Leveraged loans versus high yield bonds
Leveraged loans have been regarded as an excellent alternative to high yield bonds. Given that loans pay a floating interest rate, analysts didn’t expect their prices to remain resilient even if interest rates increased. Actually, a price increase would have made more sense since the interest income would increase.
Instead, loan prices dropped—not nearly as much as bonds (which dropped almost 3% in a couple days), but still significantly. Since then, loan prices have recovered, though bond prices have recovered as well.
In this article, we’ll explore some of the reasons why this is the case. For more on the relationship between leveraged loans and high yield bonds, see this article.
The problem is that leveraged loans aren’t seeing the benefit of increased interest rates. Most loans are priced as a spread to LIBOR (London Interbank Offered Rate), which had been stuck at 0.3% despite the ten-year Treasury spiking from 2.2% to 2.6% in a couple weeks.
New issues are being priced relative to comparable bond issuances since fixed-income investors want to get the benefit of the increased yield of comparable bonds. Existing loans should actually drop in value to reflect the fact that an investor is better off investing in comparable bonds than a loan.
The relative value versus the Treasury curve makes no sense. For example, why would an investor buy a below-investment-grade loan that pays L+200 and get 3% (assuming a 1% LIBOR floor), when by the end of next year, most major banks are predicting the ten-year Treasury to yield 4.00% risk-free?
Continue to Part 2
More From Market Realist
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- Loan managers see healthy outlook for the loan market
- Amidst a high yield turmoil, leveraged loans keep hoarding funds
- floating interest rate