Dollars and Sense podcast

Making dollars and talking sense….in leveraged finance

Ashley Wright and Tim van der Weyden, Leveraged Finance Portfolio Managers, join Mike Reed, Head of Global Financial Institutions, to explain high yield bonds and leveraged loans. They discuss how the market has undergone a remarkable transformation in recent years, evolving from its reputation as a speculative ‘junk bond’ space into a sophisticated, well-regulated asset class offering compelling, risk-adjusted returns. Yet despite attractive yields, recent turmoil in private credit markets has renewed investor concerns about leverage and liquidity, and in this episode, they highlight how active management, strong capital markets relationships and rigorous downside protection are key to navigating the asset class.

Mike Reed 00:05
Hello and welcome back to the RBC BlueBay podcast Dollars and Sense. I am Mike Reed, head of Global Financial Institutions. Well, it has been a tumultuous start to the year with the war in the Middle East driving energy prices higher, and concerns about the quality of the underlying assets in private credit funds causing investors to ask for their money back. With markets jumping higher or lower on the back of late-night tweets from the White House, we thought we would take a change and take the opportunity to step back a bit.

We have decided to take a deeper dive into the leveraged finance space and discuss the opportunities and risks involved when incorporating these products within your portfolios. Leveraged finance is the term used to describe a broad church of debt products issued by sub-investment-grade companies, which includes high yield bonds and leveraged loans. There are many flavours available, and the risk profiles vary enormously. As there is so much to unpack here today, we have actually invited two portfolio managers onto the show. Ashley Wright and Tim van der Weyden are here today. Welcome to the show, Ash and Tim.

Ashley Wright 01:15
That's great. Thanks very much for having us, Mike.

Tim van der Weyden 01:17
Hi, Mike. Thanks for having us.

Mike Reed 01:18
Great to have you on. I guess the best place to start when discussing adding an asset class to an investor's portfolio is thinking about the benefits and potential risks that including it would bring. If you were talking to a client who was thinking about allocating to high yield bonds for the first time, how would you position it relative to other asset classes?

Ashley Wright 01:41
High yield is sub-investment grade rated corporate debt. This is predominantly issued in dollars and euros with also a tail in sterling. High yield bonds are fundamentally a credit risk premium play. What I mean by that is you are being compensated for investing in companies which have smaller balance sheets. Your returns are driven less by interest rate moves and government policy and more by micro factors specific to the companies that impact their balance sheets. High yield bonds are usually issued by large- to mid-sized companies whose balance sheets are normally leveraged three to four times.

The global high yield asset class is approximately USD2 trillion in size with the European high yield market accounting for approximately a quarter of that, so roughly USD500 billion. The credit quality of the asset has been seen to be improving over the last five years and currently has an average rating of BB. It's made up of approximately 60% senior secured bonds. In Europe, you roughly get paid a yield of 5.8% versus 6.8% in the US, so pretty attractive yields given the risk there.

The asset class is liquid, transparent, and roughly USD15 billion trades per day. The market has matured to a point where sophisticated investors and allies make daily tactical allocations, so trading in and out on the same day depending on how they see the market evolving. On a return to volatility ratio, high yield outperforms equities, emerging markets, corporates, and investment grade, so it's a very well-positioned asset class.

Mike Reed 03:29
That's interesting because historically these were known as junk bonds, which obviously that's a part of the origin of name. It's interesting to see how much has evolved. I'd like to spend a little time thinking a bit more about returns because you mentioned a couple of stats there, which is helpful, but I think a lot of people, when they're investing into high yield bonds, will be doing so out of, say, probably their investment grade portfolio. Many investors hold quite a large portfolio…or a percentage of their portfolio…in investment grade and government bonds, but these generally have lower yields because you've got better balance sheets with lower leverage. They're seen as safer investments, that is investment grade bonds, and lower chances of defaulting. Historically, how have high yield bond returns actually been compared to investment grade? This additional running yield that you've already alluded to, that investors are being paid, is that sufficient to protect them or has it protected them from the higher losses that presumably result from bonds defaulting?

Tim van der Weyden 04:41
Good question, but I think we need to maybe level set a bit here. While there's no doubt that defaults in IG and the sovereign space are rare, they do suffer capital losses. It's important to highlight, I think, a couple of things here. One, default rates in Europe over the last 10 years are just over 2% and just below 3% in the US, so fairly low. A loss-given default on a rolling average is now higher than it was 10 years ago. Why is this? BB leverage is actually on par now with BBB leverage. You had an up in quality in the BB space.

As Ash mentioned, in total, the universe now is higher quality, if you think about BBs nearly being 70% of the benchmark. You have a higher percentage of secure than you did in the past. The composition of the asset class has changed. High yield is mainly dominated now by repeat issuers with a large portion having public listings. That means more conservative balance sheets, more conservative financial policies i.e. a sensible allocation of free cashflow between dividends and deleveraging. High yield companies are mostly regional companies without complicated supply chains.

Given all these factors, and you think about the high coupon, the lower default rate, that equals an attractive excess spread. When you think about over the last three, five, seven years, high yield has outperformed IG by some decent margin. While financial yield distress and defaults make headlines, if stable coupon clipping returns don't, hence the stable excess return exists.

