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Unitranche : is it really worth it?

Unitranche Debt Definition | Investopedia
Unitranche debt is a type of debt that combines senior and subordinated debt into one debt instrument; it is usually used to facilitate a leveraged buyout. The borrower would pay one interest rate to one lender, and the rate would usually fall between the rate for senior debt and subordinated notes. The unitranche debt instrument was created to simplify debt structure and accelerate the acquisition process.

After the 2008 financial crisis, US regulators tightened lending standards for banks funding commercial and industrial loans. This left a gap in the market that has been filled by unitranche products being offered by alternative lenders (Fig. 1).
Unitranche can be an attractive alternative to the traditional senior and junior credit structure.  Because it is one combined product, unitranche lending simplifies the balance sheet and transaction process. However, a “convenience” premium is incurred with the extra structuring required.

Business Development Companies and other private lenders today have been offering unitranche loans to middle market businesses; therefore, the average yield of BDCs would be a fair comparison to the yield of unitranche.  Cliffwater LLC constructs a Cliffwater Direct Lending Index (CDLI) which captures data from 62 BDCs in the past twelve years and currently tracks $76 billion in assets (over 6,000 loans).  As shown in Fig. 2, the current average yield for unitranche is 10.1% with all-in yield to maturity of 11.7% (this includes original issuer discounts on the loans).
The high-yield market (Fig. 3) currently has an average interest rate of 5.9%, which implies that unitranche charges a 580bps premium above the market rate of traditional high-yield bonds. Bond Capital wants to point out that the 580bps premium is comprised of two components – the liquidity premium and the convenience premium.  
Unitranche facilities are often held by the firm who issues them, subject to a liquidity risk premium. Research suggests that the illiquidity discount for private firms is between 20% and 30%, implying that unitranche should price in the low 7% range. With average unitranche yields at 11.7%, this suggests there is a significant convenience premium accruing to the unitranche lender.  
Canadian banks have remained strong and continue to provide senior debt capital to businesses post-financial crisis. Unitranche lending activities have not been as prevalent in Canada as they are in the USA. In Canada and the USA, Bond Capital is able to structure cost-effective solutions for borrowers at a  lower blended rate when compared to unitranche. Bond Capital constructs cost-effective, two lender (senior/junior) debt structures for our borrowers. Bond Capital also provides repayment flexibility to match companies’ projected cashflow.

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Rising Corporate Debt: Unintended Consequences of Quantitative Easing

McKinsey Global Institute published a report focusing on the total debt oustanding pre- and post- 2008 financial crisis.


Since the Great Recession, instead of de-risking and deleveraging globally, corporations have accrued more debt on their balance sheets and allowed their credit ratings to downgrade.  Bond Capital believes that rising debt is related to quantitative easing by central banks around the world.  Policy makers from major global economies have lowered borrowing rates to historic lows, which has attracted businesses to borrow cheaply.


What is the problem?

Standard & Poor’s (S&P) credit rating agency released a report earlier this year commenting on the decline in the financial health of global businesses.  Highlights of the report include:
  • The greatest difference between positive and negative outlook (6% and 17% respectively) since 2008,
  • Average corporate ratings declined half a notch to between BB+ and BB (junk bonds), from those in 2008.
We remind readers that, under S&P’s definition, a bond is considered investment grade if its rating is BBB- or higher.  As a result, credit availability or supply is now lower in most markets.  At the same time, Bond Capital thinks demand will be at an all time high for senior debt.

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Canadian High Yield Market

In prior articles, Bond Capital has used US high yield benchmarks as a proxy for riskier private debt, but what about in Canada? The yield on Canadian bonds continues to decline, and recent rate cuts by the Bank of Canada may cause them to stay low longer. Market speculation is that the US Federal Reserve may start raising interest rates in the fall, and we saw the beginning of this trend in the rise of high yield rates back in our spring article. As interest rates rise, the value of the bonds declines – which means that investing in US bonds may be less desirable than investing in markets where benchmark interest rates are steady or falling as they are in Canada today.

While Canada does not really have a high yield debt market, we do have a small, thinly traded market for convertible debentures.  Convertible debentures are loans with the option to convert to equity at a predetermined share price (“strike price”).  A convertible debenture’s value will mimic a company’s share price when the share price is trading above the strike price, otherwise it will trade like debt.  Thus, to compare the Canadian convertible debenture market to the US high yield marketing, we stripped out convertible debentures trading like the underlying equity value (depicted below), to create a proxy for a Canadian high yield bond set.

Canadian proxy high yield is comparable to its US counterpart

While the yields on US and the Canadian proxy of high yield debt is similar, the spread over the respective government bonds is 1.1% higher in Canada. This will be the result of the smaller size of companies in the Canadian market, lack of liquidity in the market and due to the fact that these are convertible debentures which are more exotic.  Canadian convertible debentures make for an interesting alternative if you are looking for yield.

Source: St. Louis Fed http://research.stlouisfed.org/fred2/categories/32347www.Bankofcanada.ca , http://www.financialpost.com/markets/data/bonds-debentures.html, Bond Capital Analysis

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High Yield Credit Spreads – A Trend Or A Blip?

High yield credit spreads are on the rise. Is this a trend or a blip? The current high yield index is still low when compared to the 15 year average of just under 10%. However, when looking at the 10 year decline in US bond yields over that same period, along with the recent uptick in high yield spreads, one has to wonder, what is going on?

Source: St. Louis Fed http://research.stlouisfed.org/fred2/categories/32347

Imagine getting paid to borrow

With the prospect of ever declining treasury yields, and with negative interest rates a real possibility as shown in the chart below, it may be that investors will start to ask for increased credit risk spreads.  This implies a decoupling of high yield rates with the lower reducing interest rates on offer from central banks.

While there are technical reasons for an investor to hold negative yielding investments over short periods, as a trade, a long term investor would choose to hold cash at 0% interest instead of incurring a cost to invest,  or to make a riskier investment for an increased return.  That this risk premium seems to be rising is interesting.  At some point when the return is so low, it may not be worth the hassle of holding something risky for a small incremental return (compared to) earning no return at all.

   

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