The S&P U.S. Issued High Yield Corporate Bond Index is returning 4.01% year-to-date with a weighted average yield of 5.78%. Similar to high yield bonds—whose credit ratings are below the investment grade cutoff of ‘BBB’ assigned by the rating agencies—are senior loans. William Shakespeare’s famous quote from Hamlet, “To be, or not to be, that is the question” can be rephrased by investors comparing high yield to senior loans as “secured, or unsecured, that is the question,” when pondering the risks of each product. Senior loans rank higher in the capital structure and are secured to the assets of the business, unlike the unsecured nature of high yield bonds. The loan’s coupon is typically the higher of a floor rate or a certain spread over three-month LIBOR. Because their coupons are tied to a short-term rate, senior loans have less interest rate risk and are considered a floating rate instrument. In a rising rate environment, senior loans are at an advantage to high yield whose bullet structure and fixed coupon would be negatively affected. Not surprisingly, senior loans tend to have slightly smaller, but less volatile returns than high yield bonds (See Total Returns table).
When investing in lower rated credit instruments, the risk of default should always be a concern. Though now, after the 2008 financial crisis, the majority of companies have put their balance sheets back in relatively good financial shape. Presently, default rates are near historical lows, with senior loan defaults at 1.4% and high yield defaults at 2.3%.
Weighing the risks, both senior loans and high yield bonds are attractive investments. Not only because of their higher yields, but also because they are relatively short investments which, when compared to other long term investments, won’t be as affected by changes in long term rates. The duration of the S&P U.S. Issued High Yield Corporate Bond Index is 5 years, while the average life of senior loan is 4.48 years as measured by the S&P/LSTA U.S. Leveraged Loan 100 Index.
An additional benefit of these two investment choices is that their returns are negatively correlated to other markets, so as one product is underperforming the other is providing return (See Correlation Table).