Issue date: 2021-09-30
The global senior secured bond market is a sub-component of the broader global high yield bond asset class and, as the name indicates, comprises bonds that are senior and secured in the capital structure. 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 tangible assets such as 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 bondholders.
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 can ultimately maximize recovery rates. For example, from 1987 to 2020, the average recovery rate for defaulted senior secured bonds was 61.4%, compared to 46.9% for senior unsecured bonds and 27.9% for subordinated debt1.
A Growing and Diverse Opportunity Set
The global senior secured bond market has continued to grow in recent years, providing investors with a sizeable and diversified investable opportunity set. To provide some context, the market grew from US$226 billion at the end of 2010 to US$527 billion through the end of July 20212.Even in the past year alone, despite the COVID-related disruptions to business, the asset class continued to experience substantial growth—due largely to its emergence as a viable source of funding for companies when other capital-raising avenues, such as loans and unsecured bonds, faced limitations.
Notably, the global senior secured bond market is not just concentrated in smaller and more obscure credits within the high yield markets. There are various reasons for issuing a certain structure of bond, and the choice does not necessarily indicate the quality of an issuer’s fundamentals. For instance, companies typically aim to match their balance sheet with what is specifically required for their needs and what is available in the market, as well as to diversify their funding sources. If a company has assets it can pledge as security, a secured bond—as opposed to a traditional high yield bond—may better suit its needs, and could be a cheaper method of financing. As a result, some of the larger companies and industry leaders across high yield credit markets have senior secured bond facilities, such as American Airlines, Virgin Media and Refinitiv.
From a geographical perspective, relative to the broader global high yield bond asset class—which tends to be heavily concentrated in the U.S. market—the global senior secured bond market is more evenly balanced across U.S. and European issuers. There are also meaningful sector deviations across these two market segments, with global high yield bonds having greater exposure to energy, automotive and consumer goods relative to the global senior secured bond market, which has greater exposure to sectors including leisure, services and telecom.
Lower Sensitivity to Interest Rates
With expectations for continued economic growth coming out of the pandemic, it is reasonable to expect that the U.S. Federal Reserve (Fed) will at some point move toward tapering, and rates will eventually rise. In a rising rate environment, global senior secured bonds, while fixed rate assets, look well-positioned—as the asset class benefits from a relatively short interest rate sensitivity profile relative to other, longer-duration fixed income asset classes. For example, at the end of July, the modified duration to worst for the index was below three years, and less than 2% of the index had bonds outstanding greater than 10 years3.
If periods of rising interest rates/U.S. Treasury yields are associated with higher growth and inflation expectations, as was the case in the first quarter of 2021, this type of a reflationary environment can be a positive backdrop for companies within the senior secured bond market. This is partly due to the low and often negative correlation in returns between the senior secured bond market and the U.S. Treasury bond market, as well as from credit spread compression during such periods. That said, interest rate sensitivity can vary considerably on a bottom-up basis across specific credits, sectors and rating buckets, and there can also be indirect effects on markets from a valuation and/or technical perspective, which warrants active and careful security selection.
A Positive Outlook, but Uncertainties Remain
From a fundamental standpoint, U.S. and European senior secured bond issuers appear to be on solid footing. Company earnings, revenues and cash flows are expected to remain well-supported by the resurgence in consumer demand this year and into 2022. Accelerating economic growth and improving corporate financial conditions, coupled with a manageable default picture, should also bolster the market going forward. However, the ongoing spread of the Delta variant has enhanced market uncertainty, and we continue to closely monitor developments and the potential implications for the market.
With that said, there have been record-breaking issuance trends across the broader high yield bond markets following the global onset of the pandemic. Pleasingly, however, borrowers have used new issue proceeds largely for creditor-friendly debt refinancing and liquidity enhancement purposes, as opposed to shareholder-friendly activities such as M&A and/or dividend payouts. As a result, debt maturity walls have been pushed out a few years and we think most senior secured debt issuers will likely remain well capitalized to withstand lingering COVID-related market disruptions. We also believe default rates should remain manageable through the end of 2021.
Over the next 12-24 months, we anticipate increased potential for improving credit rating profiles, reversing some of the sizeable credit rating downgrades observed in 2020. We have already seen an improvement in credit rating trends from the rating agencies—with recent credit rating upgrade activity outpacing downgrades—which should be supportive for asset prices.
From a valuation perspective, while senior secured bond credit spreads have tightened since the onset of the pandemic, they remain wide relative to recent market cycle lows in 2017/18. Importantly, they also look compelling relative to various other markets from a credit spread pick-up perspective.
From a supply-demand technical standpoint, while supply has continued to be robust, market demand has also been plentiful enough to absorb the sizeable new debt issuance that has taken place. While we have observed some volatility around retail flows in 2021, the institutional buyer base appears to have been more resilient. Given the relatively high coupon/income levels available across the senior secured bond market, we believe overall demand should continue to remain supportive in the ongoing low interest rate environment.
1Source: Moody’s Investors Services Annual Default Study. As of January 28, 2021.
2Source: ICE BofA BB-B Global High Yield Secured Bond Index. As of July 31, 2021.
3Source: ICE BofA BB-B Global High Yield Secured Bond Index.
The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research.
In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate.
Unless otherwise mentioned, the views contained in this document are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Parts of this document may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.
Any forecasts in this document are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Any investment results, portfolio compositions and/or examples set forth in this document are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this document. No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments.
Investment involves risks. Past performance is not a guide to future performance. Investors should not only base on this document alone to make investment decision.
This document is issued by Baring Asset Management (Asia) Limited. It has not been reviewed by the Securities and Futures Commission of Hong Kong.