Loans have received a lot of attention over the past couple of years, even before the pandemic. The view was that rates could only rise (from negative or zero territory) as inflation crept back into the system. In such an environment, the case for floating rate versus traditional fixed income high yield bonds balanced the portfolios of yield starved investors. The same mantra is still being repeated by loans managers today, but high yield bond managers are now starting to shout louder.
The simplicity of the argument to buy floating rate in a rising rate, rising inflation environment ignores the dynamics of the leveraged credit cycle. Rates may be rising, but relative to what? Interest rate floors, interest coverage, and default risk also play a role. And each of these will differ as the credit cycle rolls forward.
And at the end of that cycle when inflation is finally under control, rate cuts will start. But this usually coincides with deteriorating credit quality. So where are we today?
The universe has not stood still. Over the past 25 years, the credit quality of the high yield bond market has trended upwards with over 50% of issues now being BB rated. In contrast, the loan market has seen much more volatile moves in average credit rating, with less than 25% of issuers today being BB rated.
So as we approach the later stages of the credit cycle, interest coverage and credit quality may be a decisive factor in choosing between high yield and loans. And not interest rate floors.
High Yield Bonds have outperformed loans over the past months. But also over the much longer term. And whilst loans and private credit may be the coolest asset class in town, investors are sobering up to a world in which plain vanilla investments and liquidity have old school attractions.
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