Ivy Insights – Loans


Ivy Insights – Loans

Commentary as of November 16, 2020

In the Ivy High Income Fund, we are more active in bank loans than many of our peers. Roughly one-quarter of the Fund is currently invested in loans. Loans provides several advantages:

  • Downside protection – a loan has collateral, similar to when an individual goes to the bank for a home loan. A bond, however, is more like your credit card. If you default on your credit card, the bank cannot come and collect what you purchased. That makes a difference when it comes to recovery rates in the event of a bankruptcy. Historically, if a secured loan files bankruptcy there is a 70-80% recovery versus a 30-40% recovery for an unsecured bond.
  • Floating rate – loans typically have a floating rate, which helps eliminate interest rate risk. Of the major asset classes, nearly all are subject to interest rate risk. That's one of the reasons loans have the top Sharpe ratio due to less volatility related to interest rates. Given the current level of rates, it's difficult to see them going lower. If rates move up, however, loans provide protection that most asset classes don't offer.
  • Yields – loans currently have a 519 basis point (bps) spread to maturity versus 493 bps for high yield bonds. For 26 bps less yield, an investor can invest in loans with greater downside protection.
  • Spread history – loan spreads are currently 25 bps above their 5-year average. On the high yield bond side, spreads are 5 bps below their 5-year average. Simple math shows there is a potential advantage as spreads normalize.
  • Economies of scale – significant time and research is required prior to entering a deal. We are currently evaluating a deal that includes a loan and bond offering, which is common in most sponsored deals. The loan launched last week, ahead of the bond. If we were only looking at bonds, we would only have three days to research the company; because we also look at loans, we've had the materials for a week ahead of the bond-only investors. In addition to extra research time, we'll have additional interaction with management. We believe this generates a scale advantage.

I’d like to offer a few examples of where we've added value in both loans and bonds. Generically, these efforts fall under the category of building and utilizing relationships and designing downside protection in the governing loan and bond contracts.

Continuing with the home loan example, if the loan doesn't work out, the bank has the borrower’s house as collateral. In a downside scenario, the borrower can’t sell the kitchen, garage, or bedroom, pocket the money, and leave the bank with less collateral than it thought it had originally. However, a company can do exactly that by siphoning off portions of its plant, equipment, and/or intellectual property. Attorneys have become good at exploiting any weakness in the governing contract to the detriment of lenders, such as making large dividend payments to equity owners and thus reducing the value of the estate against which the lenders have a claim.

We also worked with a defense company that refinanced its loans last month. We have invested in the relationship with the company, owner, and bank over the past four years. As a result, we were able to help shape some terms of the deal and despite it being 50% over-subscribed, the company allowed us to obtain the full amount requested in a deal that came with good protections in a hot market. Without strong relationships, we may have done a lot of work and only received a tiny allotment.

Lastly, we stand firm with other investors when the situation warrants. In several cases, we have locked arms with other large investors in order to secure greater protections. In the past month, all lenders were repaid at par on two separate deals despite the company’s desire to extend the maturity dates. Had lenders not communicated, the company may have been able to put lenders in a “prisoners dilemma” and force a maturity extension on undesirable terms. In another case where we are the largest lender, we designed an innovative agreement to lock arms with the second largest lender in order to prevent the company from taking advantage of loopholes in the governing document.

We believe the examples above capture ways in which Ivy can add unique value to the bank loan asset class.

Q: What is the comparable Tier I loan yielding compared to a traditional high yield corporate bond?
In terms of spread, the spread to maturity is 519 bps for high yield bonds versus 493 bps for loans, according to JP Morgan data. The high yield bond spread is a little bit higher, but we view loans as very attractive.

Q: What is the average loan price and liquidity for loans?
Historically, most loans trade in the 99-100 range. Currently the most liquid loans have a price of 97-98 and the average loan has a price of 94-95. The pull-to-par effect, which is the tendency for a loan’s price to approach its par value as it approaches its maturity, should be significant both in the market and particularly for the Ivy High Income Fund. We believe that several of the marks are below intrinsic value, but we are at the mercy of where the valuation service marks the loan, and during periods of dislocation banks can be quick to move prices down but slower to move them back up. In terms of liquidity, we used to be more active in the second-lien loan market but are no longer as active there. Liquidity is still more of an issue in loans, as it may take longer to settle than a bond, which gets the benefit of a mandated three-day close. However, the loan market is larger than the bond market at $1.1 trillion versus $800 billion, and most large loans are now quoted by several banks. Loans used to be a cottage industry back in the 1990s, but growth has outpaced bonds at this point, and we expect liquidity will continue to improve.

Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Nov. 16, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Loans (including loan assignments, loan participations and other loan instruments) carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loans may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. These and other risks are more fully described in the Fund's prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.