Low interest rates since the Great Recession have driven yield-starved debt investors into riskier assets. The high-yield credit market now totals nearly $3 trillion split between high-yield bonds and leveraged loans. The growth of these markets has been spurred by a plethora of nonfinancial corporate debt, which stands at its highest level in U.S. history.
High-yield bonds have been the best-selling debt product for most of the current expansion. The value of outstanding high-yield bonds nearly tripled from 2007 to 2018, going from $500 billion to over $1.2 trillion. The default rate for high-yield bonds is now 2% and peaked in 2002 at 16.8%.
The leveraged loan market now totals nearly $1.5 trillion, having recently overtaken the high-yield bond as the best-selling debt product. Most of these debts are tied into Collateralized Loan Obligations (CLO), which are securitizations of the underlying pool of corporate debt. Historically, the default rate for leveraged loans has been much lower than that of high-yield bonds, and no CLO note rated AA or higher has ever defaulted. The current default rate for leveraged loans is 1.61% and peaked at just over 10% in 2009.
High-yield bond option-adjusted spreads are near Post-Crisis lows relative to investment-grade bonds. AMG believes that these spreads must widen considerably for an investor to find value given the higher risk of default in high-yield bonds.
A concern with rising demand for high-yield credit, and especially leveraged loans, is the increased incentive for adverse selection. That is, when there is more demand for these products, there is less motivation for the seller to ensure that the companies in the collateral pool will be able to service the debt for the duration of the loan. This was exactly the problem before the Great Recession with mortgage-backed security products and homeowners who couldn’t afford the mortgages. If a large proportion of the companies underlying the debt sold in high-yield bonds and CLO’s are “zombie” companies, only surviving by continued investment and not their own revenue stream, increased defaults and lower recovery rates are likely in a downturn. Reduced investor protections in the form of covenant-light loans and the rise of ETF investing in high-yield credit are other concerns that deserve attention.
It’s important to monitor capital flows, maturity schedules, and indicators of a deteriorating collateral pool in the high-yield credit market. We encourage our clients to be aware of the risks involved with any investment they are considering. And today, high-yield credit markets deserve prudence from investors.
This information is for general information use only. It is not tailored to any specific situation, is not intended to be investment, tax, financial, legal or other advice and should not be relied on as such.