If you're confused about the differences between junk-rated loans and bonds, don't worry, you're not alone. These asset classes look more and more alike.
While the loan market has traditionally been smaller than the high-yield bond market, it has become the more popular of the two this year for companies looking to borrow money. That's because corporations see loans as having new and improved opportunities to take advantage of debt investors.
In the past, loans were thought to be safer than bonds because they were governed by tighter protections and were repaid first in a bankruptcy. As a result, they offered lenders lower interest rates than comparably rated bonds. But those lender protections are steadily being stripped away. By some estimates, 85 percent of loan deals for bigger companies backed by big private equity firms are now considered covenant-lite, or lacking provisions allowing investors to step in when a borrower tries to incur much more debt.
Meanwhile, creative maneuvers are making loans more vulnerable to being subjugated to bonds in distressed-debt exchanges. Just look at what happened with J. Crew Group's recent distressed-debt exchange, where junior bondholders were effectively brought to the front of the line to receive repayment, ahead of term-loan holders, according to a Wall Street Journal article last week.
Still, on average, senior loans are typically cheaper to maintain for borrowers than bonds (and thus less lucrative for lenders.)
So it's not that surprising that companies have been issuing leveraged loans at a breakneck pace this year, with volumes on track to break records. In contrast, U.S. junk-bond sales are well below the recent volumes in 2013, 2014 and 2015.
According to a Fitch Ratings estimate, more than two-thirds of this year's high-yield loan sales are refinancings, with less than a quarter of such sales in February and March stemming from new deals. In other words, for the most part, companies are simply going to their lenders and saying, "We're going to pay you less and give you less control over our finances. Cool?" Or, "Hey, we're just going to take away your ability to say no if we want to pack on more leverage. Cool?"
The investors response? "Cool."
This is happening again and again. And let's be very clear: Loan investors are fully aware of this dynamic and many have no better choice but to continue to buy the debt. Investors worldwide have been pouring cash into collateralized loan obligations, for example, which raise money to buy pools of these loans. Others are buying loans for their floating-rate feature, meaning they pay more as benchmark rates rise. This is attractive when central banks are starting to withdraw stimulus.
And investors justify the lighter covenants they're accepting as the cost of doing business when there's seemingly endless demand for everything, thanks to unconventional stimulus efforts of central banks globally. It's become so common for loans to be governed by light investor protections that when they have strong covenants, it's often a sign that the borrower is in dire shape.
Of course, there will be some unpleasant consequences going forward. J. Crew just gave a taste of that. Investors are clearly getting the bum deal here. They know that. But there aren't a lot of better options in public markets right now when everything looks expensive. There will most likely be more severe pockets of losses for these investors down the line as companies run into trouble. But for now, borrowers in the loan market know they have the upper hand.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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