Download Bank Loans vs. Global High Yield

Brandywine Global Investment Management, LLC
Topical Insight | February 6, 2013
Bank Loans vs. Global High Yield
Caveat Emptor vs. Carpe Diem
The significant decline in nominal yields and commensurate decline in risk premiums of U.S. high
yield bonds have forced those with an allocation to the asset class to reconsider current positioning.
While an allocation to the U.S. high yield asset class has generated equity-like returns with significantly
lower volatility1 since 2006, we expect U.S. high yield bond market returns over the next several years
to be lower with higher volatility than the 2006-12 period, driven by several forces (see figure 1).
Figure 1 Risk / Reward Characteristics of Various Assets
December 2006 - December 2012
20
Gold
Annualized Return (%)
15
JPM
Emerging
Markets
10
Barcap AAA Corp US IT ML
Gvt Corp
Gerhardt (Gary) Herbert, CFA
Portfolio Manager
Credit Suisse
High Yield
Index
•
US LT
Gvt
ML Mortgage
FTSE NAREIT
All REITs
Barcap Agg Bd
5
ML ABS Master
US Inflation
US 30 Day TBill
Credit Suisse
Leveraged
Loan Index
Brian L. Kloss, JD, CPA
Portfolio Manager
Russell 2000
S&P 500
Joined the Firm in 2010, and has 20
years of investment experience
•
MSCI EAFE
Joined the Firm in 2009, and has 17
years of investment experience
0
0
5
10
15
20
25
30
35
Annualized Return Volatility (%)
Source: Credit Suisse, The Bloomberg Professional Service, Datastream
Chief among the concerns are the potential for higher U.S. interest rates due either to stronger-thanexpected U.S. economic growth or a surprise burst of inflation. Either outcome will likely cause an
increase in short-term rates in the U.S. and, perhaps, the removal of unorthodox monetary policies.
Many asset allocators are therefore considering other credit asset classes for their respective credit
allocations. Assets with yields that “float” with changes in U.S. interest rates are viewed as providing
a degree of protection that fixed rate U.S. bonds simply can’t provide.
Asset allocators with an eye to U.S. credit markets view U.S. bank loans as a tidy solution to these
concerns. U.S. bank loans are senior in the capital structure to high yield debt and offer floating rates.
We believe conventional wisdom in this case is wrong! While the facts are true, an empirical analysis
of long-term performance, recovery rates, and correlations with the U.S. high yield asset class
highlight that investors are simply swapping one segment of the fairly to modestly overvalued credit
sector for another.
1
See “Toward a Better Approach: Managing High Yield Credit through the Business Cycle”
Regina G. Borromeo*
Portfolio Manager
•
Joined Brandywine Global Investment
Management (Europe) Limited in
2010, and has 12 years of investment
experience
* Employee Brandywine Global Investment
Management (Europe) Limited. In rendering portfolio
management services, Brandywine Global Investment
Management, LLC may use the portfolio management
services, research, and other resources of its affiliates.
For Institutional Investors Only
Bank Loans vs. Global High Yield | p2
Brandywine Global Investment Management, LLC
Topical Insight | February 6, 2013
A review of historical performance of the U.S. loan sector shows correlations with high yield bonds above 80% for much of the prior five years;
Since the early 1990s, the two asset classes’ respective yields have averaged a near 88% correlation (see figures 2 and 3).
Figure 2 20 Month Rolling Return Correlation of Various Assets with Credit
Suisse Leveraged Loan Index
August 1993 - August 2012
Figure 3 Leveraged Loan Yield vs High Yield Bond Yield
January 1992 - December 2012
20
100
HY Yield-to-Worst
CS Lev Loan Index Yield (Assumes 3-yr Refi)
81.45%
80
17
40
Correlation = 0.88
30.20%
20
14
Yield (%)
Correlation (%)
60
0
-20
11
-40
-60
-51.34
8
12/31/12
6.25%
5.93%
-80
-100
5
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Treasury Avg = -25.81%
Libor Avg = -2.02%
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Credit Suisse High Yield Index Avg = 51.10%
Source: Credit Suisse, The Bloomberg Professional Service, LB Boston Associates
Source: Credit Suisse
More worryingly, past performance since the Great Recession highlights the inability of loans to keep pace with the performance offered by U.S.
high yield bonds (see figure 4).