Mike Reed 06:25
I guess what you're saying is there's less junk in this space, and that's why they're no longer called junk bonds, but they're called high yield bonds. That makes a lot of sense.

Ashley Wright 06:34
Correct. Look, you do touch an important point. High yield is now high yield again. The weighted average coupon is at its highest as it has been in the last 10 years.

Mike Reed 06:45
Yes, because there was a period when people were referring to them as medium yield bonds. Anyway, let's move on. I'd like to move on to another very important area of the leveraged finance space, and that's the loan market. I guess it covers a wide variety of different underlying products, the loan market.

Could you maybe walk us through, give us some insight into the different types of loans that exist, and how would an investor who is not part of a bank syndicate obtain exposure to them if they believe they are an attractive investment proposition?

Ashley Wright 07:19
When talking about the loan market, investors are normally referring to the broadly syndicated term loan Bs issued by European and US corporates. The loan market has seen significant growth over recent history, both in the US and in Europe. It's now a very similar size to the high yield bond market. We're talking, again, a roughly USD2 trillion in size with USD1.5 billion in the US and about USD500 billion in Europe. The asset class is slightly lower quality than the high yield universe and has got an average rating of single B versus BB in the high yield universe.

Investors can get exposure to the loan market in two main ways. You can either invest directly in an SMA, or they can invest via securitised credit in CLO liabilities. SMAs are single managed accounts, and CLOs are collateralised loan obligations. At RBC BlueBay, we manage both SMAs and CLOs in Europe and the US. We currently have nine active CLOs in Europe and six active CLOs in the US, so we are one of the bigger players within the market. As well as the CLOs, we also manage SMAs as well. Investing via an actively-managed SMA gives the manager more flexibility. They have less constrained guidelines, so they're able to generate more alpha. This is compared to CLOs.

CLOs, which are collateralised loan obligations, they're publicly rated vehicles. Normally, in Europe, they're rated by two of the three big rating agencies, and in the US, they tend to be rated by one of the big rating agencies. Now, because they've got these public ratings, there are more stringent constraints placed on the vehicles. They have stricter rules in terms of issue of exposure, diversification, the number of CCCs you can hold etc. They are highly regulated vehicles that are very diversified and give you broad loan market exposure.

Whereas in an SMA, you're able to be more tactical, take greater overweights. You can think about SMAs as giving you more active exposure to the asset class, whereas CLOs perhaps give you more passive exposure. At BlueBay, as I mentioned, we do manage an SMA. That one has got sort of peer leading performance over the last one, three, and five years, so something we're very proud of here.

Mike Reed 10:04
Thanks for that. It's quite interesting that obviously there's a few acronyms there, and people get a little bit concerned when they start to hear three-letter acronyms, especially if you're of my vintage of investor and you went through 2008. It's interesting how they've progressed, and there does seem to be much more regulation around them these days.

One of the things you talked about was the expansion of the asset class over the last decade or so, and generally the big drivers of the growth of an asset class are some form of structural market trend. For example, the issuance of contingent conversions, coco bonds, grew considerably after the 2008 financial crisis as banks were instructed by the regulators to raise equity-like capital to bolster their balance sheets. Within the loan market, are there some structural issues that have been driving either increased supply or investor demand, or was there anything coming in the near future that would actually continue this?

Ashley Wright 11:00
Yes, that's a really good question, Mike. As already mentioned, collateralised loan obligations account for the bulk of the loan market, and they allow investors to gain tranched exposure to leveraged loans with classes of notes rated from AAA down to single B. We've seen some dramatic growth in the CLO market over the last five years, so you can probably say this has doubled in size in Europe, from roughly USD150 billion in 2020 to around USD300 billion now. The CLO market in Europe is just a little bit smaller than the leveraged loan market.

This has meant that the technicals for the loan market, and the loan market in general, has been in very high demand and has remained really well supported. This is a trend that we expect to continue. There have been some changes announced to the capital ratio requirements under Solvency 2. That means the capital charge that an insurance investor who is investing in CLO liabilities would face.

If we use the Class A notes, which are AAA rated, as an example, previously they would have been charged 12.5% per year of duration. Under these changes in the Solvency 2 regulation, as at the start of 2027, the capital charge will go down, as I mentioned, from 12.5% to 2.7%, so a 10% reduction. Then obviously that's multiplied by the duration of the product you're investing in. If you think about CLOs, they're typically five to seven years duration. And so, that really is a significant reduction in the capital charge required. We believe this will provide a significant tailwind for not only the CLO asset class, but also the leveraged loan asset class in general.

Mike Reed 13:01
That's very interesting because I know that insurers historically used to have a lot more in the loan market because they like the attractive yields and the fact that there's no duration to them..that is…or very little duration, should I say, to them. Therefore, it is potentially a very interesting area of increased demand going out into 2027.

Ashley Wright 13:25
Absolutely. It's definitely a technical that we are going to make most of.

