For much of the past decade, bank loans and high-yield bond returns have exhibited a high degree of correlation. However, this wasn't always the case. Before the global financial crisis, these asset classes were not strongly correlated, and signs of this decoupling have re-emerged recently. This shift is significant and aligns with the intrinsic characteristics of these asset classes and typical market responses to changing interest rates. Understanding the dynamics behind this relationship is crucial for fixed income investors.
To comprehend what drives the correlation between bank loans and high-yield bonds, it's essential to consider two key differences: risk differential and coupon differential. Risk differential refers to the additional risk of high-yield bonds. Both high-yield bonds and bank loans are below-investment-grade debt. However, loans are senior in a company’s capital structure, meaning they get repaid first in a restructuring and are secured by a company’s assets. High-yield bonds are usually further down the capital structure and are generally unsecured. Consequently, high-yield bonds typically offer higher yields to compensate for the additional risk.
High-yield bonds have fixed coupons, while bank loans have floating coupons that adjust with rate changes. When interest rates rise, the prices of fixed-rate bonds usually drop to offer higher coupons available on new issues. On the other hand, the cost of loans tends to remain relatively stable, as their floating coupons adjust to reflect interest rate changes. Thus, this coupon differential contributes to the lack of correlation between high-yield bonds and loans. These differences suggest that high-yield bonds and loans should not be highly correlated, particularly during periods of fluctuating interest rates.
The global financial crisis and subsequent Federal Reserve policies significantly impacted the correlation between bank loans and high-yield bonds. For the first half of the loan market’s history, these asset classes were not highly correlated. From the end of 1992 through 2007, the median 12-month correlation was 0.45. However, this figure surged to 0.82 by 2021 due to aggressive Fed interventions, including slashing the federal funds rate to nearly zero.
This intervention pushed investors toward riskier assets, driving a high correlation between loans and high-yield bonds. However, as the Fed began signaling an aggressive hiking cycle in March 2021, this correlation began to break down, dropping to 0.79 and falling below 0.50 since December 2021. The prospect of rising short-term rates led investors to reassess the impact on interest-rate-sensitive instruments, causing a divergence in returns.
Investors considering bank loans or high-yield bonds should consider three key factors: yield parity, default rates, and volatility. Currently, both bank loans and high-yield bonds offer average yields of 3.9 percent, an unusual parity given loans' senior and secured status typically warranting lower yields. This shift allows loan investors to earn similar yields while enjoying higher security and lower interest rate sensitivity due to floating coupons.
Secondly, bank loans generally have lower default rates than high-yield bonds. As of June 30, 2021, the trailing 12-month speculative-grade default rate was 2.8 percent for bank loans and 4.6 percent for high-yield bonds. Additionally, loans tend to have higher recovery rates in defaults - $55.00 compared to $41.10 for bonds over the past year - making them a safer bet in downturns.
Thirdly, high-yield bonds historically offer more upside but also more downside potential compared to bank loans. From January 2002 through June 2021, the best three-month total return for bank loans was 19.8 percent and the worst was -26.6 percent. In contrast, high-yield bonds saw a best return of 23.5 percent and a worst of -29.8 percent.
Given the current economic backdrop, low yields across investments, and potential rate hikes, a more defensive position is advisable. Bank loans appear more attractive due to their seniority, secured nature, and floating rates, thus offering a defensive stance while still providing competitive yields.
Investors seeking higher yields should carefully consider the risks and characteristics of bank loans and high-yield bonds. Bank loans, with their defensive features, offer similar yields to high-yield bonds but with less risk. As the market landscape evolves, understanding these dynamics will be crucial for making informed investment decisions in the fixed income space.
