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Newfleet High Yield Bonds and Bank Loans

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Newfleet High Yield Bonds and Bank Loans High Yield Bonds and Bank Loans MARKET CONVERGENCE AND THE CASE FOR A FLEXIBLE APPROACH TO LEVERAGED FINANCE The convergence of high yield bonds and bank loans into a single leveraged finance asset class provides the opportunity for a single investment manager with expertise and resources in both high yield and bank loans to effectively manage a flexible strategy that tactically rotates between the two sectors. Benefiting from access to a broader opportunity set, the result is a more diversified portfolio that has the potential to perform well in various investment environments and provide attractive income and competitive risk-adjusted returns. INTRODUCTION High yield bonds and bank loans, collectively known as leveraged finance, are two sectors of the fixed income market that are converging as a single non investment grade asset class. Traditionally, investors have implemented their high yield and bank loan allocations through separate, dedicated mandates, adjusting their exposures to each asset class (or sector) based on a view of the credit or interest rate environment. The distinction between high yield and bank loans has blurred over the past 20 years or so, which we believe argues for a more efficient investment approach to leveraged finance through an actively managed, flexible strategy that tactically rotates across and within each asset class. This approach enables a single investment manager with purview over a larger opportunity set to capitalize on technical dislocations and differential relative value opportunities within industries, credit quality tiers, and across the capital structure. Effective implementation of such an approach requires an investment manager with not only expertise in each asset class, but an integrated, adaptive research capability consistent with evolving market dynamics. The paper begins with a brief historical perspective on the convergence of high yield bonds and bank loans into a single leveraged finance asset class. We then discuss advantages of combining high yield and loans into a single investment approach in terms of expanded investment opportunity set, issuer overlap, and structural differences between the two markets. The paper then turns to the risk and return benefits that a flexible high yield/bank loan strategy has the potential to provide. EXHIBIT 1: A FLEXIBLE APPROACH TO A LEVERAGED FINANCE STRATEGY Objective: Produce Attractive Income and Total Return u Bank loans provide a natural hedge against u Consistent with rising rates Bank the convergence Loans of leveraged u Senior secured status finance markets provides credit protection Flexible Credit u Low correlation to u Historically low other interest rate correlation with rates High sensitive asset classes u Equity-like total Yield u Attractive income and total return potential return opportunities Bonds FOR INSTITUTIONAL INVESTOR USE ONLY. Newfleet Asset Management | 1 MARKET CONVERGENCE AND THE CASE FOR A FLEXIBLE APPROACH TO LEVERAGED FINANCE DRIVERS OF CONVERGENCE convergence as bank loans became more widely accepted as a non investment grade instrument, and as the search for yield in The convergence of bank loans and high yield bonds is a result the low interest rate environment increased demand for more of both asset classes developing characteristics of the other. credit sensitive assets. In 2018, heightened demand for loans Exhibit 2 highlights the changes in the U.S. bank loan and was met by a loosening of restrictions and more “covenant high yield markets over the past decade. Emblematic of the lite” features that resemble the less restrictive structure of convergence trend is the substantial increase in “covenant high yield bond offerings, making the two instruments even lite” shares for bank loans, together with the meaningful less distinguishable. With the expectations of rising rates in increase in secured shares for the high yield market. The latter 2018, issuers preferred to finance through the loan market, trend in particular has continued into 2019 with $12.4 billion where demand for loans resulted in “bond like” financing, in new secured notes by high yield issuers through the end of but still with the prepayability of loans. To start 2019, February. In terms of credit quality, the bank loan market has however, the supply/demand dynamics has reversed as a more migrated heavily to B-rated issues while the high yield market dovish Federal Reserve has dampened the demand for loans has experienced an upward shift in credit quality, as evidenced and contributed to the shift in issuance from loans to high by the increase in BB-rated debt and subsequent decrease yield, exemplified by the increase in secured note offerings in single B and CCC/CC-rated exposure. The shifts in credit as discussed above. TransDigm’s $3.8 billion offering, the quality and structural changes could result in more similarity in largest secured note issuance ever, was issued instead of a recovery rates for high