Friday, September 13, 2013

Is mitigation of rate risk worth buying HY loans at sub-5% yield?

Demand for leveraged (sub-investment grade) corporate loans remains strong. Investors are paying a premium for floating rate (LIBOR+spread) paper that is supposed to protect them from rising interest rates.

Fund flows into loan funds (source: GS)

At the same time CLO issuance is expected to spike. CLO managers have been accumulating (warehousing) a great deal of this collateral in preparation for the tranche sales.

This demand is providing price stability in the syndicated loan market, as these products continue to outperform HY bonds.

(ticker symbols: SNLN and HYG) Source: Ycharts

As a result of this demand, yields on leveraged loans have been compressed and pricing is starting to look frothy. It is important to remember these are (on average) single-B type corporate loans. The yields are now sub-5% - near record lows.

While the US corporate sector is in good shape, are investors being paid enough for the credit risk? Default rates are still quite low relative to historical averages, but have risen lately. The trend shown above and the one below look a bit inconsistent.
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