Times of volatility can also yield opportunity if navigated carefully—and in the event of widespread defaults, senior secured bonds can offer some particularly compelling benefits.
The fallout from the coronavirus will likely continue to weigh on the market in the weeks and months ahead. High yield felt the effects of this most acutely in March, as bond spreads widened significantly. While spreads subsequently tightened in light of the announcement by the U.S. Federal Reserve (Fed) that it would begin to buy so-called fallen angel credits—or those recently downgraded from the lowest investment grade status to high yield—the length and severity of the pandemic is a still a big unknown. With that in mind, it’s important to monitor the situation closely on an ongoing basis and as conditions dictate.
Looking at the markets today, they are open, and quality companies have been able to successfully refinance themselves or access additional capital, albeit with investors (understandably) asking for increased compensation. Senior secured assets are proving popular among high yield investors seeking additional assurances as they navigate today’s uncertain backdrop—and senior secured bonds, in particular, can offer investors several key benefits.
Benefit #1: Higher Historical Recovery Rates vs. Unsecured Bonds
As their name indicates, senior secured bonds reside at the top of a company’s capital structure, ranking ahead of subordinated debt and equity (i.e. senior). They are also backed by issuer collateral or some form of assets (i.e. secured), which can range from real estate and equipment to intangible items like software and trademarks. Ultimately, this means that if a company defaults on its debt obligation, senior secured bondholders are prioritized in the payment structure and repaid ahead of junior debtholders.
As a result of being senior in the capital structure and secured by some or all of a borrower’s assets, senior secured bonds have historically offered higher recovery rates than unsecured bonds. As a market convention, senior secured bonds are generally twice covered by the value of the business that is pledged to them. Practically speaking, this means that if an issuing company defaults, senior secured lenders are in a favorable position, relative to unsecured creditors, to drive debt restructuring and in some instances take ownership of the company—which ultimately will maximize recoveries. As evidence of this, during the period from 1987–2019, the average recovery rate for defaulted senior secured bonds was 61.9%, compared to 47.0% for senior unsecured bonds and 28.0% for subordinated debt.1
SENIOR SECURED BONDS HAVE HISTORICALLY OFFERED HIGHER RECOVERY RATES
Source: Moody’s Global Average Corporate Debt Recovery Rates. As of February 2020.
Benefit #2: Lower Energy Exposure
As an overall market, senior secured bonds also have a smaller weighting in energy versus the broader high yield market. The challenges facing the energy sector—particularly oil—have been amplified in recent weeks as demand for oil has all but dropped off amid global lockdown conditions. As a result, oil prices have experienced increased volatility, including a sharp decline into negative territory in April. While it is impossible to predict how these risks will unfold longer-term, senior secured bonds, given their lower exposure to the energy sector, may be better positioned to weather any ongoing choppiness.
Benefit #3: Broad and Growing Opportunity Set
The sheer size and diversity of the senior secured bond opportunity set is another consideration for investors—today, the value of the senior secured bond market is in excess of $317 billion.2 Specifically since the global financial crisis (GFC), the asset class has experienced substantial growth—due largely to its emergence as a viable source of funding for companies when other capital-raising avenues (e.g. loans and unsecured bonds) faced limitations. More recently, following the onset of the pandemic, senior secured bond issuance in the U.S. has been above average. This has largely resulted from the efforts of companies—particularly those more affected by COVID-19—to bolster their liquidity profiles by tapping the secured bond market at elevated coupons as a means of compensating investors for the current market environment.
Benefit #4: Consistent Returns Over Time
Senior secured bonds have delivered solid returns on a historical basis, even during periods of geopolitical uncertainty—the global financial crisis, the sovereign debt crisis, the “Taper Tantrum” and Brexit, for instance. While that return is slightly lower than the average return generated by U.S., European and global high yield bonds, these assets have meaningful portions of unsecured credit. This means that for investors willing to give up a relatively small amount of spread or yield, senior secured bonds can offer greater claim to principal protection versus unsecured high yield bonds.
While this crisis should not be taken lightly, it is worth reiterating that financial markets have a history of exhibiting short-term pricing inefficiency during periods of dislocation or volatility. In the years since the financial crisis, there have been a number of risk-on/risk-off periods, with dips in the market often being followed by periods of recovery and gains. Further, almost without exception, the credit markets have experienced a lower drawdown than the equity markets during such periods, while also having a much quicker recovery.
While every crisis is different, we have been in similar situations before—and we know that ultimately, times of crisis can also yield significant opportunity if navigated carefully. As we look at the markets today, and as volatility continues to punctuate markets, senior secured bonds look particularly compelling given their added benefit of being senior in the capital structure and secured by issuer collateral—appealing characteristics in the event of widespread defaults.
1. Source: Moody’s Global Average Corporate Debt Recovery Rates. As of February 2020.
2. Source: Bank of America Merrill Lynch. As of April 30, 2020.