This story came out on Bloomberg yesterday and I thot it was pretty interesting. Anecdotally, I can confirm that this is happening in Canada too, as I will reflect below.
Basically, they report that many HY issuing companies have redeemed their HY bonds at a premium, either at the predetermined call price or at an even higher make-whole price, to issue leverage loans (economically it makes sense to do so for them because Loans have rallied so much there is an arbitrage). That is the opposite of what we usually see where issuers issue HY bonds to "term out" and "pay down" Loans as the banks want to reduce their credit exposure. Well now they are doing the opposite, and lots of it. YTD they have done about U$20bln while they only did about $18.3bln the previous 6yrs! Why?
Pretty simple answer...the inflows have been so enormous into Lev Loan funds (~70% of AUM YTD) that Lev Loan funds are clamouring over each other to get those proceeds invested.
So the first thing to think about is...well if they are redeeming HY bonds, then the supply outstanding of HY bonds must be dropping...and demand is picking up while supply is dropping...higher prices?! And don't forget, individually, the bonds are being redeemed at premiums.
The second thing is that the supply of Lev Loans is picking up dramatically. And this has implications on a few levels: 1) Lending standards are dropping as per the Fed and the Office of the Comptroller of the Currency warning in letters sent to banks over the past few weeks and 2) more supply...lower prices?!
And as I mentioned, I can confirm that this is happening in C$ HY too. Here are a list of issuers where we have had bonds called at a premium only to see the issuer issue in the Term Loan B (Institutional Lev Loans) market as the covenants are no less restrictive than in HY bonds but the pricing has rallied so hard that it is cheaper to issue in the Loan market as the demand has been so high:
1. Air Canada
2. Livingston Int'l
3. Garda World
And I think we will see a few more...
So why would you buy into a market that is seeing unprecedented increasing supply vs one that is seeing decreasing supply, at least on a relative basis? I suppose some are still concerned about interest rates rising. Well read some earlier posts on which part of the yield curve is rising, and over what time frame. Also read about how Libor Floors work. Both are very important.
Think about what they are selling you...a floating rate note, or so they claim.
Previous to 08-09, that was largely true as Loans did float at 3mos Libor (which goes up and down every day...or used to..as it has been stuck at ~25bps for a long time).
However, what changed a few years ago was that no one wanted to buy Loans with 3mos Libor that was so low (25-50bps) and had little chance of actually increasing. So they devised what are called, "Libor Floors" which effectively give you a minimum level of coupon (typically 1.00%) and then you get the coupon spread (~300bps) on top. That gets you a coupon of roughly 4.00%. Or does it? It is important to note that this Libor Floor (1.00%) acts as a Fixed Rate coupon, as long as 3mos Libor stays below the Floor. Loans with Libor Floors only Float if 3mos Libor rises above the Floor.
Ok so now you own a Lev Loan thatt looks like this:
1. Libor Floor at 1.00%
2. Coupon Spread of 3.00%
3. Total coupon of 4.00% (Fixed unless 3mos Libor rises above 1.00%)
Well, given the Libor Floor of 1.00%, one now needs to ask when Libor is going to rise from its current level of ~25bps to more than 1.00% so you can actually start to benefit from the "floating" rate aspect of these Lev Loans.
Well if you have been following what the FOMC and BoC have been saying, we are unlikely to get a taper of monthly bond purchases out of the Fed any time soon and the BoC just downgraded their economic outlook rather significantly. Now on that news, longer term rates like 10yrs, rallied rather well the past week or two. 3mos Libor is still stuck at .25%.
So when do you think the Fed will:
a) start to taper monthly bond purchases?
b) finish tapering monthly bond purchases so they are buying Zero?
c) start hiking overnight Fed Funds and the Discount Rate which will start moving 3mos Libor higher?
d) and when will 3mos Libor finally hit and get significantly beyond 1.00% where the Libor Floor sits?
I think the answers to all of the questions is:
a) 2yrs, if ever
b) 4yrs, if ever
c) 5yrs, if ever
d) 10yrs, if ever
Why do I take such a draconian view? Economic growth is declining, inflation is declining, and USA politics are a complete mess. The Fed and US Gov't are in a rock and a hard place where both are stretched way too far. Neither fiscal nor monetary policy have led to much of an economic or inflation recovery in 5yrs. The Gov't has no room left for stimulus and althought the Fed's balance sheet is theoretically infinite, ever the most ardent monetarists would have to agree it is rather stretched...and besides, rates can't really go lower.
On inflation, we do have asset price inflation but I think all that does is create bubbles. Bubbles burst on their own when there isn't a marginal buyer left. Greater fool theory. (I am talking about the stock market specifically here).
So, to conclude, there is a place for some Lev Loans in a portfolio...they are senior secured after all (but make sure what that security level is...is it 1st Lien or 2nd Lien??). They also help dampen out volatility in a portfolio. Just don't expect to receive any protection from rising rates for quite some time. To be sure, what you own is a low fixed rate coupon that may never Float and may very well be a Fixed Rate Coupon for the entire life of that Loan.
I find this chart to be rather unnerving. It may not be tomorrow, next week or next month, but it sure looks stretched. One could argue that "it is different this time due to unprecedented monetary policy". Well that may be the case but don't forget, these are equities with little-to-no yield...ie...the "carry trade" is not based on a daily yield like from a bond...it is based on equities going up...forever!