The author is a bond portfolio manager at Barksdale Investment Management

Readers who grew up watching Peanuts Linus’ character will be remembered as an unlikely sage with a beloved security blanket usually in tow.

Investors in high yield bonds may sympathize with Linus’ fixation. When we have the opportunity to buy bonds with collateral, we feel, well, more secure.

This type of paper generally falls under the leveraged loan market, which secures most secured debt issues. The riskier and unsecured parts of a company’s debt capital structure are left to finance the high yield securities market.

But in times of turbulence, such as the early days of the pandemic, more fickle loan investors disappear, forcing companies to look to the more sustainable high-yield market for secure bailout financing.

The 2020 issuance frenzy included a series of covered bonds that were priced points higher than unsecured bonds. For example, in May 2020, Royal Caribbean priced a so-called first lien bond – the debt that has the most security in a company’s capital structure – at $ 97, $ 3 below par. , with an interest rate of 11.5%. At the time, the price of its unsecured bonds languished in the 1950s.

When a bond trades in a range of $ 50, total return forecasts replace return in investors’ thinking. It doesn’t take complex math to understand the risk-reward calculation of RCL investors a year ago; the unsecured bond had the potential to double in value to return to “par”, while the more secure first lien did not have the same benefit.

Likewise, around the same time, Macy’s was valuing a five-year senior bond at 8.375% at par, while its shorter-dated unsecured bonds were trading in a range of $ 70 at implied yields of 19%.

Why the price difference for bonds issued by the same company? This is because of the guarantees, in the form of thing, like real estate or ships or oil in the ground or factories, or – as is more typical – a seniority position that represents the highest claim on the overall franchise of the business.

Covered bondholders predict that if their research fails and the issuer ends up in bankruptcy court, they will likely be paid in full before unsecured lenders receive a dime.

To be comfortable with Macy’s unsecured bonds, you should assume that consumers are flocking to real and virtual stores in comparable numbers to 2019. But given the amount of debt at the first lien level, only a fraction of 2019 customers should continue shopping for the owners of these bonds to be cured if Macy’s fails.

In return for their higher risk, unsecured bonds offer a significantly higher yield than covered bonds with similar maturities to compensate investors for their weaker recovery prospects. Except when they don’t.

Obviously, the secure / unsecured spread is, and deserves to be, cyclical. When credit markets are accommodative, risk appetite is high and investors are hungry for yield, the discounts offered by unsecured bonds to secured paper decline.

Rather than measuring them by points (of the price in dollars), investors look basis points (yield / spread). The “risk-free” price differentials of the RCL and Macy examples from a year ago have all but evaporated. Today, you sacrifice a modest amount of return to hold the first privilege portions of these capital structures (less than a percentage point, according to Bloomberg data).

There are caveats to this comparison. Valuation of high yield securities can be difficult due to the illiquidity of the asset class as well as dollar price differences, bid-ask spreads, maturity, buy base and assumptions about when a bond will be redeemed.

Investors’ willingness to trade a large increase in risk for a small increase in yield has at least as much to do with low interest rates and an accommodating Federal Reserve as it does with the mass return of customers to ships and stores. .

Take, for example, Tenet, a hospital company that is an unwanted issuer but is also viewed as a defensive investment with stable income. The spread between guaranteed and unsecured returns narrowed from 2.1 percentage points last September to 1 percentage point today.

Investors who took unsecured risks a year ago have been generously rewarded. For example, RCL 2028 unsecured bonds returned 90% in the year following the issuance of the first bailout finance lien, compared to 30% for this bond. But it appears the unsecured vessel has sailed. Towards the end of PeanutsIn the long run, Linus decides he’s old enough to give up his blanket. As high yield investors do the same, it looks like end-of-cycle behavior.

Barksdale Investment Management may hold interests in companies mentioned

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