As a high yield fund manager it has been interesting to watch leveraged loans become something of an investor darling this year – almost $13bn has flowed into US loans over the year to date. Investors have sought out loans as a place to hide from a Fed that is raising interest rates, and with the perception that they are a “safer” income provider than conventional bonds.
But is this logic sound? How do loans perform in hiking cycles?
US leveraged loans underperformed US high yield by almost 2% per annum over the 2004-2006 hiking cycle. In a hiking cycle, high yield bonds tend to perform well due to their positive exposure to economic growth, while loans offer far less opportunity for capital appreciation.
And how much safer are leveraged loans? The peak-to-trough drawdown was 95% of that seen in high yield during the financial crisis, while high yield has produced 123% more total return over the last 15 years. In other words, investment in leveraged loans over the past decade and a half has resulted in almost as much drawdown while sacrificing the large profits that could have been made by a long-term investment in high yield (a topic my colleague David Ennett has discussed previously http://bondtalk.co.uk/high-yield/carry-me-home-the-source-of-high-yield-returns/).
Source: Bloomberg as at 31 May 2017
Leveraged loans are also more exposed to problem sectors than high yield. Retailers that are mortally threatened by Amazon make up more of the investable universe in loans than in the high yield universe. Leveraged loans are getting riskier too – in Europe the average secured indebtedness for new loans is almost 70% higher than at the end of 2010. In contrast, European high yield leverage has actually fallen over this period.
From my perspective a well-managed high yield portfolio provides a much better way to generate strong sustainable income versus alternatives such as loans. By investing with high yield teams focused on finding defensively-positioned companies with strong business models, attractive risk-adjusted total returns can be generated. Whether the same can be said for loans remains to be seen…