Mike Reed 13:31
I can't be all positive here! As I mentioned at the start of the show, there's been a lot of news coverage in recent months about problems within private credit funds where underlying default rates have risen and investors have been attempting to redeem the money. Unfortunately, redemption rates have now exceeded the 5% quarterly cut-off threshold that exists in many of these funds, so redemption requests are not being met in full. There's a fear that this could potentially create a vicious cycle as investors' concerns increase, so more investors ask for their money back, and this causes forced asset sales by the fund themselves, meaning the prices go lower, and then the cycle repeats. Do you have any worries that this problem could cause issues in the broader leveraged finance world?

Tim van der Weyden 14:17
Okay, I'll jump in and answer that one. I guess I'd be annoying and say yes and no to that question. Let's be clear. More credit available to the economy is not a bad thing. It's obviously a good thing. Too much leverage is a problem, particularly when you're lending long and borrowing short, which is what is happening in private credit, where redemption liquidity desired by investors is bumping up against the fact that these have been invested in illiquid longer-term assets. To give context, when we think about private credit, it's grown from a standing start, they call it 15 years ago, to rival the size of the public loan markets, which Ash has outlined already.

Hence, if the question is, if all investors ask for their money back, although it will be a multi-year process, that's a significant drain of credit out of the system. Unless that is inserted back into the system, it's going to cause a macro drag and thus will impact all credit markets. If the question is more about if we're describing a slower deflation of the asset class after a sharp run-up, then while it's significant, it won't be systemic in my view.

Why has there been this effective bank run on private credit? If you think back into the second half of last year, there were a few idiosyncratic events in the credit markets, which led investors to question underwriting standards in general. Then overlay that this year with the concerns around software and AI. That's led to increased concerns that private credit was overexposed to a structural shift i.e. AI and software. Equally important, the private credits are static, and they couldn't divest their exposure. There's concerns around valuation and transparency.

Public markets, by their very nature, are transparent. Valuations are struck daily, sector exposure is much more diversified, and active managers have the ability to divest and alter their portfolio.

Over time, there will be some transition, I think, from private credit to public market refinancing. You will see the private credit market shrink, and public loan markets increase. You're most likely to see an up in quality bias where the best-in-class assets of private credit come to the public markets and the tougher assets, either because they're in structurally tougher sectors or they're too levered or they're smaller, these deals will have to stay within the private credit ecosystem. Private credit isn't a bad thing. Higher leverage, illiquidity, lack of diversity, these things are.

Mike Reed 17:13
Let's hope they don't all redeem at once because that would create some issues, but I can't see that happening. Moving on, you touched on this somewhat in the show already, but with asset classes such as high yield bonds and loans, there appears to be a considerable amount of idiosyncratic risk, which we've talked about. The companies that issue capital in these markets, they vary hugely, as does the risk profile of their balance sheets. Given the variety of opportunities, does the lev fin market lend itself to the RBC BlueBay active management style? If so, how do you look to generate alpha for clients and how do you position your portfolios?

Ashley Wright 17:55
Yes, 100%. Look, it does. The BlueBay, for one, RBC BlueBay has a 20-year-plus track record investing in sub-investment grade. A long, long history investing in the asset class. We've always had a big focus on downside protection. Over the cycle, if you can think about the downside, then you will outperform the market. Really good risk management, both having stop losses, having good systems, and also the structure of the team. You've got to think, the analysts here are effectively sectoral PMs with average 15-plus years’ experience. They have strong capital market relationships with direct links to the owners of these assets i.e. private equity.

The analysts know the deal teams. They can ask the hard questions because they have that dialogue. In some instances, we've been lending to these companies for over 10-plus years. I think, as you mentioned, fear plays a big part of it. Fear and greed still dominate credit markets more than defaults. Having a good understanding of broader risk of the technicals is also crucial. I think what RBC BlueBay does very well, it does a great job ensuring that all risk-takers are talking to each other. There's over 150 risk-takers across the floor covering a whole range of different sectors and asset classes. There's constant dialogue between all different pods to ensure that there's knowledge transfer from one asset class to another.

Mike Reed 19:26
I guess there's the marrying up of the top-down, the macro view, and very much getting into the nitty-gritty and the bottom-up, especially in high yield asset classes or high yielding asset classes, where defaults are higher than they are in investment grade. If you can avoid the defaults, then you stay with 100% of your capital to reinvest. That's really key for staying at the table.

Ash and Tim, thank you for joining us today. It's been fascinating getting to learn so much more about an asset class that is so fundamental to companies' capital-raising plans, but is, as we discussed earlier, often treated with a degree of skepticism by investors. It really does sound like a key building block within every portfolio and definitely things that people should be considering.

Ashley Wright 20:20
Yes, absolutely. Thanks very much for having us, Mike.

Tim van der Weyden 20:22
Cheers, Mike. Thank you.

Mike Reed 20:23
It's been a pleasure. Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. We will be back next month when we'll be joined by Marc Stacey, who is a portfolio manager in our investment grade team. As I mentioned earlier, high grade bonds make up such a large percentage of many investors' portfolios, so it'll be good to hear Marc's views on the macro trends that will likely impact returns going forward.

If you wish to listen to any of the previous editions of the podcast, they are available on our website, www.rbcbluebay.com or can be found on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.