Bankers have long argued that properly structured leveraged bank loans offer companies a better value than bonds. Now they have some proof.
A study by Portfolio Management Data LLC finds that borrowers save more than 1 percentage point off their interest rate spread by using the bank market rather than the high-yield bond market.
"It confirms what we've been hearing and knew anecdotally for a long time," said Steven Bavaria, a director of loan ratings for Standard & Poor's. "But we were surprised at the level" of savings.
The study, due to appear this week in S&P's CreditWeek, reviewed the prices of 46 loans and bonds underwritten during a 14-month period beginning in January 1998.
To ensure fair comparisons, the study focused on new-issue spreads-loan rates over the London interbank offered base rate and bond yields over comparable Treasuries.
But the findings come with a caveat. To achieve significant savings, loans must be structured so well that they receive better credit ratings than bonds.
That means not only that lenders would be paid off before bondholders in the event of default, but that a company's fundamentals-assets, earnings, and cash flow among them-must be strong, Mr. Bavaria said.
"It might seem intuitively obvious" that better secured loans would cost less, Mr. Bavaria said. "However, the magnitude of the difference is surprising."
For instance, loans that carried ratings that were two notches above bonds from the issuer saved 161 basis points in annual percentage rates. The study also found that as the gap in ratings increased, so did the savings.
The market has traditionally set the ratings difference between bank loans and bonds at two notches. True to form, of the 46 financings studied, 37 carried a two-notch difference; nine carried a three-notch difference.
Unfortunately for lenders, hard evidence that bank debt is cheaper than bond debt is unlikely to drive much more business. The amount a bank can lend is limited, because such loans are usually secured by a company's assets.
Michael Rushmore, a loan analyst with BankAmerica Corp., said lenders generally will restrict loan sizes to two to four times a borrower's cash flow. As a result, bonds still have their place.
"Bonds increase the debt capacity of the issuer," he said. "Bonds are typically subordinated and unsecured and don't have any meaningful covenant protection, and they're fixed rate."
Steven Miller, a principal at Portfolio Management, said the lesson of the study is not that borrowers should choose the bank loan market over the bond market. Rather, borrowers should push for higher ratings on their loans.
"The question for borrowers is how much more credit are you getting from your lenders for having a superior credit notch?" Mr. Miller said. "There are instances where the amount of subdebt and the strength of your story will result in a decrease of your spread."