Market History
Ratings agencies, such as Moody’s and S&P Global, have long ranked both corporations and their respective credit instruments. Leveraged Lion Capital analyzes and invests in debt assets that fall under the high-yield category.
High-yield instruments receive their name from the inherent compensation associated with the investment. They are more risky and fixed income investors demand more yield for bearing that risk. Associated with larger returns, high-yield assets typically pay greater coupons, as compared to their investment grade counterparts, and are often sold at a discount to par to increase the return.
Investment grade companies and credit instruments receive ratings from Aaa/AAA to Baa/BBB. High-yield companies and credit instrument receive ratings from Ba/BB to C/D. Within high-yield there are subcategories to denote credit risk. Ba/BB is labeled “non investment grade speculative”, B/B is labeled “highly speculative”, Caa/CCC is labeled “substantial risks” and Ca/CC is labeled “extremely speculative”. The final two tranches of credit ratings in the high-yield space deal with companies in bankruptcy. C/C is labeled “in default with little prospect for recovery” and C/D is labeled “in default”.
Non-Investment Grade Markets
Leveraged Loan Market
Leveraged loans are an asset class that sit high in the capital structure, ranking senior to its fixed-rate counterpart. In conjunction with high-yield bonds, leveraged loans are issued to speculative-grade companies (ranking Ba/BB and below) and typically have claims on collateral in the event of default. At inception, loans are usually issued with a revolver – a credit facility that acts as a corporate credit card – and have different claims on assets.
Leveraged loans typically have liens on hard assets such as PP&E, whereas revolvers typically have liens on short-term accounts such as A/R.
The spike in leveraged buyouts (LBOs) through the mid-1980s resulting in popularity growth for the asset class. The LBO of RJR Nabisco in 1989 furthered that growth through $16.7 bn worth of loan debt.
Leveraged loans became the prominent way for issuers to tap bank debt for one reason: syndicated loans are less expensive and more efficient to administer than traditional bilateral credit lines. The asset class received business from speculative-grade issuers while investment-grade borrowers remained heavily entrenched in traditional vanilla bonds.
Following the spike in leveraged buyouts and the credit crunch of the early 1990s, the Loan Syndications and Trading Association’s (LSTA) emergence spearheaded growth in the market. Despite comparisons with the SEC, the LSTA focuses its attention on making an inherently illiquid market more liquid rather than compliance. Some of its largest contributions in the early stages include:
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Originating first for dealers only mark-to-mark pricing (1996)
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Mark-to-market pricing for all participants (1999)
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Launching the LSTA Leveraged Loan Index (2001)
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Providing distressed purchase and sale agreements (2003)
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Providing netting agreements (2003)
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Providing model credit agreement provisions (2003)
Throughout the mid and late 2000’s, the LSTA focused its attention on accurate pricing and credit documentation standardization. During that time period, CLO demand skyrocketed, far outpacing supply. The LSTA accommodated the market by further providing liquidity for investors.
In recent news, the LSTA has devoted itself to aiding the loan market in transitioning from LIBOR to SOFR-based interest rates. LIBOR has received numerous criticisms for its calculation, exposing the rate to price manipulation.
In addition, with the rise of covenant-lite structures (credit documents with incurrence covenants rather than maintenance covenants) and aggressive EBITDA add-backs, the LSTA has focused efforts on creating uniformity.
High-Yield Bond Market
The origin of the high-yield bond market can be traced as far back as the genesis of many other corporate bonds. Although, market participants generally believe that the rise in popularity resulted from the boom in issuance seen in the 1970s and the 1980s. The increase in lending came as a result of fallen-angel companies and LBO activity.
Following the downgrade, fallen-angel companies did not receive a widening on their interest rate margins. As a result, the bonds were traded for pennies on the dollar which consequentially increased yields.
The surge in high-yield lending, facilitated by Drexel Burnham, grew the asset class at an alarming rate. By 1983, more than one-third of all new corporate bond issuance was classified as speculative grade. The growth in the market was fueled by a number of characteristics aligning the instruments with the overall landscape. Non-investment grade issuers could borrow at lower interest rates and with greater liquidity than through private lending. In addition, high-yield bonds contain less restrictive incurrence covenants when compared to its bank debt counterparts. In conjunction, investors discovered that high-yield bonds earned larger risk-adjusted rates of return compared to investment grade, further fueling the fire.
Throughout the course of the 1980’s, the junk bond market grew at a rate of 34% per year from $10 bn to $189 bn in outstanding issuance (size of the market is relevant in comparison to the equity market because the bond market operates without the assumption of infinite life – bonds are issued, serviced and matured). New sectors began issuing high-yield debt with names such as Turner Broadcasting, MCI Communications and McCaw Cellular coming to market.
Junk bonds also grew in popularity due to the instrument’s ability to restructure defaulting debt. For example, high-yield bonds successfully restructured Chrysler’s capital stack throughout its chapter 11 bankruptcy proceedings. This has become common practice and is a large function of the investment banking world.
Issuance dried up from 1989 to 1991 when Rudolph Giuliani and other credit market participants campaigned against junk debt. The bankruptcy of Drexel Burnham, an American Investment Bank with distinct exposure in the high-yield markets, set the stage for negative press and poor returns. Over the two year span, the market saw no material issuance and investors realized losses of 4.4% (1990).
The 1990s were lucrative years for high-yield bond investors. Yearly returns for the market averaged 15% annually from 1990-1999, fueled by 40% returns in 1991. The asset class diverged from the negative press and became desired by market participants, highlighted by large returns and minimal defaults (defaults averaged 2.4% from 1992-2000).
The Dotcom Bubble and the Great Recession were the two most recent periods of abnormally high defaults and negative returns. Despite the aforementioned speed bumps, the market continues to expand upon historically low interest rates, a dovish Fed, strong underlying economic fundamentals and demand for yield. The current size of the high-yield bond market is $1.21 trillion in outstanding issuance, with indices such as the Bloomberg Barclays High-Yield Index returning roughly 8% YTD.