Why leveraged loans have followed high yield bonds (Part 1)

Why leveraged loans have followed high yield bonds (Part 1) PART 1 OF 1

Why leveraged loans have followed high yield bonds (Part 1)

Why leveraged loans have followed high yield bonds (Part 1)

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If high duration drove the bond sell-off, why did loans follow suit?

High yield bonds and leveraged loans are the two main asset classes composing the sub-investment grade called “fixed-income debt capital markets.” High yield bonds are defined as bonds rated below BBB-, and leveraged loans are those paying over L+125 basis points or rated below BBB-. (The exact definition for leveraged loans varies by source.)

Bonds pay a fixed coupon, so they’re subject to interest rate risk, known as “duration.” Duration is the sensitivity of a bond’s price to changes in interest rates. As interest rates increases, bond prices decrease. Sensitivity depends on the weighted average life of the cash flows1, which is known as duration. Bonds with lower coupons or those with longer maturities have longer duration since they receive more of the cash flows further in the future.

Leveraged loans, on the other hand, pay a floating rate. This means that the interest income will vary according to changes in interest rates, and since the interest payment is reset to the existing LIBOR rate (London Interbank Offered Rate, the benchmark rate for most loans) every quarter, interest rate risk is much lower.

Given the lower duration risk in leveraged loans, investors fled bonds and continued to favor leveraged loans, as the speculation of higher interest rates was built up in May, leading up to the June FOMC (Federal Open Market Committee) meeting. The idea that leveraged loans could weather the storm made sense—at least in principle. After Bernanke’s statements, both bonds and loans started to sell off.

Leveraged loans sucked into bond turmoil

Between early May and early July, high yield ETFs (exchange-traded funds) such as JNK and HYG lost between 4.5% and 5.0% of their value due to collapsing high yield markets. The issuance in the high yield market fell by 75% and $12 billion fled the high yield funds over five weeks. The leveraged loan market was able to maintain steady inflows, keeping up a pace of over $1 billion in investors inflows per week. Its weekly issuance, though, fell by 25% to 30%—not as bad as high yield bonds, but significant nonetheless.

The above is just a recap of the situation. The important lesson you should learn is why this happened. Read on to find out in Why leveraged loans have followed high yield bonds (Part 2).

  1. For a bond, this implies semi-annual coupons and principal repayment at maturity

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