As High-yield Indexes Hit Peak Levels, RMWC's Coleman Andrews Describes Sharp Differences Between Senior and Junior Credit

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One form of debt is investor-friendly right now; the other is not. Investors must recognize the difference.

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Risk/return metrics for senior secured debt and high-yield debt look very different at this point. Why? What are the implications for investors?

The prices of various risk assets have reached or are flirting with all-time or recent high levels. The S&P 500 has set several recent records, and most high-yield debt indices are trading at a substantial premium to par. But the risk/return metrics for senior secured debt and junior high-yield debt look very different at this point. Why? What are the implications for investors?

    Since the spring of 2009, the Fed has made junior credit investing a relatively happy proposition. The combination of Zero Interest Rate Policy and bond purchasing by the Fed has generally worked to drive up the prices of junior credit assets. Hundreds of billions of dollars have flowed into the high-yield sector alone as investors have sought nominal return to replace what they once could reasonably expect from traditional fixed-income investments. Demand has driven a robust appetite for new issues, in turn driving the high-yield indices into premium territory.

    During the same period, a very different picture has evolved in the middle market, senior secured lending sector. Supply has contracted as dozens of large banks have been merged out of existence, and as mega-banks and super-regionals have struggled to delever. At the same time, CLOs and hedge funds are no longer the source of ample capital that they were in 2006 and 2007 for the middle market sector.

    It is a tale of two markets, leaving investors to wonder which one is mispriced. In late March, junior high-yield bonds were offering an average of 6.35% while senior secured middle market loans were offering 6.83%. The bonds are generally fixed rate—no inflation protection there—while the middle market loans are variable rate tied to LIBOR. The bonds represent higher risk due to leverage—1.27% of yield for every unit of leverage—while the middle market loans earn 1.75% of yield for every unit of leverage. Data from Moody’s and S&P for 1987-2009 show that junior bonds tend to fare more poorly in a default situation, recovering an average of 29% of principal versus an 86% recovery for middle market loans. Terms and conditions are also very different: the bonds are typically covenant-light whereas the middle market loan tends to have muscular covenants that favor the lender.

    All in all, one market is offering paper that is very borrower-friendly. The other market is offering credit that is very lender-friendly. The prudent investor should think carefully about which type of paper is more investor-friendly.

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Coleman Andrews
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