Gap between loans and bonds widening, sustaining bond prices due to scarcity

Examining the gap for similarly rated bonds and leveraged loans gives an idea of the advantages of issuing a bond or a loan. There are two key differences between bonds and loans: security and interest rate type.

  • Security: Bonds can be unsecured, meaning they are not backed by specific assets of the issuer; instead, they are just guaranteed by the issuer. Loans are secured or backed by specific assets, so they have a higher recovery rate in case of bankruptcy (e.g. lower risk).
  • Interest Rate: Bonds pay a fixed coupon while bonds pay a floating rate, usually a margin over a benchmark (e.g. LIBOR + 3%). While fixed coupons are better in an inflationary environment with rising interest rates, companies can easily swap floating rate liabilities out for fixed rate by using derivatives (at a small cost).

Gap and issuer appeal

When the cost gap between issuing a bond or a loan gets narrower, more companies will prefer to issue bonds since for a similar cost they can obtain financing that is not backed by assets. This is beneficial for two reasons: the first is that they can pledge those assets later for another secured loan. The second is that having unsecured debt is common among investment grade companies, hence it can show rating companies that the firm may be ready for an upgrade, which would lower the risk for investors and result in cheaper debt.

Also, when the gap is narrow enough, the cost of the swap from a floating interest rate to a fixed interest rate will eat away the savings of a secured loan.

The gap between BB rated bonds and loans had widened to almost 1.8% by the end of March (currently around 1.6%) after having been effectively zero in June 2012.

In the B rated space, the gap is above 1.8% since September last year. While it contracted recently, it is wide enough to give loans a clear advantage.

Term loan issuance ahead of bond issuance

While not all companies have the luxury of choosing between both markets (e.g. CCC rated companies rarely issue loans and highly cyclical companies may not be welcomed by TLB investors), the gap between both markets can help gauge where the issuance will go.

This is both the reason why term loan issuance has outpaced bond issuance over the past two months, as well as the reason why bond prices have been sustained for so long despite very low inflows into high yield bond mutual funds. The limited supply of new bonds in the market has created a scarcity much greater than the lack of investor interest.

For the first quarter of 2013, high yield bond issuance totaled over $90 billion, though the overall amount of bonds outstanding increased approximately by just $55 billion. Throughout the year, approximately over 30% of issuance has been to refinance bonds[1. Close to 70% to refinance debt in general (e.g. bonds, term loans, etc.)], limiting the amount of new bond supply available for high yield investors to replenish matured or refinanced bonds.

How much longer?

Higher interest rates would drive investors away from bonds since their fixed rate coupons would cause their prices to decline as interest rates increase. As long as the expectation quantitative easing remains in place to sustain the low interest, investors may continue to hold on to their bonds and squeeze the approximately 5% interest income yield.

Once interest rates rise, then investors will likely leave the market at a faster rate than issuers will reduce their issuance due to higher cost of debt, and subsequently bond prices will finally fall. In the medium term, this is a very likely scenario; in the short term it is all up to the Federal Reserve.

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