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Fundamental Risks Driving Spread Compression in Leveraged Credit Markets

Spread compression between the high yield bond and leveraged loan markets reflects not just today’s technicals, but the changing composition and growing risk in the loan market.

Many investors are asking why the market for U.S. leveraged loans – which are generally considered high risk assets that are typically secured debt (secured by a company, borrower, or assets) – has recently been pricing a similar (and by some calculations, greater) premium than the unsecured and theoretically “riskier” U.S. high yield market. Some observers cite weaker demand for loans as the driving factor behind this spread compression (i.e., the relative difference in loan and high yield spreads above like-maturity U.S. Treasuries). But we believe there’s a more fundamental driver: a transformation in the overall risk composition of the leveraged loan market.

Relative risks
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All investments contain risk and may lose value. Leveraged loans expose an investor to heightened credit risk, call risk, settlement risk and liquidity risk. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Investors should consult their investment professional prior to making an investment decision.

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