Commonalities
High yield FRNs and leveraged loans share numerous common attributes.
Floating rate coupons
Both pay floating rate coupons, which reset for each new payment period, based on the prevailing reference rate. In the United States, floating-rate debt now uses the Secured Overnight Financing Rate (SOFR), which is based on actual overnight transactions in the US Treasury repo market. In Europe, floating-rate instruments typically reference EURIBOR, which continues to be used after a significant reform in its calculation methodology.
Whilst coupons will decrease as the Fed continues cutting rates, HY FRN yields remain higher than other types of credit due to their low average credit rating of B-, leaving room for rate cuts whilst still providing attractive additional yield.
Seniority and the security it brings
Both typically occupy a senior position in the capital structure. This characteristic may provide greater security to investors in the event of a default compared to junior debt and equity. Historically, recovery rates for senior securities following a default are higher than for subordinated securities.
Non-investment grade status
Both asset types are of non-investment grade status, with credit ratings, either explicit or inferred, of BB+ or lower. They may be reasonably expected to offer greater potential reward than an investment grade equivalent (BBB- or higher) as the credit spread they carry is likely to be higher to reflect the additional risk they represent.
Similar, but different
What may be more interesting, and provide the basis on which to prefer one market over the other, are the differences between them and in particular, how M&G approaches managing global high yield FRN strategies.
Liquidity
Perhaps the most material difference, in our view, is that high yield FRNs typically offer greater liquidity than leveraged loans. In normal market conditions -- those that prevail the majority of the time -- FRNs may be expected to trade freely, with a standard T+2 settlement period.
Loans in the US are less liquid, and may be expected to trade with a longer settlement period, commonly T+5 to T+10, and potentially more. In the European market, T+30 settlement for loans may be more likely. Having such extended settlement periods may potentially compromise a manager’s ability to easily deal with portfolio flows.
Diversification of sectoral exposure
The loans market, in which the US is dominant, tends to be more concentrated in sectors such as technology, services, and healthcare. In contrast, global high yield FRNs, where European borrowers are more prevalent, offer diversification with greater exposure to financial services, retail, and capital goods.
The market index that our strategies use as a benchmark, the ICE BofA Global High Yield 3% constrained (USD hedged), reflects this diversification. These sectors have different risk profiles compared to US loans, allowing for greater geographic and sectoral diversification in portfolios.
In addition to the differences in market structure, we typically take what we believe is a relatively conservative approach to managing global high yield FRN strategies. The benchmark index tends to contain a concentration of risk, partly due to the relatively high minimum issue size required for inclusion. This means that the index is typically smaller than the broader market and less diversified, containing some relatively large weightings to higher-beta credits, many of which have performed strongly over the past few years.
The index omits some names in the mainstream of issuance that the fund may look to hold. It is also somewhat tilted towards riskier, more leveraged credits. Our approach has been to remain underweight in those credits. This cautious positioning is deliberate, intended for the benefit of investors, seeking to avoid volatility associated with these names in pursuit of delivering a smooth return path.
Accessibility for investors
The loans market has historically been accessible primarily to institutional investors, who are better able to trade and hold such illiquid assets. Requirements for regular daily liquidity in funds have typically prevented loan products being made available to wholesale investors. By contrast, by being a more liquid market, global high yield FRN funds can provide the daily liquidity that is required, making the market accessible to a wider investor base.
The decline in protective covenant safeguards for loan investors
In the past, leveraged loans were typically issued with covenants attached. Maintenance covenants require companies to maintain certain measures of financial strength. Incurrence covenants may act as hurdles, which aim to prevent a borrower taking a specified action, such as incurring new or additional debt, unless a particular measure of financial strength is in place. Covenants such as these are applied in order to safeguard their ability to service the debt and protect lenders.
High yield FRNs by contrast are more typically, though not always, secured on assets of some form and not subject to such covenants. However, over time, as investment demand for loans grew after the Global Financial Crisis in 2009, borrowers were able to issue debt with fewer and less restrictive covenants. So called cov-lite loans now represent 90% or more of the loan issuance in the US and Europe, having been almost non-existent in 2010. As a consequence, any perceived advantage or safety net that the presence of covenants can bring has substantially eroded.
A look at market returns over time
Over the long term, high yield FRNs have proven to be a good, and liquid, proxy for the US leveraged loan market. A long-term performance comparison shows that the global high yield FRN index we use when managing our strategies has tracked, and even outperformed, the US and European leveraged loan market over time, as shown in Figure 2.
We believe the higher liquidity of high yield FRNs has proved helpful during periods of market turbulence.
Figure 2: Returns compared by market index