yield bonds and loans in the next cycle. loan to finance recent M&A. For some historical perspective, bank loans have evolved from their role of private bank funding of M&A and leveraged FEATURES/ADVANTAGES OF COMBINING HIGH buyouts in the 1980s to a common form of corporate YIELD AND BANK LOANS financing today. Over time, as corporate borrowers integrated bank loans and high yield bonds into their capital structures, Expanded Opportunity Set the distinctions between the two debt instruments faded, Combining bank loans and high yield bonds in a single strategy prompting underwriting desks and other parties to consolidate roughly doubles the size of the opportunity set from that of each their analysts and traders into single teams to cover both asset class separately (Exhibit 3), providing the potential for a loans and high yield. The Financial Crisis accelerated the more diversified source of returns. EXHIBIT 2: THE EVOLUTION OF THE U.S. LEVERAGED FINANCE MARKET U.S. INSTITUTIONAL LOAN MARKET* U.S. HIGH YIELD MARKET** 2018 2007 2018 2007 Total Par Outstanding $1.08 trillion $554 billion Total Par Outstanding $1.17 trillion $629 billion Issuer Count 1,113 851 Issuer Count 911 894 U.S. Domiciled U.S. Domiciled 85% 94% 86% 90% Borrowers' Share Borrowers' Share Technology, Healthcare, Communications, Consumer Cyclical, Services, Utilities, Consumer Cyclical, Communications, Top 3 Sectors Top 3 Sectors Healthcare Auto Energy Consumer Non-Cyclical (33% combined) (23% combined) (49% combined) (50% combined) BB Rated Share 27% 51% BB Rated Share 46% 36% B Rated Share 54% 30% B Rated Share 40% 43% CCC/CC Rated Share 6% 2% CCC/CC Rated Share 14% 20% Covenant-lite Share 80% 17% Secured Share 18% 10% *Source: LCD, an offering of S&P Global Market Intelligence. **Source: Bloomberg Barclays. Based on S&P/LSTA Leveraged Loan Index and Bloomberg Barclays U.S. High-Yield 2% Issuer Capped Index. EXHIBIT 3: EXPANDED OPPORTUNITY SET – HISTORICAL MARKET SIZE (PAR OUTSTANDING) $2500B Loans High Yield $2000B $1500B $1000B $500B $0B YE 1997 YE 1998 YE 1999 YE 2000 YE 2001 YE 2002 YE 2003 YE 2004 YE 2005 YE 2006 YE 2007 YE 2008 YE 2009 YE 2010 YE 2011 YE 2012 YE 2013 YE 2014 YE 2015 YE 2016 YE 2017 YE 2018 Source: LCD, an offering of S&P Global Market Intelligence; Bloomberg Barclays; as of 12/31/18. Includes all loans including those not in the LSTA/LPC mark-to-market service. Vast majority are institutional tranches. Newfleet Asset Management | 2 MARKET CONVERGENCE AND THE CASE FOR A FLEXIBLE APPROACH TO LEVERAGED FINANCE The expanded opportunity set extends to both industry and As one last but critical advantage of combining bank loans credit quality breakdowns. The proportional representation and high yield, the expanded opportunity set offers an across industries of the bank loan and high yield markets additional layer of liquidity management. This is especially is quite different. Energy, for example, represents 14.2% relevant when considering the liquidity challenges of loan- of the high yield market but only 2.9% of the loan market only portfolios, at least in terms of settlement times. (data as of 12/31/18). Conversely, technology has a higher weighting in loans (13.8%) than in high yield (7.1%). A Issuer Overlap portfolio manager’s favorable view on the energy sector would Issuers utilize both the bank loan and high yield markets as thus be more difficult to implement in a dedicated bank loan funding conditions fluctuate and as considerations of their portfolio than in a combined bank loan/high yield approach. capital structure dictate. As Exhibit 6 indicates, a meaningful Correspondingly, as Exhibit 4 shows, there is a difference in overlap exists in the high yield and bank loan markets based the distribution by credit quality tier of the two asset classes. on both numbers of issuers and par value. Finally, Exhibit 5 compares the performance differential among credit quality tiers for the two, demonstrating that EXHIBIT 6: ISSUER OVERLAP the ability to rotate across and within bank loans and high yield can add value. The expanded opportunity set opens up a wide array of investable options for an investment manager to source and implement ideas, again, providing the potential Issuer Overlap for a more diversified stream of returns and an improved risk Loan Market 302 Issuers HY Market management profile than available from investing in either $1.08T $1.17T By Index Weight 1,424 Issues 1,947 Issues asset class separately. 46% of Loan Index 1,113 Issuers 911 Issuers 48% of HY Index EXHIBIT 4: CREDIT QUALITY DISTRIBUTION – LOANS VERSUS HIGH YIELD 60% S&P/LSTA Leveraged Loan Index Source: FactSet. S&P/LSTA Leveraged Loan Index and Bloomberg Barclays U.S. 50% Bloomberg Barclays U.S. High- High-Yield 2% Issuer Capped Index. As of 12/31/2018. Yield 2% Issuer Capped Index 40% Investment managers with a dedicated bank loan or high 30% yield mandate are limited in how they choose to invest in a company, lacking the opportunity to substitute one debt 20% instrument for the other on the basis of relative value or 10% as macroeconomic or other conditions might warrant.
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