Just how closely can two markets converge? That question is on many minds as the markets for bank loans and high-yield bonds become more and more alike.
In the past few years, the two markets have come to envelop many of the same customers, investors, and bankers. In the view of many observers, this has benefited everyone involved.
It has meant broader choices for portfolio managers and corporate treasurers, and new business for banks and Wall Street firms. With the secondary market for bank loans growing rapidly, the lines between the two products are sure to get even thinner.
The convergence, however, is unlikely to be completed-at least not any time soon. Experts says there is still ample reason for distinctions to persist.
"It's good that there is a bit of cross-pollination, but (the markets) will retain their roots, and that will provide value," said Elliot Asarnow, a managing director and chief financial officer at ING Capital Advisors.
Most bank loans will continue to have floating rates, and bonds will sport fixed rates, he said. In addition, the two markets will continue to rely on different pricing benchmarks.
"The markets don't change in the same way at the same time," Mr. Asarnow said.
Unquestionably, the driving force behind the market convergence has been the growth of the secondary market for bank loans. About $41.5 billion of bank loans were traded last year, up from $21 billion two years earlier, according to Meenan, McDevitt & Co. That activity has turned the credits into virtual bonds.
Banks and securities firms have fueled the growth by making loan documentation more standard and by creating B and C tranches-classes of loans with longer maturities that appeal to institutional investors. Rating agencies have begun grading the loans.
The highly liquid loan market has attracted investors typically fixed on purchasing high-yield bonds.
"The convergence gives people who are managing other people's money more alternatives," said Kevin Matthews, a high-yield portfolio manager with Pilgrim America.
"In certain instances, you can go out of subordinated bonds and buy senior bank debt, and give up very little, if any, yield," he said.
Robert Haley, a vice president and head of distressed loan trading at First Union Capital Markets Inc., said that with more B and C tranches, "bond investors are looking at institutional tranches (of loans) more on an apples-to-apples basis to a typical bond."
Some say there are natural boundaries to that convergence-and those boundaries ultimately will benefit investors, issuers, and underwriters.
Because the returns on high-yield bonds are typically more interest rate sensitive than loans, investors may want to move between the markets as economic conditions shift.
Michael Rushmore, managing director and head of loan trading and syndications research at BankAmerica Securities Inc., said loans often are attractive to investors trying to build defensive positions in their portfolios.
"Investors can move from an unsecured and unsubordinated asset class to a senior secured asset class as the rising risk that the economy will not continue this late in the economic cycle," Mr. Rushmore said.
Then there are varying degrees of loss risk. In the event of default, Mr. Rushmore said, investors in a senior secured obligation have historically stood a 90% chance of collection-much higher than on bonds.
"If the economic cycle turns and it causes an increase in the frequency of default on all asset classes, bank debt will trade down relatively less than the other assets classes," Mr. Rushmore said.
The distinctions also benefit corporate issuers and their underwriters, who are pushing to maintain their relationships.
As the markets fluctuate, and corporate financing needs change, underwriters with both loan and junk bond capabilities may be best positioned to serve their clients.
"Banks' primary obligation is to reduce the cost of capital for the issuing client, to protect and develop the relationship, and to recognize the practical realities of the bank loan market and the capital markets," Mr. Rushmore said.