our approach to adjusting yield expectations and managing risk amid elevated loan refinancings.

Report Highlights

• The primary issuance market is witnessing a strong resurgence in activity, but refinancing makes up the lion’s share. Combining high-yield corporate bond and institutional leveraged loan issuance, refinancing volume represented 52 percent and 66 percent of total new issue activity in 2016 and the first quarter of 2017, respectively, compared to the 10-year average of 43 percent.
• Borrowers shaved roughly 90 basis points from contractual spreads through refinancing transactions in the first quarter, effectively lowering investors’ spread income. This is something investors should factor into yield expectations going forward.
• Even with adjusted return expectations, bank loans look more attractive than high-yield corporate bonds due to their higher position in the capital structure, their floating coupons, and their lower spread durations.
• In this report we discuss our approach to adjusting yield expectations and managing risk amid elevated loan refinancings.

Leveraged Credit Scorecard

As of 3.31.2017

High-Yield Bonds

Bank Loans

Primary market activity surged in the first quarter amid improved sentiment and strong demand for riskier bonds. U.S. institutional leveraged loan issuance volume totaled $169 billion, up 316 percent from the first quarter of 2016, and above the previous quarterly record of $149 billion set in the first quarter of 2013, according to S&P LCD. The U.S. high-yield market rebounded similarly, with $81 billion of issuance volume during the first quarter, up 125 percent from the $36 billion seen in the first quarter of 2016.

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.

Our research finds that during periods of exceptionally high refinancing activity as much as 45 percent of outstanding loans (by par value) have been refinanced. Should current trends continue—and we expect they will—we could see as much as $352 billion of refinancing volume in the loan market alone by the end of 2017.

Investment Implications

Refinancing activity is ultimately a credit-positive trend when the loan size remains unchanged. The probability that the borrower will default declines as their borrowing cost declines, all else equal, which in turn should help push a default cycle further out into the future. However, we believe investors must manage this risk and adjust return expectations lower.

As a first defense in managing call risk, we constantly evaluate a universe of loans for the likelihood that they will be called soon. As part of Guggenheim’s extensive credit coverage, we monitor loans that are trading above their call price and those nearing the end of their call protection period. More nuanced, issuer-specific reasons might cause a borrower to choose to not refinance a loan, which is information we glean from having long-term ongoing coverage on a particular credit or issuer.

The best line of defense would be to avoid buying a loan at a premium, but this is unrealistic when 70 percent of the universe is trading above par. As a result, investors must adjust return expectations. When a loan is refinanced, the existing loan investor is typically given the option to roll into the new loan. The worst case scenario would be that the loan is taken out by a bond, and the investor’s investment guidelines prohibit rolling the proceeds into the bond. In this case, the investor may earn a negative total return if the loan was purchased above par and it was held for a short period. This scenario is rare, but it happens often enough to note.

Most investors roll into the new loan but must accept a lower spread. In setting more realistic return expectations in this case, a straightforward approach would be to adjust the average loan index spread down by the average contractual spread reduction in recent transactions multiplied by the share of loans we can expect might be refinanced this year.

For example, the average loan contractual coupon was Libor plus 390 basis points as of March 31. A representative portfolio pays roughly this coupon. The average refinancing transaction reduced the contractual spread over Libor by 90 basis points, but not every loan will be refinanced in a portfolio. As we mentioned earlier, 45 percent of all loans were refinanced at the height of a refinancing wave. As such, when calculating expected yields, investors holding a representative portfolio should adjust the spread down by about 41 basis points, which is the average spread reduction of 90 basis points multiplied by the share of loans that might be refinanced. Combining this adjustment with an expected path for Libor would yield a more realistic return projection.

Libor increases should help to offset the spread reduction resulting from refinancing activity, though this is not a foregone conclusion, of course. As mentioned earlier in the report, we currently expect that the Fed will raise rates three more times in 2017 (for a total of four), putting Libor at around 1.90 percent by year end. This means the rise in Libor will offset the reduction in spread income for refinancing activity over the next 12 months under our assumptions, which should support a rise in coupon income. Therefore, despite this high call risk, we continue to expect loans will outperform bonds in the coming years as coupons rise from the Fed raising short-term interest rates.

We maintain a selective approach to opportunities in the high-yield corporate bond market, as spreads are tight relative to historical levels. Our internal credit spread dashboard, which monitors spreads in fixed-income sectors on a time-weighted percentile basis, indicates that high-yield corporate bonds have traded at tighter spreads only 34 percent of the time, with BB-rated and B-rated bonds being even richer than the index. This makes us more cautious when deploying capital. Moreover, spreads tend to widen at this point in the business cycle, as the chart above shows. Industries where we continue to see opportunities include technology, communications, and energy, albeit to a more limited extent. But given tight spreads, an aging credit cycle, and high level of policy uncertainty, we would prefer to buy into weakness.

In reality, the forward curve may already price in some rise in bond yields in the future, and gains from rolling down the yield curve would offset some losses. Incorporating bond convexities would result in a more accurate illustration of bond price movements. Nonetheless, our hypothetical example demonstrates that yield curve positioning can be as impactful as duration when the yield curve is flattening.

In practice, we currently find long-dated taxable municipal bonds to be attractive at the long end of a barbell strategy. They typically offer higher yields than long-dated Treasurys and provide similar duration exposure. Since Donald Trump’s election as president, elevated market uncertainty regarding the federal budget, infrastructure initiatives, healthcare policy, and tax reform has weighed on the municipal market, resulting in some cheapening of municipal bonds relative to Treasurys. Notwithstanding increased policy uncertainty, we still find value in AA and A-rated special tax and monopolistic utility revenue bonds. Like other sectors that have historically carried greater credit risk, we follow a credit intensive approach when selecting municipal securities.

The Future of Core Fixed Income Management

We believe that the surest path to underperformance is to remain anchored to outdated core fixed-income conventions. Traditional core strategies are overly confined to a benchmark that no longer accurately reflects all of the investment options that exist in today’s fixed-income landscape. As such, they restrict portfolios from reallocating toward more attractive opportunities that have emerged as a result of the evolution of U.S. capital markets.

Taking the easy path of bearing greater credit or interest-rate risk to generate incremental yield today may come at the expense of future returns. The accommodative policy stances of major central banks may continue to foster a benign credit environment in the near term, but we believe they are also likely resulting in a general underappreciation of investment risks.

With the chasm between investors’ income targets and benchmark yields likely to persist, traditional views of core fixed-income management need to adapt. Achieving yield targets while maintaining a high-quality portfolio is possible, but it requires a willingness to look beyond the benchmark. In our view, investors must gravitate to sectors where value remains unexploited. This approach demands significantly more credit expertise and ongoing diligence, but it may offer the prospect of superior risk-adjusted returns over time.