Bank loans and high yield bond returns have been highly correlated for much of the past decade. But it wasn’t always that way. Before the global financial crisis (GFC), the asset classes were not strongly correlated—and signs of that decoupling have recently reemerged. It’s a significant shift, but one that’s in line with the asset classes’ characteristics and the typical market response to changing interest rates. Here, we’ll look at what drives the relationship between loans and high yield bonds, and why the recent shift matters for fixed income investors.
Understanding the Relationship
To better understand what drives the correlation between the two asset classes, we think it’s important to consider two key differences.
- The risk differential. Both high yield bonds and loans are below-investment-grade debt, but loans are senior in a company’s capital structure (they get paid back first in a restructuring) and are secured by a company’s assets. High yield bonds are often further down in the capital structure and generally not secured by a company’s assets. High yield bonds generally yield more than loans to compensate investors for less security.
- The coupon differential. High yield bonds have fixed coupons, while loans have floating coupons that adjust to rate changes. When interest rates rise, bond prices tend to drop to adjust for higher coupons available on newly issued fixed-rate bonds. Loan prices tend to remain relatively steady as their coupons float to match interest rate shifts.
These characteristics tend to influence market behavior and suggest that high yield and loan returns should not be highly correlated, particularly during periods of changing interest rates.
Fed Policy: A Game Changer for Correlations
The major shifts in Federal Reserve policy during the GFC changed the game for loan and high yield bond correlations. For roughly the first half of the loan market’s history, loan and high yield returns weren’t highly correlated. From the end of 1992 through the third quarter of 2007, the median 12-month correlation between the two asset classes was 0.45.[i] Then the GFC happened, and this figure changed to 0.82 between the fourth quarter of 2007 and the third quarter of 2021.[ii]
Federal Reserve intervention during the GFC was formidable. The Fed slashed the federal funds rate to nearly zero, and rates have remained very low since then. Investors struggled to earn adequate returns investing in short-duration bonds. Markets generally believed the Fed would step in should something go wrong, creating an incentive to take risk. With this backdrop, many risk assets became more highly correlated than usual; loans and high yield bonds were no exception.