Phil Redding, managing director of institutional business development at Aviva Investors, makes the case for high-yield loans
In recent years, ultra-low interest rates and historically low returns on government bonds have been the driving force behind demand for high yield corporate bonds amongst institutional investors.
But while UK investors have become increasingly familiar with the high yield bond market, there is less awareness of the investment opportunities from high yield bank loans.
We believe there are some compelling arguments for UK institutional investors to consider bank loans in complementing a high yield bond strategy.
They can provide superior risk-adjusted returns over several alternative investment classes, portfolio diversification benefits, a senior claim position with higher recovery potential in bankruptcy, and potential for strong returns in a rising interest rate environment.
High yield loans have a credit rating below investment grade, lower than BBB – as indicated by Standard & Poor’s. Initially, the high yield loan market was the preserve of the traditional banks but the sector has grown rapidly over the last two decades and now totals approximately $650bn (£408bn).
The market is heavily focused on the US, as the euro-denominated market is not as liquid or broadly syndicated. In contrast, in the US syndication has facilitated the participation of a much broader investor base, including hedge funds and insurance companies as well as pension funds.
Although the IT and healthcare sectors comprise a significant proportion of the US market, industry representation across the high yield loan market is diversified, and includes aerospace & defence, retailers and telecoms.
While there is an overlap between the high yield bond and loan markets in terms of issuers, there is a substantial number of ‘loan only’ issuers. In our opinion, bank loans currently offer a number of significant attractions for institutional investors.
First, they have a floating rate coupon that typically adjusts on a quarterly basis, limiting the interest rate risk inherent in their fixed interest counterparts. While interest rates remain at historic lows, long-term investors need to anticipate the impact of higher inflation and an eventual tightening of monetary policy.
An allocation to this floating rate asset class should provide superior returns to fixed income securities as interest rates begin to rise.
Secondly, high yield loans are at the top of the capital structure and are usually secured by all company assets, providing the added protection of covenants with mandatory loan pay-downs. This seniority means that they have typically realised higher recovery rates in corporate restructurings.
Current recovery rates for loans are at 71% as opposed to 50% for unsecured high yield bonds, according to Moody’s. Furthermore, high yield loans offer institutional investors significant diversification benefits, as returns are negatively correlated with the US Treasury market.
We have recently seen yields on two-year and ten-year Treasury bonds fall to new record lows, strengthening the investment case for high yield loans.
In addition, a low correlation with other asset classes such as high yield and investment grade bonds means that loans compare favourably overall from a diversification standpoint. High yield loans have historically provided low volatility of returns in comparison to other asset classes.
Notwithstanding the recent credit crisis, the long-term Sharpe ratio from high yield loans is very favourable, indicating that a substantial allocation to this asset class would significantly enhance risk-adjusted returns over and above a portfolio of high yield bonds alone.
For institutional investors, we believe high yield loans now merit serious consideration in the asset allocation decision.