Looking Under the Hood at High-Yield Bank Loans

When you’re shopping for a car, you take a look under the hood to see what makes the thing run. You also check out the car’s features: does it have heated seats, a rear-view camera, a GPS?

What goes for buying cars goes for investing in high-yield loans. As it turns out, not all loan features are what you’d call investor-friendly.

Recently, many investors have flocked to high-yield loans, assuming that floating-rate coupon payments will provide better insulation against rising interest rates than high-yield bonds will. Historically, though, this hasn't been the case.

High-yield loans have a number of pitfalls, including “call” features, which allow loans to be repaid when it’s advantageous to the borrower. This can happen at any time after the loan is issued—sometimes as soon as it’s issued. When investors flocked to loans in early 2011, issuers took advantage by calling 15% of bonds in the market in half a year. Many high-yield bonds are callable, too, but usually not for years after they’ve been issued.

Promises, Promises

Then there are covenants, the promises investors demand from a firm before they’ll agree to lend it money. A covenant might require that a company limit additional borrowing, so that its total debt stays under a specific percentage of its equity. This helps ensure that a borrower will have the means to repay a loan.

Investors want more and stronger covenants; borrowers prefer them fewer and weaker. With investors desperate to buy high-yield loans lately, borrowers have had the upper hand. They can go light on covenants and still find willing lenders. According to estimates from Barclays Research, as much as 40% of high-yield loans issued today are “covenant light.”

The Quality Thing

Credit quality comes into play, too. A lot is made of the higher position of loans in the capital-structure pecking order, which may help loan investors recover more of their money in a default than bond investors could.

But by some measures, the loan market is of lower quality than the bond market, as seen in the display below. The three biggest high-yield bond issuers are fairly stable companies that were previously rated investment grade (known as “fallen angels”). Two of the top three loan issuers, by contrast, are lower-rated, and all three result from leveraged buyouts (LBOs). In fact, seven of the top 10 high-yield loan issuers today are from LBOs. That’s true for only two of the top 10 high-yield bond issuers.How the Top 10 High-Yield Issuers Stack Up

The weaker overall credit quality and greater risk of default among loans may more than offset their capital-structure superiority. Think of it as being on the top step of a ladder when the floor is more likely to give way. Since there’s not much overlap between high-yield bond issuers and high-yield loan issuers, the quality differences between the markets are important.

Today, investors are overlooking many of the nicks and dents in high-yield loans. Loan performance has been generally strong in 2012, up about 10%, but not as strong as high-yield bond performance. Longer-term returns show a similar relationship: since the bottom of the credit crisis at the end of 2008, loans have returned 87% cumulatively, while bonds have returned 118%.

As for guarding against rising rates, some investors are looking at another possible solution: higher-quality, shorter-duration high-yield bonds. These bonds have historically shown less sensitivity to rate movements, without some of the structural drawbacks of high-yield loans.

When it comes to high-yield loans, we think it’s a good idea to be selective when investing, and consider high-yield loans as part of a more broadly diversified high-yield strategy.

It also makes a lot of sense to kick the tires before you buy.

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. Past performance of the asset classes discussed in this article does not guarantee future results.

Ashish Shah

Head—Global Credit
Ashish Shah is Head of Global Credit and a Partner at AllianceBernstein. He is also a member of the Absolute Return portfolio-management team. Prior to joining the firm in 2010, Shah was a managing director and head of Global Credit Strategy at Barclays Capital, where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy Groups, and the Special Situations Research team. Prior to that, he served as the head of Credit Strategy at Lehman Brothers, leading the Structured Credit/CDO and Credit Strategy Groups and covering the cash bond, credit derivatives and CDO product areas for global credit investors. Before that, Shah served as North American CFO at Level 3 Communications from 1999 to 2000 and gained trading experience at Soros submanager Blue Border Partners and at Bankers Trust, where he ran US equity arbitrage from 1994 to 1999. He holds a BS in economics from the Wharton School at the University of Pennsylvania. Shah has long been committed to diversity issues and has led several key diversity-related initiatives across the firm. Location: New York

Gershon M. Distenfeld, CFA

Director—High Yield
Gershon M. Distenfeld is Senior Vice President and Director of High Yield, responsible for all of AllianceBernstein’s US High Yield, European High Yield, Low Volatility High Yield, Flexible Credit and Leveraged Loans strategies. He also serves on the Global Credit, Canadian and Absolute Return fixed-income portfolio-management teams, and is a senior member of the Credit Research Review Committee. Additionally, Distenfeld co-manages the High Income Fund and two of the firm’s Luxembourg-domiciled funds designed for non-US investors, the Global High Yield and American Income Portfolios. He has authored a number of published papers and initiated many blog posts, including “High Yield Won’t Bubble Over,” one of the firm’s most-read blogs. Distenfeld joined the firm in 1998 as a fixed-income business analyst. He served as a high-yield trader from 1999 to 2002 and as a high-yield portfolio manager from 2002 until 2006, when he was named to his current role. Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: New York

Ivan Rudolph-Shabinsky, CFA

Portfolio Manager—Credit
Ivan Rudolph-Shabinsky is a Portfolio Manager on the Credit team and leads the Low Volatility High Yield Portfolio Management team. He joined the firm in 1992 as a Portfolio Manager, and has held several posts, including head of the Product Development team; head of Product Management; and senior portfolio manager for the Stable Value, Inflation-Linked Bond, Canadian Fixed Income and Global Fixed Income teams. Rudolph-Shabinsky is the author of “Beyond Interest Rate Anticipation: Strategies for Adding Value in Fixed Income” and co-author of “Assigning a Duration to Inflation-Protected Bonds,” both published in Financial Analysts Journal. He also co-wrote both “Managed Synthetics,” published in The Handbook of Stable Value Investments, and “LDI: Reducing Downside Risk with Global Bonds,” published in The Journal of Investing. Rudolph-Shabinsky holds a BA in economics and Soviet/East European studies from Cornell University and an MBA from Columbia University. He is a CFA charterholder. Location: New York

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