How leveraged loans can outperform when rates are volatile
Leveraged loans are increasingly a place where one can find solid returns, says Jeremiah Lane of KKR.
Imagine you're starting a lemonade stand, but you need more than just the existing cash you have on hand. In this scenario, you will need a loan to buy supplies and get things rolling. But here's the twist: you haven't quite proven yourself as a lemonade entrepreneur yet, so a conventional lender might be hesitant.
This is where a leveraged loan comes in. It's a secured, sub-investment grade (i.e. rated BBB- or below) loan that was originated by a bank and syndicated to a group of buyers such as private credit funds, collateralised loan obligations (CLOs), and hedge funds.
One of those managers of private credit funds, and a major customer of such products, is KKR. And the man who helps look after KKR's investment in these products is San Francisco-based Jeremiah Lane. In this episode of The Pitch, Lane will explain how the leveraged loan market works and how you can access it as an everyday investor.
Edited Transcript
Lee: What is a “leveraged loan” and why is it an investment opportunity worth talking about right now?
Lane: A leveraged loan is a loan that is originated by a bank and syndicated to a group of investors. We're one of those investors that they syndicate the loan to. It's rated sub-investment grade - so it's rated BB, B, or CCC. It typically pays a floating rate over SOFR (secured overnight funding rate).
Higher quality loans today might pay 250 or 300 (basis points) over SOFR. Single B loans are probably paying around 400 over SOFR, and triple C loans depend on the credit quality specifics of the borrower.
They're typically secured by the assets of a company. That provides a measure of protection if the company has problems - say it ends up filing for bankruptcy. You're able to be first in line for an ultimate recovery through the bankruptcy process.
Lee: Compared to other parts of the credit market, where do leveraged loans rank in terms of risk and reward?
Lane: One of the really interesting things over the last two years has been the change in Fed policy. Parts of the fixed income market that were historically considered very safe have caused huge problems in people's portfolios.
If you think about a government bond that was issued in 2021 at rock-bottom interest rates, that bond has a lot of sensitivity to a change in the rate environment. An investor who at that time bought that and said, I'm locking in 1-1.25% in the US for the next 10 years, fast forward a couple of years, and all of a sudden, a 10-year bond yields 5%. That results in a huge decline in the price of that bond.
One of the nice things about leveraged loans is that they're floating. They don't have that same sensitivity to interest rates. If the Fed raises rates from 0 to 5.5% as they've done, that just means that the spread over SOFR continues and just goes up and up and up.
Initially, that loan was paying, all in, 4.5% when the reference rate was zero and it paid 450 basis points over that. Today it's paying 10% given the reference rate is 5.5% and it's paying 450 basis points over that.
And so the price of the instrument doesn't fluctuate with interest rates in the broader economy. That's meant a lot less volatility and better outcomes for investors. That's one of the biggest differences.
There are also differences in ranking. High yield bonds tend to be unsecured. That means that versus a loan, they're often second in line for recovery after a bankruptcy and there are a number of other more esoteric differences between the products.
Lee: The average coupon in leveraged loan markets is higher than in high yield for the first time. Why does that matter from a returns perspective?
Lane: I think one of the things is that if you invest in an index of leverage loans, we look at it and we would say that that you can get about 10% in a a broad portfolio of leveraged loans today and a broad portfolio of high yield bonds would yield about 7.75% to 8%.
When you think about the two as alternatives to one another, in order for high yield bonds to outperform, they really need to appreciate by about 2% in order to outperform loans. And when we look at that, we say that it looks relatively unlikely to us.
Either rates need to go down a lot, and we're very sceptical of that outcome. We're in the higher for longer camp. We don't think that there's going to be a big and fast rate cutting cycle. Or spreads need to compress a tonne. But when we look at spreads, we say that they look pretty fair over the long term.
We think about the tradeoffs between the two markets all the time. And right now, we tend to favour the higher running yield that is available to you in loans versus the somewhat lower yield, but with more interest rate sensitivity that's available in high yield bonds.
Lee: How can you access this opportunity given it’s not widely available in Australia?
Lane: We offer our capability in two ways to Australian investors. We have a listed investment trust - KKR Credit Income Fund (KKC) (ASX: KKC) that trades on the ASX. A portion of that is dedicated to our credit opportunities fund, which invests in leveraged loans and high yield bonds. A portion of it is also also invests in our private credit capability in Europe.
And then, we've created an unlisted unit trust that investors can invest in, which specifically pursues our credit opportunities fund where we're investing in loans and bonds in a concentrated high conviction way.
To learn more about the KKR Global Credit Opportunities Fund (AUD) ("GCOF (AUD)"), click the link here. You can also find out more about KKR CREDIT INCOME FUND (ASX: KKC) here.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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