September 24, 2012 11:38 pm

Loans v bonds – fight for yield

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Rally in junk has thrown the relationship with leveraged loans out of whack

Junk bonds have been on a much-publicised bull run this year. The fever for yield has given junk’s lesser-known cousin, leveraged loans, less of a boost. This year, high-yield bond funds have taken in $34bn, increasing assets 15 per cent, versus $5bn and 8 per cent for loan funds, Lipper data show. In the US, banks provide loans, but typically sell a portion of the debt on to mutual funds (such as Eaton Vance’s $7bn Floating-Rate Fund) or hedge funds. Loans are also packaged into collateralised loan obligations, which issue shares to institutions.

The rally in junk bonds has thrown their relationship with leveraged loans out of whack. Lenders are repaid before bondholders in bankruptcy. Since 1988, investors have on average recovered 80 per cent of par in bank debt after defaults versus 48 per cent in senior unsecured bonds, Moody’s says.

Companies, therefore, have historically paid 100 to 200 basis points less in interest to borrow with loans than bonds. Now the difference is 30 to 50bp. In the past month, single B loans were issued with average yields of 6.6 per cent whereas new single B bonds were 6.9 per cent, according to Standard & Poor’s Capital IQ LCD.

The compressed spread makes loans look relatively cheap. But a big selling point for leveraged loans is that, unlike fixed-rate junk bonds, they pay floating rates, so buyers benefit when rates rise. That might not come in handy soon: the Federal Reserve has pledged to keep rates near zero until mid-2015. A falling rate environment could be positively painful. Companies can usually pre-pay the loans at any time, leaving investors to reinvest at lower rates.

But it looks like loans will only prove a true bargain in the near term if US employment data defy expectations and improve enough to make a very determined Fed back off. Optimists, step right up.

Email the Lex team in confidence at lex@ft.com

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