| Effective Duration in years | Ave Yield-to-Maturity | Standard Deviation (3yr) | Ave YTM/SD | |
|---|---|---|---|---|
| iShares $ Treasury 0-1yr ETF | 0.29 | 5.24% | 0.71% | 7.38 |
| iShares 3-7 Year Treasury Bond ETF | 4.28 | 4.33% | 5.22% | 0.83 |
| iShares 7-10 Year Treasury Bond ETF | 7.21 | 4.29% | 8.48% | 0.51 |
| iShares 20+ Year Treasury Bond ETF | 16.58 | 4.51% | 16.92% | 0.27 |
| iShares Aaa - A Rated Corporate Bond ETF | 6.98 | 5.20% | 9.04% | 0.58 |
| iShares MBS ETF | 5.78 | 5.10% | 7.73% | 0.66 |
Remember this table from the US Investment Grade Corporate Bonds Primer? From US Treasurys to US Mortgage-Backed Securities and US IG Credits, this Asset Primer series has covered much of the US investment-grade fixed-income spectrum.
In this post, we will build on what we have covered to complete the overview of the fixed-income universe. We will look at various non-investment grade US fixed-income segments, including:
- US High Yield (HY) Corporate Bond market
- US Broadly Syndicated Loan (BSL) market
- Direct lending middle market
These three segments make up the highest-yielding corner of the fixed-income universe in exchange for lower liquidity and credit quality. In this post, we shall provide a high-level overview of:
- Key characteristics of these three markets
- Key differences between these asset classes
- Key risk factors to consider when allocating to them
Market characteristics
The US High Yield (HY) bond market is an important financing source for corporates with less robust credit profiles. The market started in the 1970s as a small niche corner of US corporate debt for “fallen angels”–investment-grade (IG) bonds that got cut to BBB or worse in credit ratings, but rose to prominence through the infamous Mike Milken-financed leveraged buy-outs in the 1980s.
The qualification for being a high-yield or non-investment grade corporate debt issuance is a credit rating of BB+ or lower. They are of a lower credit quality than IG bonds. HY bonds tend to have weaker credit metrics than IG credit:
Source: Asset Primer Overview US Investment Grade Corporate Bond
When it comes to the non-investment grade debt market in the US, there are two buckets: public and private. The US HY market is a non-investment grade public credit market of $1.4 trillion in size with $50+ billion in daily trading volume.
On the private side is the Broadly Syndicated Loan (BSL) market and the middle market. Together they are often referred to as the leveraged loan market and are roughly equal in size to the HY market.
The biggest component of the private market is the Broadly Syndicated Loan (BSL) market. It is often used by smaller but still sizable corporates of at least $100 million in annual EBITDA.
This $100 million mark is often the dividing line between what is considered liquid and what is not. Loans of companies issued and traded in the BSL market are less liquid than the HY bonds but much more liquid than loans issued by smaller corporates.
If the business has an EBITDA between $20-$100 million it often accesses the middle market to look for financing options from direct lenders. Businesses with EBITDA of less than $20 million can still go into the market but they will be met with higher financing rates.
As a general rule of thumb, the smaller the size of a corporate issuer, the more “private" the loan gets. This is because smaller businesses are not capable of maintaining credit facilities of significant size and thus there are fewer interested lenders. Therefore, when it comes to secondary trading liquidity, there is hardly any liquidity for smaller issuances and lenders invest with the expectation of holding the loan to maturity.
The chart below provides an illustrative framework for categorizing non-investment grade corporates looking for debt financing options:
Note the key variables on the chart are:
- The size of a company’s cash flow as measured in EBITDA
- The seniority of its debt
Depending on where on these two sliding scales a company falls, it faces different sets of capital sources and borrowing conditions. At the risk of oversimplifying, the bigger a business’s cash flow and/or the more senior the debt, the more options it has to raise a bigger amount of debt financing. The more protected a bond is, through capital structure seniority and free cash flow, the bigger the investor pool it can find.
Key differences between these markets
There are three main differences between these different sets of capital sources and borrowing conditions:
- Capital Structure
- Yield performance and default loss risk
- Liquidity profile
Capital Structure
Imagine a scenario where there is a pot of $100 million in the middle of a city square. And everyone who lines up in front of the square gets a portion of the pot until the money runs out. It is not difficult to understand the importance of relative positioning in the queue.
In a company’s capital structure, debt holders have seniority over equity holders in a bankruptcy case of laying claims to a company’s assets. Where you sit in that queue of debt holders when it comes to receiving payouts is therefore extremely important. The higher you sit, the more likely it is for you to recover the full amount.
As the chart above illustrates, HY bonds often occupy junior positions in a company’s debt structure. In comparison, the BSL loans are often senior, ranking above HY bonds in priority of repayment, and secured, meaning they have assets pledged as collateral to secure the loans in the first place.
All else being equal, a higher-ranked loan in a capital structure offers more protection against late or non-payments.
The chart below lays out the seniority differences between various debts:
Yield profile and default loss rate
The key difference between the HY bonds and BSL/mid-market loans is that the former is fixed while the latter is floating.
Given the floating rate nature, BSL and mid-market loans benefited from a rising rate environment. The returns of BSL and mid-market loans are made of two components: price appreciation and interest returns.
In 2023, the US leveraged loan market as a whole enjoyed an exceptional year:
Using the popular Morningstar LSTA Leveraged Loan Index as a proxy for the whole category, US leveraged loans had returned 13.32% in 2023–its best performance since 2009. And the interest component provided the bulk of the gain at 9.26% as of December.
By comparison, using the ICE BofA US High Yield Index, the US HY market had a yield of 7.39% on December 31, 2023. And as for March 2024, it is hovering around the same level.
