Monday, February 1, 2010

Loan - Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond's cost is 50 basis points higher than the loan's cost.  Since both debt instruments were issued by the same borrower, shouldn't they cost the same?

Corporate Finance 101
Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).

Investor: Risk vs. Return
As with Jarden, the yield on non-investment grade (i.e. "high yield") bonds is typically higher than the yield on non-investment grade (i.e. "leveraged") loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:

  1. Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds.
  2. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have "bullet" maturities (i.e. all the principal comes due at once), whereas loans often amortize (i.e. get repaid) over time.  This longer maturity and lack of amortization make bonds more risky to own than loans.
  3. Covenants:  Loans have more (and more restrictive) covenants than bonds.  Thus, as a company's operating performance begins to deteriorate, the loan will default long before the bond.  This early default gives the loan holders the opportunity to re-negotiate and improve their position before bond holders can do so.

Thus, in order to accept the greater risk of owning a high yield bond, investors demand a higher return than what they would receive on a leveraged loan from the same company.

Issuer: Risk vs. Cost
As with Jarden,  for non-investment grade issuers, bonds typically have a higher all-in-cost than loans.  This is because bonds are less risky for issuers and provide issuers additional flexibility.

  1. Refinancing Risk: Companies are constantly faced with the risk that they will not be able to borrow money when they need it.  If the need is for a new project or operations, we refer to it as funding risk; if the need is to repay maturing debt, we refer to it as refinancing risk.  Companies can reduce their refinancing risk by issuing debt with longer maturities.  The longest maturity typically available to a non-investment grade company is a 10-year high yield bond.
  2. Flexibility: Bonds place few restrictions on a borrower's operations or financial performance when compared to the large number of restrictive covenants typical in loans to non-investment grade companies.
Thus, many companies are willing to pay a higher borrowing cost (and issue bonds) in order to achieve other objectives, specifically lower refinancing risk and greater flexibility.

Loan-Bond Relative Value
When investors compare the risk and return of related instruments, such as loans and bonds from the same issuer, it is called relative value analysis.  In our Jarden example, a portfolio manager would focus on the yield difference of 50 basis points.  
  • If they think this additional return does not adequately compensate them for the additional risk of holding the bond, they will buy the loan.  
  • If, as was the case at the beginning of the credit crunch, the difference was several hundred basis points for many high-yield issuers, they would buy the bond.


Peter Melichar said...

Thanks - this is a really enlightening for someone, like me, who works in commercial banking and has seen leveraged loans but not high yield bonds. A couple of follow up questions:
1. generally, how large must companies be before they can issue high yield bonds?
2. Why are they typically unsecured and subordinated? Couldnt they also issue senior secured bonds? Is there something with the bond market which makes it more attractive to issue a debt instrument with lower restrictions (e.g. maybe because you dont know who is buying your debt.)
3. So although the bonds are typically unsecured and subordinated, I presume they will always include a cross default which should enable bond holders to react to senior covenant breaches (subject to the senior lenders declaring a default and any other terms?)?


Ron Carleton said...

Good questions.
1) There is no strict rule about who can issue bonds, and the market's reception varies over time, but a good rule of thumb is that the company must have sales of at least $250 million and EBITDA of at least $75 million. Also, high yield bond issues themselves are typically at least $125 million, so if the company only needs, say $50 million, that would rule them out also.
2) Again, there is no rule that says high yield bonds must be unsecured and subordinated, and there have been senior, secured bonds, but generally high yield bonds are structured to rank behind the bank debt. That priority ranking can be the result of one or more of: collateral, structural subordination, or contractual subordination. In Europe, issuers typically rely more on structural subordination than contractual subordination (see our blog entries on these topics).
3) Bonds do have some type of cross-default, but it is rarely very effective. It may be structured as a cross-acceleration (i.e. the bondholders can only act after the loan holders call the loan, which means the company is in bankruptcy). Even if it is a regular cross-default, the loan holders will rarely leave the loan in default, knowing it would allow the bondholders to come to the table. The loan holders will give a temporary waiver, taking the loan out of default while they are negotiating a restructuring, thus avoiding tripping the bond cross-default.


peter said...

thank you.