Investors who rush into high-yield bank loans seeking competitive returns might find the yield they chase is hardly worth the pursuit. Loan yields—currently quoted at about 5%—seem attractive at first blush, but we think there’s a lot less here than meets the eye.
To understand why, let’s consider how yield is calculated. As with any fixed-income investment, yield is the rate of return that equates the present value of future cash flows to the asset’s price.
The price part is straightforward: most loans trade at or near par (face value). But loans’ floating-rate coupons make cash flow hard to predict. Some investors will decide they can live with that, since floating rates offer protection against a future increase in short-term interest rates, though as we’ve pointed out, there’s a catch.
Another wrinkle in high-yield loans is issuers’ ability to refinance at will. The traditional rule of thumb for investors has been to assume they’ll receive three years of coupon payments followed by the face value when the issuer redeems the loan.
Shrinking Spreads Benefit Loan Issuers
Few loan issuers are waiting that long to refinance these days. Investors have poured more than $80 billion into bank loans since 2012, almost three times the inflow into the much larger high-yield bond market. That demand has caused a steady decline in yield spreads, making it possible for issuers to refinance at lower rates whenever they want.
The data bear this out. More than 90 percent of the loans in the S&P/LSTA US Leveraged Loan 100 Index that were issued over the past two years have been refinanced, saving issuers a bundle on annualized interest costs—about 1.2% on average last year. Investors, meanwhile, are left with the bad end of that bargain: lower coupons.
In the high-yield bond market, shrinking spreads are good news for bondholders since they mean gains through price appreciation. With loans, the gains accrue directly to issuers. Last year, nearly two-thirds of loans were called when prices were at or above par. The percentage was even higher in the first quarter of 2014 (Display).
Unrealistic Return Expectations
All of this adds up to smaller future cash flows for high-yield loans—and smaller returns for investors.
Of course, today’s low interest rates will eventually rise, and that could slow the race to refinance. But there’s no guarantee rates will rise rapidly—Federal Reserve policymakers appear wary of tightening policy too soon for fear it could derail the US recovery. If rates rise more slowly than the market expects, that too would affect cash flow and yields. High-yield bonds, on the other hand, might do better in such a scenario.
While loans are currently priced with the expectation of a 5% yield, we think 4% is a more realistic forecast. Other analysts have at times said yields could be as much as 1.5% lower than quoted yields.
High-yield bonds, meanwhile, boast average yields above 5%. If our estimates are correct, investors may want to consider not only loans’ lower returns, but their higher prepayment risk as well.
The Risks of a Crowded Trade
There’s something else we think investors should consider: the reach for yield has created a crowded trade in an illiquid asset. Investors poured money into loan mutual funds for 95 straight weeks until flows turned negative in mid-April—a useful reminder that the extended run into loans will one day end.
That’s when things could get tricky. Last year, the Loan Syndications and Trading Association estimated that it takes 21 business days on average to settle a loan trade, suggesting investors may not be able to exit as quickly as they might expect.
In our view, loan investors are in a bind. If spreads keep tightening, issuers refinance at better rates and leave investors with lower coupons. But if demand declines and spreads widen, loan prices suffer, taking another bite out of returns.
All of this might be worth the risk in exchange for an attractive yield. But we think investors expecting loans to boost returns may be setting themselves up for disappointment.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Ivan Rudolph-Shabinsky is a Portfolio Manager of Credit at AllianceBernstein (NYSE: AB).