Bank loans may be the hot ticket right now, but high-yield corporate bonds are delivering the yields.
When it comes to capturing yield in the corporate debt space, ETF investors are showing a preference this year for senior bank loans over high-yield corporate bonds. That preference, some argue, is largely due to what looks like an overvalued junk corporate bond segment, but it is a choice that has its trade-offs.
In a recent webcast discussing his views on the market, DoubleLine’s Jeff Gundlach pointed out that in 2014, he has opted for bank loans over high-yield corporates for that very reason: overvaluation in the high-yield segment. But as one advisor recently asked, “Is there any asset today that isn’t overvalued?”
The S&P 500 is up 200 percent from its March 2009 lows without serious signs of economic expansion; long-dated Treasurys are at multimonth highs, rallying in tandem with the stock market this year; and riskier fare such as emerging markets are in back in vogue. “Overvalued” could be a relative term these days.
Consider two ETFs as proxy for these separate segments: the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-69) and the PowerShares Senior Loan ETF (BKLN | B).
Year-to-date, investors have poured more than $736 million into BKLN, and yanked more than $1.82 billion from HYG. These flows have come despite BKLN’s relatively unimpressive rally of 1.8 percent, while HYG broke through new record-high levels, climbing 4.5 percent in the same period.
Chart courtesy of StockCharts.com
HYG has been on a performance roll, benefiting from tightening of credit spreads amid a hunt for yield, even if not evident in the ETF space.
“Credit spreads are approaching pre-crisis levels, but not historical lows,” Howard Lee, ETF analyst at ETF.com, said. “The conventional wisdom is that credit spreads will tighten during an economic recovery and early stage of expansion."
In that environment, Lee says, default risk goes down as companies coming out of a recession are likely to have focused business models and lean structures.
"They’re likely to be profitable and be able to meet payment obligations in a good economy," Lee said. “If one believes we’re still in the early stages of recovery and expansion, then the logic will suggest that spreads will tighten further, leading to lower yields or higher prices.”
From a yield perspective, HYG also has the upper hand, shooting off 12-month trailing yields of 5.7 percent, while BKLN is serving up comparable yields of 4.0 percent.
“In most economic environments, investors do better owning bonds over loans,” Anthony Parish, of Sage Advisors, told ETF.com. “Bonds will greatly out-yield loans over time.”
But it’s easy to understand the appeal of senior bank loans, or a fund like BKLN. The reason you’re paid more for high-yield corporate bonds is because you’re essentially taking on more risk.
3 Key Differences
There are three key differences, broadly speaking, between senior bank loans and other corporate debt, such as high-yield bonds:
Collateral: Senior loans are collateralized by firm assets. These assets are not tied to any other debt instruments, so if a company goes belly-up, these assets are liquidated to repay the senior loans before any other creditor can be repaid from the proceeds of the sale. This makes senior bank loans less risky than other forms of corporate debt.
Seniority: In the capital structure of the issuing company, senior bank loans are typically the highest-priority credits on a firm’s balance sheet. In the event of bankruptcy or liquidation, they’re repaid before any other type of financing—including high-yield debt. That seniority also translates into relatively lower yields because the less risk you take, the less you’re compensated for it.
Floating Rates: Senior loans are typically floating-rate instruments whose rates are often benchmarked to Libor. These rates reset regularly, with an agreed spread to the benchmark. As such, bank loans have minimal duration risk.
High Yield Has More Room To Run
Now, whether you’re investing in bank loans or high-yield corporate bonds, there’s no question that the hunt for yields is still raging, even as the market braces for higher rates ahead.
What’s interesting is that traditionally, high-yield corporate debt moves directionally with equities, while Treasurys move inversely, but this year, they have all moved higher somewhat in tandem. That’s unusual, Parish says, and makes it even harder for investors to figure out what to do about fixed-income exposure, credit risk or duration risk alike.
“Can we expect more of the same? No,” Parish told ETF.com. “The only way for the broad Barclays Agg to continue to rally would be for rates to continue to drop.”
That would mean 10-year Treasury yields would have to slide closer to 2.2 percent, a scenario in which equities would be hard-pressed to rally, Parish says. Still, he argues that the bull ride in high-yield debt is not quite over.
“Risk markets continually overshoot,” Parish noted. “There’s still room to eke out attractive returns in high-yield bonds.”