Pairing Short Duration High Yield with Bank Loans
Between bond purists and bank loan enthusiasts, there exists a little bit of rivalry. Those backing the loan horse will tell you that loans are senior in the capital structure, are secured by assets (much of the high-yield market is unsecured) allowing them greater recovery rates, and have almost no duration. They will tell you that their coupons increase with interest rates, allowing investors to potentially earn attractive yields – which is counter to the conventional wisdom that bonds are negatively impacted by rising rates. They will most certainly show you that bank loans exhibit less volatility than high-yield bonds. And, they would be correct.
The other side will tell you that loans have negative convexity – the yield curve property which effectively puts a ceiling on the price of a security since they are callable at any time (after an initial period of soft call protection), are less liquid, and generally offer less total return potential than bonds. It would be difficult to poke holes in the bond purist argument. They, too, are correct.
How do we settle this? Let’s start by looking at investor behavior.
Figure 1: High-Yield Flows Are Erratic, While Bank Loans Follow a Trend
Source: JP Morgan, as of 9/30/17. Chart created by NYLIM. Asset class flows include mutual funds and ETFs.
What immediately stands out upon looking at fund flows (Figure 1) over the last two years is that high-yield flows appear to be erratic, whereas loan flows follow more of a trend. During the period shown, high yield performed very well, yet flows were still inconsistent. On the other hand, as the London Interbank Offered Rate (LIBOR) pushed through LIBOR floors and rhetoric surrounding the Fed raising rates became more prevalent, investors flocked into bank loan funds in order to take advantage of the floating rate feature of the asset class. More recently, inflows into loans subsided and even turned negative, perhaps as there was a growing perception of a more measured pace of interest-rate hikes than originally anticipated.
For investors looking to reduce their exposure to loans, or for those simply trying to determine how to most efficiently play the below-investment-grade space, we have an idea for you.
Pair a Bank Loan Allocation with Short Duration High Yield
In What Does Short Duration Mean for Credit-Sensitive High Yield?, we discuss the benefits of short duration high yield, and the idea that it is a higher-quality, lower-volatility segment of the broader high-yield market. It is a “high-yield lite” strategy that has historically underperformed the broader high-yield market during rallies, and outperformed during periods of spread widening.
Figure 2: Over 60% of Issuers in the High-Yield and Loan Indices are Unique to Those Indices
Sources: Morgan Stanley Research, Citigroup Index LLC, S&P LCD, and Bloomberg, as of 10/13/17. High Yield represented by Citi’s US High-Yield Market Index. Loans represented by S&P/LSTA Leveraged Loan Index.
In addition to the varied features of each of the asset classes, they have a significant number of unique constituents as well. In Figure 2, you can see that the Citigroup High Market Yield Index contains 478 issuers that are not in the loan index. Therefore, by pairing the asset classes, an investor gets exposure to a diversified set of credits.
From among traditional high yield, short duration high yield, and leveraged loans, one might expect longer duration high yield to offer the greatest yield, as it carries the most risk. Similarly, an investor might expect loans to compensate investors the least for their lack of duration and relatively senior position in the capital structure. Figure 3 shows that over the last five years, these expectations have held up, although there have been periods in which the yields of short duration and bank loans converged. An investor’s risk tolerance should dictate the allocation across loans and bonds, and allocating to both may be a prudent way to generate a diversified stream of income.
Figure 3: For the Past Five Years, Bank Loan Yields Have Remained Range-Bound
High-Yield, Short-Duration High-Yield, and Bank Loan Yields: 2012-2017
Sources: Bank of America Merrill Lynch, S&P/LCD, as of 9/30. Chart created by NYLIM. Bank Loans represented by the S&P/LSTA Leveraged Loan Index; Short Duration High Yield represented by the BofAML US HY Corporate Cash Pay BB-B, 1-5 Year Index; High Yield is represented by the BofAML US High Yield Master II Index. Bonds are measured by yield to maturity and loans use effective yield, which is defined as nominal yield/average bid price. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Likewise, over the last 15 years, short duration high yield has outperformed leveraged loans in almost every calendar year, as seen in Figure 4. In 2015, when bonds sold off amid energy concerns, bank loans held up a bit better. The financial crisis is somewhat of an anomaly, as loans exhibited a higher beta with respect to bonds, due to technical nuances; however, we expect loans to maintain a lower beta in the future.
In addition to charting the performance of short duration high yield and bank loans, we show the volatility of bonds as a percentage of loan volatility. In other words, how much added risk does an investor take on to generate the excess return from short duration high yield?
Figure 4: What Is the Cost of Short-Duration High-Yield’s Extra Returns?
Returns vs. Incremental Volatility
Source: Morningstar, as of 9/30/17. Chart created by NYLIM. Bank Loans represented by the S&P/LSTA Leveraged Loan Index; Short Duration High Yield represented by the BofAML US HY Corporate Cash Pay BB-B, 1-5 Year Index. RHS = Right-Hand Side; LHS = Left-Hand Side. Volatility is measured by standard deviation of returns. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
For bank loan investors looking for the potential for diversification and enhanced total returns, but wary of putting money into high yield because of tight spreads, short duration high yield may be the perfect complement. In Figure 5, we examine the pairing from a portfolio perspective.
