With such low yields for US Treasuries and other high grade debt, many investors have moved further out on the risk curve to high yield bonds, but that has just compressed spreads and made it difficult for investors to find compelling investments even with the increased risk. Oaktree Capital Group LLC (NYSE:OAK) is expected to scale back its fundraising targets for exactly this reason, but Artisan Partners portfolio manager Bryan C. Krug argues that high yield bonds and leveraged loans are still the most attractive fixed income assets.
Economic growth usually benefits high yield debt, even with rising rates
“From a fundamental perspective, non-investment grade assets typically do better when the economy is healthy. Rising rates often come hand-in-hand with economic expansion, rising corporate profits and healthier balance sheets, which reduce default rates and lead to spread compression, all of which is favorable for the non-investment grade asset class,” writes Krug.
Realistically, there isn’t much room for spreads to be any more compressed than they are now, as Krug acknowledges, but default rates have been and are expected to remain low at least in the near term and there is plenty of precedent for making money on non-investment grade debt when government bonds are losing value. The reason is that credit risk is a much bigger factor than interest rate risk – whether or not you get repaid is more important than a few basis points one way or the other.
Krug also argues that the use of these proceeds suggests that most companies are refinancing their debt under better terms and extending its maturity while rates are low, both of which should be reassuring for investors. The percentage of leveraged loans and high yield bonds being used to finance acquisitions has risen since last year, but the absolute level is still low.
Beware the libor floor
For investors who are new to leveraged loans in particular, Krug warns against a common misconception that could get you into trouble if you’re not careful. Leveraged loans are often negotiated with floating rate coupons, so they might seem like a good way to protect yourself against interest rate risk. But rates are typically recalculated every 90 days as a spread from the three-month Libor (3ML). Since the 3ML has been very low for a while now, investors have demanded that leveraged loan coupons be calculated from a Libor floor of between 1 – 1.5%. Since the 3ML is currently around 25bp you would need at least a 75bp jump in 3ML (which is quite large) before the coupons get a boost.