Figure 4 Cumulative Returns of Bonds, Loans and Equities
December 2006 - December 2012
70
Total Returns Since 12/31/2006
60
50
40
CS High Yield Index
BarCap Agg Bond
CS Leveraged Loan Index
S&P 500
30
20
10
0
-10
-20
-30
-40
-50
2006
2008
2010
2012
Source: Credit Suisse, The Bloomberg Professional Service
While U.S. loans have not kept pace with U.S. high yield bonds in terms of performance, the conventional wisdom that because U.S. loan rates
“float,” they will provide protection in a rising rate environment is simply not true. A historical review of return correlations highlights surprisingly,
relative to conventional wisdom, no relationship exists (see figure 2).
Bank Loans vs. Global High Yield | p3
Brandywine Global Investment Management, LLC
Topical Insight | February 6, 2013
While U.S. bank loans are senior in the capital structure, the downside economic sensitivity of the underlying assets that bank loans have claims on
overwhelms the ability of the liabilities to re-price upwards—negative convexity in bond market parlance—especially given today’s premium prices
to par and weaker covenant quality (see figures 5 and 6).
Figure 5 Most Loans Trade At or Above Par2
Figure 6 Cov-Lite Issuance Near All-Time Highs
1997-2012
50%
$120B
45%
Broader Loan Universe
Liquid Par Loans
40%
Cov-Lite Volume (LS)
% of All Institutional Loans (RS)
$80B
28%
30%
97
$100B
40%
30%
35%
87
57
$60B
$40B
14%
11%
10%
10%
9%
11%
3%
5%
$20B
2
3
100-101
101-102
102-108
0
0
0
0
0
3
3
8
5%
0%
19
99-100
0
2
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
$0B
0%
98-99
10%
24
5%
0-98
20%
15%
19%
20%
25%
Source: Morgan Stanley, Bloomberg
Source: Morgan Stanley, S&P LCD
Having established that the downside and upside of U.S. bank loans are in fact quite similar to U.S. high yield bonds, many U.S. bank loan
managers assert higher recovery rates on loans. A careful review of the recent data reinforces the changing nature of the U.S. bank loan market.
Smaller, less well-established enterprises are accessing the U.S. bank loan market with weaker covenants and at higher acquisition prices (see
figures 6 and 7), which leads to recovery rates that are not significantly higher on loans than those on bonds (see figure 8).
Figure 7 Leverage Metrics for Leveraged Loan Underwriting Total Debt to
EBITDA Multiples, Avg. of Upper Quintile
2003 - 2012
Figure 8 Bank Loan Recovery Rates by Covenant and Lien
1995-2012
cov-Lite
first lien
(%)
8.5
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
12
20
20
11
Q4
11
12
Q4
20
20
10
20
09
08
20
20
07
20
06
05
20
20
04
20
20
03
4.0
Source: S&P LCD
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Avg.
48.21
40.79
77.13
69.77
58.98
full
covenants
first lien
(%)
56.75
57.09
62.67
65.96
82.30
90.13
83.64
94.52
60.24
51.93
70.77
68.41
55.09
73.02
cov-lite
second lien
(%)
7.96
10.03
14.38
11.31
10.92
full
covenants
second lien overall
(%)
(%)
94.00
56.92
78.00
73.58
51.17
56.75
57.09
59.56
62.59
100.25
66.97
97.87
83.41
74.27
86.09
49.41
66.08
72.91
88.63
41.67
53.65
20.76
43.18
18.20
50.54
23.38
55.44
13.56
48.72
45.78
65.16
Source: Credit Suisse
Bank Loans vs. Global High Yield | p4
Brandywine Global Investment Management, LLC
Topical Insight | February 6, 2013
A better approach to capturing yields and total returns associated
with the leveraged finance sector is to go global. Although risk
premiums are declining globally, not all international credit markets
have experienced the magnitude of the spread compression seen in
the U.S. high yield markets (see figure 9).
