Many investors are asking why the market for U.S. leveraged loans – which are generally considered high risk assets that are typically secured debt (secured by a company, borrower, or assets) – has recently been pricing a similar (and by some calculations, greater) premium than the unsecured and theoretically “riskier” U.S. high yield market. Some observers cite weaker demand for loans as the driving factor behind this spread compression (i.e., the relative difference in loan and high yield spreads above like-maturity U.S. Treasuries). But we believe there’s a more fundamental driver: a transformation in the overall risk composition of the leveraged loan market.
Since January 2007, the spread differential between U.S. high yield (HY) bonds and leveraged loans has averaged 79 basis points (bps) – see chart. This relationship makes intuitive sense, as loans are positioned higher in the capital structure than HY bonds, and in the event of a restructuring or default, recoveries on loans have tended to exceed recoveries on HY bonds in past credit cycles. HY investors have therefore demanded a risk premium versus their secured loan counterparts. So why, over the last year, has this historical premium – or spread – compressed and sometimes even inverted?
Many observers have posited that the current spread compression is simply due to market technicals, with weaker demand for loans than for HY today. While we agree that loan demand has sagged with the Federal Reserve on hold and the market broadly pricing in a rate cut, we think this tells only a small part of the story.
Instead, we argue that the spread compression in leveraged loans versus high yield reflects a fundamental change in the loan market’s overall risk profile. In recent years, the composition of the loan market has changed: An increase in loan-only issuers (which lack subordination or downside covenants for investors) changes the recovery picture for loans, which in turn tends to drive loan investors to seek more HY-bond-like yields. Erosion in credit terms across the loan and bond sectors stands to further stress recoveries versus historic results, which would also drive spread compression.
Leveraged finance markets: default and recovery history and forecast
A forward-looking hypothetical illustration based on current and historical market data highlights the changing risks in loan markets. Defaults across the HY and loan markets have averaged 3.2% in the past 20 years, with HY bonds subsequently recovering $41 out of $100 of their value on average and loans $66 (as proxied by the J.P. Morgan U.S. High Yield Index and the J.P. Morgan Leveraged Loan Index, respectively). But drilling into loan recoveries more deeply, J.P. Morgan reports that since 2008, first lien loan-only issuers averaged recoveries of 52%, while loans with bonds in the capital structure recovered 70%.
This distinction could be critical in the next default cycle, whenever it happens, because the loan-only segment of the market has grown from 35% in 2008 to 55% today. This means that if average default rates remain unchanged and defaults are evenly distributed across the loan market, average recoveries would drop to $60.
Using these lower recovery rates, and again assuming defaults in line with historic averages in both the loan-only and the bond-and-loan cohorts, we estimate that investors would see realized losses of 1.28% (3.2% defaults and 60% average recoveries), as compared with an average of 1.08% in the past 20 years (3.2% defaults and 66% average recoveries). Using the average default rate of 6.4% experienced in the last default cycle (2008–2011), estimated losses in a similar cycle would widen nearly 40 bps.
We also have to consider ratings migration in the loan market relative to high yield. The loan market has seen a rise in single-B rated issuers from 25.2% in 2008 to 52.8% today (70% of which have loan-only capital structures). The HY market, conversely, has seen growth in the BB rated cohort from 24.0% to 35.1% over the same period. (Market proxies are the J.P. Morgan Leveraged Loan Index and the J.P. Morgan U.S. High Yield Index, respectively.)
The eight-year average default rate for loan issuers rated single-B is 2.33%, compared with just 0.77% for BB rated loans (source: J.P. Morgan). Thus, a doubling of single-B issuers hypothetically could add an additional 63 bps to the average loan default rate. Using an average $60 recovery, as noted above, that would represent an additional 25 bps of loss versus prior cycles. In high yield, BB issuers default at an average rate of 1.2% versus single-B at 3.35%, so default rates could be expected to decline in that market. We believe this divergence supports the spread compression we see today.
This is a simplistic hypothetical analysis to make the point. Defaults could exceed or fall short of historic averages for a variety of reasons, including weaker credit terms prevalent in the loan and bond markets today that could give issuers more flexibility to operate in a weaker economic environment. Similarly, actual losses could be more or less severe in the loan-only cohort than the loan-and-bond cohort, which would vary the results. And these are market-based average expectations. Portfolios with a higher concentration in loan-only issuers would be expected to tend to see more excessive losses, while more defensive portfolios, with higher-quality investments and a lower concentration in loan-only names could experience both a lower default rate than the market average, and higher recoveries in the event of default.
Spread compression between the HY bond and leveraged loan markets reflects not just today’s technicals, but the changing composition and growing risk in the loan market. Given the increased risks from weaker capital structures and weaker terms, we continue to highlight the importance of credit selection, careful monitoring, and active management of loan portfolios.
By positioning in higher-quality, larger, more liquid issuers with more robust capital structures, investors may sacrifice some spread today, but we believe they would be better positioned to withstand greater losses in the next default cycle. Avoiding defaults and positioning in market segments more likely to see recoveries closer to historical levels should drive performance in loan portfolios. And with a broad view that recoveries could be lower across the entire leveraged credit spectrum in the next cycle, loan investors should logically demand a higher premium to compensate for that increased risk.
Learn more about changing composition of leveraged finance markets and what it means for investors in our recent Viewpoint, “High Yield and Bank Loans: A Tale of Two Markets.”