Although both high yield bonds and leveraged loans are issued by non-investment grade institutions, investors differentiate between the two while investing based on the nature of their returns. Since bonds carry fixed interest rates, their payout remains the same, even in a rising interest rate environment. For this reason, while high yield bonds do quote a higher nominal return, their real return is much lower in inflationary conditions.
On the other hand, leveraged loans and leveraged loan ETF investors do not suffer in terms of real returns as their payout is pegged to LIBOR, that is, if LIBOR increases, their payout increases, and vice versa. They also have some surety in terms of their investment being backed by the issuing company’s assets. Consequently, the issuer company also does not need to pay a premium as high as in the case of high yield bonds to sell these securities. So, loans have lower quoted yields than high yield bonds.
The investors in both cases, react in a similar way to interest rate changes, but the magnitude of change may differ. Since the real returns of high yield bond ETF investors are affected more strongly by interest rate volatility than leveraged loan ETF investors, whose investment is backed by some surety, high yield ETF investors react more strongly to market interest rate changes, as is evident from the chart above.
Leveraged loans, paying floating rates, will continue to gain investor interest as they offer higher yields than Treasury.
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