In instances such as this, we do see much less leverage in the loan portion of the debt, and thus less risk associated with it. However the reality is that many companies have debt financing that consists entirely of loans and some of those loans are still part of capital structures that are very highly levered. We continue to see the envelope being pushed by loan issuers with many so-called “1st liens” being levered north of 5x EBITDA (leverage multiple of debt to EBITDA). Debt levels over 5x EBITDA are not always a problem per se, but can be if the cash flow generation is not there to give the issuer some margin of safety.
In assessing the cash flow situation, investors need to look at the cash needs of the company (capital expenditures, debt service/interest costs, taxes, and other needs) relative to the EBITDA generation, and with a floating rate loan in a rising rate environment, the interest cost to the company can be increasing (versus the bond market where the coupons are fixed). EBITDA multiples are also important to consider as investors put a valuation on the company.
Finally, loans often carry a lower interest rate given they are considered less risky and are “secured” by the “assets” of the company, but when leverage multiples become elevated the value of that “secured” feature can be illusory. We believe that investors need to make sure they understand what they are purchasing in this space on both the credit and the coupon side. While we do currently see an opportunity in the floating rate bank loan market as a supplement to an existing high yield bond allocation, we believe this opportunity is for active investors who are able to decide what credits they want to own.
Active investors in the loan market are able to consider and invest according at the credit fundamentals and the security metrics. That flexibility can also allow the active investor to take advantage of the higher rates by investing in loans where they are not seeing repricing activity eat away the benefit of the LIBOR move. So for investors concerned about rising rates, we continue to see the high yield bond market as an attractive place to be positioned but do see the opportunity to supplement that bond allocation with an active allocation to the floating rate loan market, whereby investors can expand their opportunity set, take advantage of where in the capital structure they want to be positioned, and potentially benefit from the rising floating rates.
For more on investing in high yield debt in a rising rate environment, see our recent piece, “Strategies for Investing in a Rising Rate Environment.”
1. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
2. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
3. Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leverage Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, 2014, p. 1.
4. Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, comparing 12/31/12 to 12/31/13.
5. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
6. Data for the period 5/15/13-5/14/18, LIBOR and Treasury data sourced from Bloomberg.
7. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/2/18, https://markets.jpmorgan.com.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risks and uncertainties, as well as the potential for loss. High yield bonds are lower rated bonds and involve a greater degree of risk versus investment grade bonds in return for the higher yield potential. As such, securities rated below investment grade generally entail greater credit, market, issuer, and liquidity risk than investment grade securities. Interest rate risk may also occur when interest rates rise. Past performance is not an indication or guarantee of future results. The index returns and other statistics are provided for purposes of comparison and information, however an investment cannot be made in an index.
This article was written by Heather Rupp, CFA, Director of Communication and Research Analyst for Peritus I Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD), www.advisorshares.com/fund/hyld, fund distributed by Foreside Fund Services, LLC. For questions, please contact Ron Heller, CEO of Peritus I Asset Management, LLC at [email protected], 805- 879-5620.