The difference in yields between leveraged loans and high-yield bonds narrowed in the past three years as loans outperformed, but the trend is expected to reverse course soon — and may have already started.

All things being equal, loans should yield less than bonds because they sit higher up in the capital structure. Creditors will tend to demand higher interest rates on bonds to compensate for the additional risk that they might not be repaid.

However, for the past few years bond investors have been getting less and less of a yield pickup. At the beginning of 2010, the average yield-to-maturity differential between high yield bonds and leverage loans was 2.12%; today the differential is only 1.16% on average, according to Royal Bank of Scotland (RBS) data.

That's starting to change as bonds fall out of favor. One indication of this: investors have been pulling money out of high-yield bonds funds and pouring it into leveraged loan funds. So far this year, loan mutual funds and exchange-traded funds have pulled in $6.6 billion, net of redemptions, while high yield bond mutual funds and ETFs have seen a net $266 million walk out the door, according to data from Loan Syndications and Trading Association.

Not all of the money leaving bond funds is being put to work in loans; market observers believe much of it is being redirected to the equity market.

New money has also been entering the loan market via collateralized loan obligations, which have raised $15.5 billion year to date, LSTA data said.

Ted Basta, senior vice president of market data and analysis at LSTA, said there are likely two reasons investors are favoring loans over bonds. The first one is that the average bond is trading roughly at 105 cents on the dollar. This compares with the mid-97 cents on the dollar range for leveraged loans. Investors may simply see more upside in loans.

Another explanation, according to Basta, is the uncertain outlook for interest rates. He says investors "might also be looking to trade out of longer duration assets — bonds — and into shorter-duration — loans."

Bonds typically have terms of eight to 10 years; seven years is more typical for broadly syndicated leveraged loans, although most loans can be called after the first year.

Recent data on leveraged loan fund inflows are a good indication of the popularity of loans versus bonds.

Leveraged loan funds, which cover exchange-traded funds, took in $996 million for the week that ended Feb. 20, according to Lipper FMI. This is a drop from the previous week's figure of $1.42 billion in positive flows.

Meanwhile, Lipper said that the four-week trailing average moved to $1.14 billion from $1.06 billion. Leveraged loan funds have had positive flows since mid-June of last year and the flows have ramped up significantly since Jan. 1.

Despite the signs of divergence between loans and bonds, the differences in yields in both markets remain on the tighter end compared with early 2010.

This tightening began in the third quarter of 2011, when both the high yield and bank loan markets shrugged off concerns about Europe's sovereign debt crisis and a stagnant U.S. economy, and secondary prices for both loans and bonds rallied, and yields on new issues declined. This happened amid expectations that official interest rates would remain low for some time.

"This phenomenon has been driven by tremendous investor demand as they've searched out higher yields in credit markets due to Fed policy, which has kept interest rates very low," Basta said. However, "yields have in fact fallen at a much faster rate for bonds than loans and therefore the yield gap between the two markets has tightened to multi-year lows," he said.

This has happened despite the fact that bank loans are typically secured by the assets of the issuers, while bonds typically are not.

"Because loans are more senior in the capital structure compared to bonds, in the event of a company bankruptcy, recovery rates are expected to be higher," said Gregory Kamford, a credit strategist at RBS. He added that bank loans are also floating rate so they provide extra protection from increases in interest rates compared with bonds.

However, "yields on bonds have fallen in relation to loan yields with the rally in high yield bonds," Kamford said.

But with expectations that interest rates might rise sooner with the backup in Treasurys, the difference between the yields in these two markets will start to narrow.

If "rates rise sooner than the market had previously expected, the floating rate nature of bank loans offers some protection compared to the fixed-rate feature in investment grade and high yield bonds," Kamford said.

Credit Suisse projects annual returns for U.S. high yield bonds at 7% this year, with a 1% to 2% default rate. It expects total return for U.S. leveraged loans of 5.5%. The firm projects a 1% to 4% default rate for leveraged loans for 2013 and 3% to 6% for 2014. Almost all of the loan default rate increase is focused on half a dozen borrowers.

Since September 2009, when high yields dropped below 10%, the market has seen five cycles of tightening/widening, where yields have risen by at least 50 basis points and subsequently retraced the entire move, according to Credit Suisse.

The firm expects the trend of tightening/widening cycles to continue. These cycles have shown some similarity in strength and duration, although estimating their timing has proven difficult.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.