Fixed or Floating: How We’re Assessing Relative Value in Leveraged Credit
Fixed rates or floating? It’s a question we’ve been hearing more often lately in U.S. leveraged credit markets. Since March 2022, when the U.S. Federal Reserve embarked on its first of 11 rate hikes, floating interest rates have provided a clear advantage. (As a reminder, high yield bonds tend to have fixed interest rates, while leveraged loans and CLOs tend to have floating rates.) For our part, we were skeptical in early 2023 of the market’s view that interest rates would decline imminently, and we increased our overweight to floating rates by selling high yield bonds and moving into structured credit (CLO BBs and CLO BBBs). The trade was the right one.
EXHIBIT 1: PERFORMANCE OF ASSET CLASSES THROUGH SEPTEMBER 29, 2023
But what about now? The latest inflation data shows a more convincing moderation, and the Fed appears to be on pause for the moment. Henry McVey, our Head of Global Macro, Balance Sheet and Risk and Chief Investment Officer for the KKR Balance Sheet, has also pointed out that the rising of rates at the back-end of the yield curve represents a second monetary tightening that could spur the Fed to move more cautiously. In addition, the economy faces some headwinds that point to more subdued growth in the next few quarters, including the resumption of student loan payments October 1, labor strikes, and the potential geopolitical impacts of two major wars, among several other factors.
Despite these factors, we still prefer floating-rate to fixed-rate credit — but perhaps less overwhelmingly than we did in the recent past. In fact, we have been reducing our overweight to floating-rate assets recently. Here’s why.
Spreads, Rates and Yields
The first thing we look at in comparing different assets is spreads, which are somewhat wider in loans than in bonds (Exhibit 2). However, after adjusting for quality, we think they’re closer to fair value. High yield bonds are more likely to be secured than in the past, with some 60% of new high yield issuance being secured. The firms included are also larger and higher rated, on average. For example, over 50% of the U.S. high yield market and 60% of the European high yield markets are BB-rated, which is the highest ratings category for leveraged credit. Moreover, the bank loan markets are dominated by issues that are sponsored by private equity firms, whereas the high yield markets have a larger share of more conservative public firms and non-sponsored private firms. Taken together, these factors mean that high yield bonds may be more attractive from a risk-reward perspective than current spreads suggest.
Then, we consider the overall yield, which is partly determined by the underlying interest rates. Here, the difference between the two assets is more clear. Floating interest rates came with some 200-plus basis points of yield relative to high yield bonds as recently as a few months ago. Given the recent spikes in longer-term Treasury bonds, however, the higher yields available in the high yield bond market changes the calculus.
EXHIBIT 2: A COMPARISON OF YIELDS, SPREADS, AND PRICES IN HIGH YIELD BONDS AND LOANS
Rounding out our analysis are a few other factors. High yield bonds are trading at lower prices, which means they have more convexity, or room for prices to rise, than leveraged loans do. With limited call protection, loan investors also run the risk of prepayment. Should short rates decline in the future, issuers may refinance their loans, causing lenders to forego the high coupon rates they currently receive.
Where Is the Relative Value in Liquid Markets?
Taking everything together, we still think that it makes sense to tilt a portfolio toward taking advantage of the high yields available in floating-rate loans. However, the convexity, quality, and changing macroeconomic picture make fixed-rate high yield bonds more attractive than they were even a few months ago. And that rotation may well continue.
In fixed-rate debt, we see more value in European high yield than in the U.S. market. We have been deploying incremental cash flow to Europe, as currency-hedged yields are higher, spreads are wider, and the market is higher quality, with a greater proportion of BB-rated bonds. Looking more closely at relative spreads in the two regions, we see in Exhibit 3 that the since the beginning of 2023, the spread differential between European and U.S. high yield bonds has been widening, with the current differential at around 63 bps. That’s significantly above the median of 4 bps since the beginning of 2013.
EXHIBIT 3: SPREADS HAVE BEEN WIDER IN EUROPE SINCE INTEREST RATES STARTED RISING
Spread Differential: EU HY BB minus US HY BB
Spread Differential: EU HY BB minus US HY BB
In floating-rate debt, we see more value in BB- and BBB-rated CLO tranches, which offer higher spreads to similarly rated leveraged loans but have significantly more downside protection. For example, a typical BBB-rated CLO note can withstand an approximately 25% cumulative default rate in its underlying bank loan portfolio before experiencing its first dollar of losses.
As we continue to assess the balance between fixed and floating-rate debt in publicly traded credit, we think it is important to be ready to keep an eye on high yield bonds and maintain a wish list for when a rate cut comes. Public markets can move very quickly once they start going, and being flexible and ready to move is paramount.
