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:
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
Dear Mr. Carleton,
thanks for this interesting and instructive article.
I really would like to get to know further articles/examinations about the difference between bonds and loans but unfortunately there are no citations mentioned here. Relatively often one can find expressions like something is “typically” so and so, but there is no reference to studies or other examinations. Especially in the end you state indirectly that by the beginning of the credit crunch the yield difference declined dramatically and there is not so much of a difference between bonds and loans as it was before the crisis. Where do you get this information from? Why is this the case? Is it mainly because of the loans approaching the bonds or vice versa or both? For me it is quite interesting to know how the difference between bonds and loans evolves. Do you know about further literature/results on relative analysis?
Thanks für your help and thanks again for your great article.
Kind regards
Peter Lebmeir
Peter,
Thanks for your comment. My favorite source of data on relative value (and the source for my observations about how the spread differential has changed over time) is the Gold Sheets, published by Thompson Reuters LPC (see http://www.loanpricing.com). They compare yields on loans and bonds for non-investment grade issuers on a LIBOR-equivalent basis.
Quoting from them:
“Loan spreads are determined by their coupon and secondary market price, and are calculated through a discounted cash flow model. Bond LIBOR-equivalent spreads are determined by taking the yield to worst, subtracting a comparable Treasury yield and swapping the result to a floating-rate equivalent.”
You can think of the spread differential between loans (which are typically senior secured) and bonds (which are typically unsecured and often subordinated) as the market’s pricing of risk. At the beginning of the credit crisis, no one wanted to own the risk, so the spread on the (more risky) bonds went up more than the spread on the (less risky) loans.
Hope this helps.
Ron