Comparing leveraged loans and high yield bonds: Interest rates

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Comparing leveraged loans and high yield bonds: A guide (Part 3 of 7)

(Continued from Part 2)

Interest rates

Leveraged loans (BKLN) generally pay a quarterly floating rate, quoted as a spread to a benchmark (for example, LIBOR + 125 basis points). On the other hand, high yield bonds (HYG) pay a fixed interest rate specified by the bond’s coupon.

The fixed nature of the coupon makes bonds susceptible to interest rate changes. When interest rates increase, investors are left with a bond that pays a coupon below the market rate, so the bond loses relative value against newer bonds issued at the new market rate and therefore the price drops. The opposite happens when interest rates decrease, since the bonds pay a higher rate than the prevailing market rate, so bond prices are boosted. The longer the maturity of the bond, the higher the impact to the price, since theoretically, the investor is locked in for much longer (assuming the bond is held to maturity) at the below–market rate yield.

Since leveraged loans pay a floating rate, the interest amount is adjusted up and down based on the fluctuations of the index (e.g., LIBOR). Since the index is a reference interest rate, its moves are positively correlated with the overall interest rate environment, therefore the interest rate on the loan is adjusted accordingly. For this reason, their price is not affected as in the case of bonds.

Some other aspects of difference include security, amortization, maturity covenants, and investor base, as we’ll see in the next parts of this series.

Continue to Part 4

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