High yield debt is viewed from a lens of better compensation for the risks investors take. While credit risk is often cited, Polen Capital says that it is only one part of the equation and leveraged credit markets also provide investors with excess spreads.
The investment management firm talks about the average spreads of high yield debt and compares them with the average default rates during the past decade.
“The explanation is that much of this excess spread compensates investors for participating in a less-liquid asset class. This excess spread is called the liquidity premium,” writes Polen Capital.
Talking about credit risk, the asset manager says that there is a general observation that spreads within the leveraged credit markets compensate for more than credit risk. “Over the last ten years, the spread premium between issues $201 m – $300 m in size and issues greater than or equal to $1001 m has averaged 148 bps,” as per Polen Capital.
Another observation is that smaller issue sizes offer better liquidity premiums compared to their larger peers in the high yield debt market. “On average, the spread premium provided by loan deals $101 m – $200 m and $201 m – $300 m in size over the last ten years was 412 bps and 210 bps, respectively,” says Polen Capital.
Lastly, the asset manager compares the performance of the ICE BofA U.S. High Yield Index to that of the iBoxx USD Liquid High Yield Index. Polen Capital observes that the performance of the broader ICE index was consistently better than the iBoxx index over different time periods.
The investment management firm says that larger investors generally view small deal sizes as unattractive, and Polen lists some other preferences of large investors. The firm says that preferences create mispricings, which provides opportunities to active managers with more flexible mandates.
“Any liquidity premium loses its worth if one cannot protect the principal value of the investment. That said, both leveraged credit markets offer an enticing opportunity for patient investors with the flexibility and time horizon necessary to capture this attractive liquidity premium,” concludes Polen Capital.
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