In fact, most international markets are developing their belowinvestment credit markets out of necessity (as the U.S. did in the early
1990s). European financial institutions are shrinking their balance
sheets, while Asian corporates are seeking diversified funding source
(see figures 10 and 11). The trend toward disintermediating traditional
banking channels in international markets will persist.
The ability to capture these excess risk premiums outside U.S. credit
markets will be dependent upon a manager that can identify value in
an international high yield credit through traditional credit analysis,
but also must be able to identify the value offered by the underlying
country and currency fundamentals. These three factors determine
returns in international high yield, and have been core competencies
at Brandywine Global for two decades.
Figure 9 European B-Rated Credits Trade Much Wider than US B-Rated Credits
2010 - 2012
(bp)
1300
1200
USD
EUR
1100
1000
900
800
700
600
500
400
Jan 2010
Jul 2010
Jan 2011
Jul 2011
Jan 2012
Jul 2012
Source: Morgan Stanley, The Yield Book, iBoxx
Astute investors are eschewing the more fully valued high yield bond
and bank loan markets in the U.S. for the cheaper and safer valuations
offered in international high yield bond markets. Carpe diem!
Figure 10 European Banks Still Deleveraging
Figure 11 Asian Disintermediation Continues: Estimated Breakdown of MSCI
AJX Corporates’ Debt Funding3
2008-2013E
140
Japan (Peak = 1993)
US (Peak = Q3 2007)
W Europe (Peak = Q4 2008)
UK
130
Loans / Deposits (%)
120
100%
*Estimate
90%
110
80%
100
70%
60%
90
2008/09 represents low
debt issuance volumes.
39%
66%
76%
69%
63%
82%
50%
80
40%
70
30%
60
20%
Peak
24
48
72
96
120
144
168
192
Months After Peak
Source: Morgan Stanley Research, SNL Financials
49%
17%
29%
10%
0%
2%
2008
17%
16%
17%
12%
2009
8%
2%
2010
2011
Bonds (US)
Bonds (Local ccy)
17%
20%
2012
2013E*
Loans
Source: Bloomberg, Morgan Stanley Research
The broader loan universe is based on a list of 305 leveraged loans (term loan tranches only) with pricing data, representing $304bn in par outstanding. Liquid par loans list based on a
smaller set of liquid par (non-distressed) loans with $196bn outstanding.
2
3
The estimate is base on 100 corporates that make up about 67% of the total debt of the whole MSCI AXJ non-financial universe.
The views expressed represent the opinions of Brandywine Global Investment Management, LLC or any of its affiliates and are not intended as a forecast or guarantee of future results.
Bank Loans vs. Global High Yield | p5
Brandywine Global Investment Management, LLC
Topical Insight | February 6, 2013
All information obtained from sources believed to be accurate and reliable. In rendering portfolio management services, Brandywine Global Investment Management, LLC may use
the portfolio management services, research and other resources of Brandywine Global Investment (Europe) Limited, an affiliate. Fixed income securities are subject to credit risk and
interest rate risk. High yield, lower-rated, fixed income securities involve greater risk than investment-grade fixed income securities. The Barclays U.S. Aggregate represents securities
that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate
securities, mortgage pass-through securities, and assetbacked securities. Characteristics, holdings and sector weightings are subject to change and should not be considered as
investment recommendations. Indices are unmanaged and not available for direct investment. Unless otherwise noted, performance returns and other data are current as of December
31, 2012. Brandywine Global will not change the information at a later date. Past performance is no guarantee of future results.
©2013, Brandywine Global Investment Management, LLC. All rights reserved.