When comparing HY and leveraged loans, it is particularly interesting to note that the floating rate nature of loans is tremendously beneficial vs the duration risk of an HY bond in a rising rate environment. You can read more about duration risk here.
Although both BSL and mid-market loans are floating rates, given mid-market issuers’ smaller balance sheets and higher sensitivity to business and economic volatilities, smaller mid-market loans are usually priced using a higher spread to larger BSL loans.
According to KBRA DLD, first-lien loans ended 2023 at SOFR +584bps while LSEG LPC tracked middle-market term loans ended at SOFR +554bps.
Of course, yield in a vacuum doesn’t offer us any insights into comparative risk/reward profiles across different options. We also need to consider the risks associated. And the biggest risk to these floating rate loans is Loss Given Default (LGD). This is essentially the credit risk of a borrower. Understanding the exact risks facing a borrower given its balance sheet and business vertical is key to intentional risk management as well as risk-taking.
A complete deep dive walkthrough on credit analysis is beyond the scope of this post, but it is worth our time to look at the broad index-level default rates to get an idea of benchmarks.
According to the latest KBRA DLD report, the 12-month trailing direct lending index default rate is around 2%. According to the Q4 2023 Lincoln Senior Debt Index, the index default rate is around 3.4%. Since the Lincoln number included covenant defaults, depending on how liberal the KBRA classified its default, the number may need to be adjusted upwards.
Source: Lincoln International
Nevertheless, these two numbers fall somewhere between a B+ and a B rating, using the long-term median one-year default rates from our previous post.
Source: S&P 2021 Annual Global Corporate Default And Rating Transition Study
The equivalent single-B US HY index yield is currently at 7.44%. It is the investor’s job to answer whether a SOFR +550bps pricing for a 5-year loan is attractive vs the HY option.
And don’t forget while the duration risk of HY bonds worked against them in a rising rates environment, it will transform into a tailwind in a declining rates environment. Similarly, the floating rate nature of loans, while working well in a rising rates environment, will become a headwind in a falling rates environment.
Depending on your view of the Fed’s rate path forward, the calculation of risk/reward over a one-year or three-year horizon can be very different when comparing BSL loans to HY bonds.
Liquidity
All the asset classes we have discussed so far all have good daily liquidity. This means an investor can easily sell their position in the market without impacting the price unduly. However, when it comes to non-investment grade credit, liquidity is not a given.
The HY bond market is relatively straight forward. It is open to the public and traded daily with an average of $50 billion in volume.
The BSL market is still relatively liquid. Normally in a BSL loan, there can be up to 200 participants. The Rating Agencies including Standard & Poor’s and Moody’s Investors Service rate individual loans. Secondary market prices of loans are provided by two services (IHS Markit and LSTA/Refinitiv LPC mark-to-market Pricing).
These services provide daily marks on more than 2,800 individual loan tranches. Importantly, there is roughly $700 billion of loan trading each year, so these prices are tied to real transactions. There is considerable information available on individual loans.
However, the same is not true when it comes to middle-market direct lending. The investor base in such cases is mostly like-minded investors instead of traders. Private credit loans are often not rated by any rating agencies and are provided by a single lender or by a group of lenders, although typically a smaller group than in a syndicated loan deal.
Secondary market trading under such a set of conditions is hard to find. Normally when someone is looking for exit liquidity, the discount from the mark-to-market price can be significant.
This can have a major impact on the overall performance of the allocation from an investor perspective. As we discussed in the Asset Allocation Primer, the appropriateness of any investment is a function of investors’ objectives. If liquidity is one of the overarching criteria for an investor, then there needs to be a very compelling reason to allocate to an illiquid asset with a multi-year maturity profile.
In exchange for this illiquidity, investors are offered seniority in capital structure compared to the HY bonds and extra yield over BSL. Normally direct lending middle market loans command 100bps - 200bps spread premium to BSL loans.
Crafting your investment mandate
The non-investment grade credit market represents a significant asset bucket of the investable universe. With a total size of approximately $2.8 trillion, the non-investment grade credit market should command attention and consideration from allocators with a credit-focused mandate.
High-yield bonds and leveraged loan markets both offer yield premiums to other fixed-income asset categories including US Treasurys, US Agency MBS, and US IG Credit. This premium could be significant depending on the overall business and rates environment.
In 2023, leveraged loan, as an index measured by LSTA, had outperformed US IG credit by 8% due to its floating rate nature and large yield return component. 8% outperformance a year on a hypothetical $100 million fixed-income portfolio translates into a staggering $8 million extra return a year (a very substantial number).
However, in exchange for this higher yield, an investor is faced with extra risks including credit risk, interest rate risk, liquidity risk, capital structure subordination risk, and recovery risk in default events.
Credit risk, as measured by default rate, is key to understanding the pricing of any particular loan or bond. Identifying and benchmarking vs comparables in terms of yield, debt seniorit, and credit protection terms are important steps in an investor’s allocation process.
Disclaimer:
This post does not constitute or offer legal, tax, commercial or other advice and users of the post should not rely on it as such advice. Although care has been taken as to what is contained in the post, no attempt has been made to give definitive or exhaustive statements of law or any opinions on specific legal, tax or commercial issues and no representation is made or warranty given that the information is complete or accurate.
As more legislation and regulatory guidelines are issued or updated, the accuracy of the information contained in the post may alter. Anyone requiring advice on any of the matters referred to herein should consult lawyers or other professionals familiar with the appropriate jurisdiction and legislation.
Nothing contained in this post is to be construed as a solicitation or offer, or recommendation, to buy or sell any interest in any note or other security, or to engage in any other transaction, and the content herein does not constitute, and should not be considered to constitute, an offer of securities. No statement herein made constitutes an or to sell or a solicitation of an offer to buy a note or other security.
Very well done