Why leveraged loans have followed high yield bonds (Part 2)
If high duration drove the bond sell-off, why did loans follow suit?
This analysis continues from Why leveraged loans have followed high yield bonds (Part 1).
Below are some feasible explanations for why the loan market dropped along with the bond market despite the structural differences of both markets.
Duration
While leveraged loans have a much smaller duration compared to bonds, the floating rates they pay have a fixed component, and additionally, the floating portion may be subject to a floor. For example, you can think of a loan paying L+300 basis points as a loan paying LIBOR (London Interbank Offered Rate) combined with a bond of the same amount paying a fixed coupon of 3%. (Assume the loan interest and the bond coupon are paid at the same frequency.) While the duration of the fixed side is very small compared to a bond with a 7% coupon, for example, it should have a smaller—but still meaningful—effect.
Additionally, since LIBOR is currently at 0.3%, many loans are issued with a LIBOR floor. This means that if, at the time of the interest payment, LIBOR is below the established floor, then the floor applies instead of the current LIBOR. Many loans had floors of 1.00% or 1.25%, and looking at the forward LIBOR curve two months ago, that threshold wouldn’t be exceeded until mid 2016. Again, while the duration contribution of a 1.25% floor would be small, it adds up. The L+300 basis points loan we used as an example starts behaving closer to a bond with a 4.25% coupon.
Relative value
Many institutional fixed income investors are able to invest across both the bond and loan markets. Since bond prices dropping and their corresponding yields going up, loans would need to increase their yield in order to make sense from a relative value perspective.
If a bond and loan for the same or similar companies are yielding of 7% and 5%, and post-correction, the bond now yields 8%, then now the loan isn’t pulling its weight relative to the bond. So the loan gets repriced down to increase the yield.
Cash redemptions
In just five weeks, from the end of May through June, high yield funds saw a total of $12 billion in outflows. This means that fund managers had to sell current positions to raise cash to meet the redemptions. A fixed-income manager with a portfolio of both bonds and loans could sell bonds in a panicking, falling market or instead sell loans to raise cash and deal with the bonds later, when prices stabilize. This approach would reduce the steep discount at which bonds would otherwise have to be sold, and allow the manager to later buy back the loans and sell bonds when prices stabilize. This approach would be beneficial as long as loans didn’t drop more than bonds.
The selling pressure on loans contributed to the loan price drop.
Conclusion
While leveraged loans were able to weather the Bernanke post-FOMC (Federal Open Market Committee) storm, they didn’t pull through unscathed. Loans are structured differently than bonds, but they both belong to the fixed-income class and have overlapping investor bases. It made sense that a dip in one would pull the other down—to a lesser degree, but down nonetheless.
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