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Just as bond and loan deals got funky when the Federal Reserve began to raise rates in 2022, there are once again some odd pricing dynamics taking shape as the market prepares for rate cuts.

Issuers and their bankers are recalibrating how they structure their instruments to meet investor demand in this environment, multiple sources said.

Borrowers would prefer to issue in loans because the repayability and floating rate exposure would allow them to take advantage of expected rate cuts to lower interest costs quickly. But investors are well aware of this dynamic and are demanding either a greater spread over SOFR or more bond exposure to lock in today’s levels at a fixed rate.

This dynamic has been on display in several deals that have priced in the leveraged loan and high yield bond markets over the last month and is expected to continue into the historically busy post-Labor Day blitz.

For example, print and digital marketing company RR Donnelley changed the mix of its $2.3bn bond and loan structure several times before successfully pricing the deal with upsized bonds and a smaller private TLB.

Likewise, airliner JetBlue decided to upsize the bonds in its $2.76bn debt deal when demand proved more potent for that tranche. Others such as textbook maker McGraw Hill refinanced a TLB with new SSNs while amending and extending a separate loan that priced some 200bps wide of the comparable bonds.

In total, there have been 55 SSN/TLB dual issuances in 2024 with the loans pricing 155bps wide of the bonds on average, according to 9fin data. That’s 50bps wide of last year’s average and about 100bps wide of periods when rates are stable.

Link: Table. Smallest and largest yield premiums of loan tranches relative to concurrently issued bonds.

“Any kind of capital structure where there are loans and bonds, the relative value on a pure yield basis is surprisingly high for the loan,” one portfolio manager said. “With the view that rates are coming down, there's been some push into bonds.”

But it’s not as simple as saying bonds are in vogue and loans are out of style, sources were quick to note.

New CLO formation is propping up demand for loans, the lack of new supply makes each new money deal highly sought after, and investors can justify deals differently based on spot versus forward curve SOFR.

How much yield a loan deal produces depends on whether one prefers to look at today’s spot SOFR price or the five-year forward SOFR curve.

The recent dual tranche deal for JetBlue provides a good illustration of this dynamic.

The airliner’s $2bn 9.875% SSNs due 2031 priced at 99.36 for an all-in yield of around 10% earlier this month.

By comparison, JetBlue’s loan offered more yield when using spot SOFR of around 5.3% as the base rate. The $765m TLB due 2029 priced at S+550bps with a 98 OID for an all-in yield of around 11.3%, which is a 130bps premium over the bonds.

In a more normal environment, investors would absolutely take that premium to the bank, and some CLO managers are still eager to do so today.

“A CLO investor might talk themselves into the loan being attractively priced on a spot basis to get an attractive carry opportunity,” one banker said. “But if an investor thought the JetBlue loan ought to be priced more attractively, then they would probably use forward SOFR for their argument.”

Indeed, looking at the bond-to-loan differential on a forward curve basis totally changes the calculus.

Five-year swap rates on term SOFR sit at around 3.4% in August, so using that as the base rate brings the all-in-yield on the loan down to 9.4%.

By that calculation, the loans are actually yielding about 60bps less than the bonds on day one.

This bond-to-loan yield differential has been trending down most of the year but spiked back to above 200bps in August amid renewed rate volatility, as the chart below shows.

Source: 9fin data. YTM calculated at issuance. Loan YTM calculated using 3Y all-in yield using a SOFR spot rate of 5.35%.

Those are the two most basic ways of calculating yield and different shops will deploy much more sophisticated models than this. But generally, it's creating an environment where short-term investors are happy to take the extra yield in loans while long-term investors are seeking bonds.

“We should start to see that bond-loan differential shrink, once rates really in earnest start on a cut cycle,” a second banker said. “For now, investors are maximizing their take if they go into some of the floating rate instruments because, on an all-in basis, it's definitely yielding higher.”

To this point, the loan market is still on fire.

There’s a healthy stream of new CLO formations and a slew of repricings and refinancings in the primary. Issuers generally prefer loans for the floating rate exposure in this current environment, the flexibility to repay debt faster than bonds, and the ability to reprice at a lower rate.

However, even with all the new CLO formation, there is very little new loan supply to buy, and so the buyside is fighting over scraps, one investor said.

That’s why some issuers have been able to reprice multiple times in the last year — a category of borrower we’ve dubbed the serial repricers. When that happens, the premium the loan initially offered over bonds can be erased in just six months.

“They’re not going to reprice to save just an eighth, they’re going to want to take out a quarter, three eighths or a half,” the investor said. “So if in six months you reprice, then the issuer is kind of indifferent to initially paying up for the loan.”

So even if rates start to come down and bonds look more attractive to investors than loans, issuers may still be able to push through new loan issuance to a supply-starved buyside.

“As the Fed eases, you would expect SOFR to come down, and I would guess that the bond market will start to look more attractive,” the first banker said. “We’re heading to a period where you might see a cross over there, but I don't think we've gotten there yet.”

People have been wrong all year about when rates would be cut, but Fed Chairman Jerome Powell at last week’s Jackson Hole meeting made his most forceful statement yet that rate cuts are on the way in September.

“Broadly, the market is pricing in three rate cuts this year and a 100% probability of one in September,” the buysider said. “Our desire is to be more in bonds than loans at this point because we want the duration, and we want the upside in price.”

If rates start to fall that fast — maybe 100bps or more in the next year — there are some CFOs that are going to feel foolish for issuing bonds at these high rates, one direct lender said.

On the other hand, those are the kinds of bonds investors are coveting because of the potential to trade up as rates decline.

“When the market does see some rate cuts, some of these bonds are going to trade up to 110 or 115,” the portfolio manager said. “There's been some push into bonds, and it's kind of like get in before they cut rates so you can get that convexity move.”

Looming rate cuts drive wider loan margins, bigger bonds

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