The Potential Benefits of Global Senior Secured Bonds
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 debt.1 In the context of senior secured bonds’ low historical default profile, these high recovery rates suggest relatively small loss rates2 for the asset class overall, particularly for investors who are able to access this market through an appropriately diversified selection of assets. For context, Barings has been a pioneer investor in the global senior secured bond market, with a more than 10-year dedicated track record. Over this period, the Barings strategy has experienced an average annual default rate of 1% and a recovery rate of over 70%, resulting in an average annual loss rate of less than 0.3%.3
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 2021.4 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 and Virgin Media.
Financing via senior secured bonds also enables companies to more effectively access capital markets during challenging market conditions. We observed this phenomenon in the early stages of the pandemic, when several companies raised capital via this channel—as a result, the senior secured bond market grew by roughly 30% in 2020.5 Given the timing of some of these capital raises, the average coupon rate available across the senior secured bond market has been considerably higher than what we have observed in the broader high yield bond market. This debt will generally still be outstanding in periods of subsequent market recovery, as bond investors will typically protect the embedded contractual yield with call protection penalties. As a result, investors may potentially have an opportunity to take advantage of the higher cash yield even as they are in a preferred position in the capital structure.
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 years.4
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 can be observed from 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.
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.
Barings’ Approach
At Barings, given the market uncertainties at play, we continue to manage our global senior secured bond strategies in a highly active and nimble manner. Ultimately, when it comes to uncovering relative value and deciding whether to invest in a particular company, we believe analyzing the underlying credit fundamentals is paramount. In order to mitigate credit risk, we undertake in-depth fundamental credit analysis. We have one of the industry’s largest dedicated global teams, with 40 U.S. and European high yield credit research analysts, six traders and 20 portfolio managers.3 This size and breadth allows us to conduct detailed, bottom-up analysis of company financials and to actively engage with company management in order to identify attractive opportunities.
1. Source: Moody’s Investors Services Annual Default Study. As of January 28, 2021.
2. Loss Rate (%) = Default Rate (%) x [1 - Recovery Rate (%)], and calculates the total loss from a default situation, adjusting for any recovery value.
3. Source: Barings. As of July 31, 2021. Past Performance is not necessarily indicative of future results.
4. Source: ICE BofA BB-B Global High Yield Secured Bond Index. As of July 31, 2021.
5. Source: ICE BofA BB-B Global High Yield Secured Bond Index. As of December 31, 2020.