Figure 5: Increasing Portfolio Efficiency with Short Duration High Yield
Efficient Frontier: Return vs. Standard Deviation
Source: Morningstar, 10/02 – 9/17. Chart created by NYLIM. Core Bonds represented by the Bloomberg Barclays Aggregate Bond Index; Bank Loans represented by the S&P/LSTA Leveraged Loan Index; Short Duration High Yield represented by the BofAML US HY Corporate Cash Pay BB-B, 1-5 Year Index. Risk is measured by standard deviation of returns. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
The efficient frontier analysis uses historical data spanning the last 15 years, and shows that a fixed-income portfolio made up of core bonds, represented by the Barclays Agg, and bank loans is preferable to one comprised only of core bonds. In fact, for the same level of risk, as measured by standard deviation, a 60/40 split between core bonds and loans generated 40 basis points in return per annum, greater than the core bond index portfolio alone. (Past performance is no guarantee of future results which will vary.)
Taking it a step further, we analyzed a portfolio of core bonds, and added to it a blended high yield portfolio, split evenly between short duration high yield and bank loans. This pushed the efficient frontier out, which means the portfolio made up of core bonds, short duration high yield, and bank loans has a more attractive risk/return profile than the portfolio that excludes short duration high yield. While the 60/40 portfolio is dominant to the core only portfolio, a 66% core/34% high-yield (split 17% each in short duration high yield and loans) achieved an even greater return for the same level of volatility. Said differently, by including short duration high yield, total return was higher for a given risk level. (Past performance is no guarantee of future results which will vary.)
Therefore, this analysis demonstrates that a portfolio with an allocation to both short-duration high-yield bonds and bank loans would have produced greater returns over the last 15 years than had they held only core bonds or a core bond portfolio with bank loans.
We are still constructive on credit fundamentals, and default rates are expected to remain benign. Acknowledging that credit spreads are tight and there is not the same opportunity in the market for capital appreciation, we still believe non-investment-grade credit remains a sensible, low-duration investment option for those seeking to generate income.
As it turns out, the loan enthusiast and bond purist are both right. Rather than viewing them as adversaries, combining these two asset classes provided the best historical results. While both asset classes invest in credits rated below investment grade, they may be more different than they are alike, and with investing, that is very often a good thing.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility
Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.
Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
Bank loans are represented by the JP Morgan Leveraged Loan Index.
High-yield bonds are represented by the JP Morgan U.S. High Yield Index.
Short-duration high-yield corporate bonds are represented by the BofA Merrill Lynch 1-5 Year BB-B U.S. High Yield Corporate Cash Pay Index.
Broad U.S. bond market is represented by the Bloomberg Barclays U.S. Aggregate Bond Index.
Investment-grade corporate bonds are represented by the Bloomberg Barclays U.S. Corporate Investment-Grade Bonds Index.
High-Yield Corporate Bonds are represented by the BofA Merrill Lynch U.S. High Yield Master II Constrained Index.
Treasury bonds are represented by the Bloomberg Barclays U.S. Treasury Index, which represents the U.S. Treasury component of the U.S. Government Index.
Basis points (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short-term interest rates around the world.
LIBOR floors – The London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. LIBOR floors provide a guaranteed minimum yield on loans no matter how low the benchmark three-month London interbank offered rate fell. Today, most loans offer a 1% LIBOR floor, and the three-month LIBOR rate stands at 0.25%, meaning a loan with a LIBOR floor gives investors a yield base that’s three-quarters of a percentage point higher than a floorless loan (loans vary in terms of how much additional yield, or spread, they offer above either LIBOR or the floor rate).
Interest-rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest-rate relationship.
Standard deviation is a measure of the dispersion of a set of data from its mean. It is calculated as the square root of variance by determining the variation between each data point relative to the mean. If the data points are further from the mean, there is higher deviation within the data set. In finance, standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment. The greater the standard deviation of a security, the greater the variance between each price and the mean, indicating a larger price range. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is usually rather low.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
BoA Merrill Lynch U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index is a subset of the BoA/ML U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 5 years and rated BB through B inclusive.
BofA Merrill Lynch U.S. High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issuers included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. No single issuer may constitute greater than 2% of the Index.
The BofA Merrill Lynch U.S. High Yield Master II Index is tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays U.S. Corporate High Yield Index is a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody’s.
The Bloomberg Barclays U.S. Corporate Investment Grade Index is a market-weighted index that includes publicly issued US corporate and specified foreign debentures and secured notes that meet the maturity, liquidity and quality requirements.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
Citi’s US High-Yield Market Index is a US Dollar-denominated index which measures the performance of high-yield debt issued by corporations domiciled in the US or Canada.
JP Morgan Leveraged Loan Index tracks the performance of U.S. dollar-denominated senior floating rate bank loans.
JP Morgan U.S. High Yield Index is designed to mirror the investable universe of the U.S. high-yield corporate debt market, including issues of U.S.- and Canadian-domiciled issuers.
The S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
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