Over the past several months, there's been a significant institutional rotation out of high-yield bonds and into floating-rate senior secured loans ("senior loans" for short).
In the U.S. this year, there has been approximately $9-billion of mutual fund outflows from high-yield bonds, while mutual fund inflows to senior loans have been approximately $44-billion.
Recently I've had my "ear to the ground" on this subject, speaking to many colleagues who operate within the High Net Worth space, and have been talking to industry contacts and private family office managers I know. From what I hear, this rotation seems to be just starting in earnest within HNW portfolios as well.
Some time ago I made the case for senior loans. As I said back then, senior loans have a number of good things going for them–attractive yield; their higher position on the corporate capital structure; their lower correlation to many other asset classes compared to high-yield bonds. Most important of all, however, is their potential for excellent performance in times of rising interest rates.
For all those reasons, our practice has been a part of this rotation: over the past year, we've trimmed allocations to high-yield bonds in the HNW portfolios we manage and have re-allocated to senior loans instead.
Recently, the case for this rotation has become a little stronger, as events in the bond market have made this type of fixed-income investment quite popular. I'd like to revisit the case for senior loans, and explain why I believe that if high-yield bonds are a part of your income portfolio, now is the time to rotate out some into senior loans instead.
Senior Loans | HY Bonds | |
Average Credit Rating * | B+/BB- | B |
Current Spread to Worst * | 5.01 per cent | 5.22 per cent |
Average Historic Recovery Rate | ~ 80 per cent | ~ 48 per cent |
Average Duration * | < 90 day | 4.57 years |
Source: Credit Suisse Leverage Loan Index and Merrill Lynch High Yield Master II Index
You can see from the chart that when it comes to yield and credit ratings, there is very little difference between senior loans and high-yield bonds. But you can see that senior loans sit at the top of the capital structure – their recovery rate is much higher than that of high-yield bonds.
That's a critical difference for conservative investors. There is no such thing as a "risk-free" investment, and senior loans are certainly no exception. But the chances of an absolute disaster are much lower with senior loans than they are with high-yield bonds. Something to think about.
The second critical difference is the duration. As you can see, the average senior loan has an ultra-short duration (less than 90 days); the average high-yield bond about four and a half years. Without bogging down the discussion with high-level math, in practical terms that means senior loans are significantly less sensitive to interest rate movements than high-yield bonds are.
Quite frankly, shortening duration hasn't really been a strategy that's been worth paying for over the past two-plus decades as interest rates dropped to historic lows. But as we look forward to rising rates, this becomes an exceptionally attractive feature.
The U.S. Federal Reserve has started talking openly about the end of its quantitative easing program – how it will "taper" its bond buying spree. Effectively, this would likely mark the end of the low-interest rate era. Yields have already spiked over the last four months, and the stage could be set for further increases.
Now, remember the core feature of senior loans: the interest rate floats. When the benchmark rate (typically LIBOR) rises or falls, the rate on the senior loan will move in the same direction. So in a rising rate environment, senior loans will see coupon payments increase. The attached chart shows you how well senior rate loans have performed when rates rise.
Keep in mind that this is investing, and no one can predict the future with 100 per cent accuracy. You see that contrary to expectations, high-yield bonds actually performed better than senior loans during the last period of interest rate hikes. But that's looking increasingly unlikely this time around.
I'm not saying this will happen over night. If anything, I would say we're still in the very early innings of this increasing rate cycle, and therefore in the early innings of this rotation.
Senior loans still make a lot of sense now, with an investment horizon of three to five years, and perhaps longer. I'd encourage all investors who have high-yield bonds in their portfolio to take a second look (or perhaps a first look) at senior loans.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada (www.tiger21.com/canada). He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.