Investing in loans to SMEs may be less risky to investors than high yield corporate bonds

The low rates of losses on loans to UK SMEs means they have proven to be far less risky to investors than high yield corporate bonds, shows a new study by Hadrian’s Wall Capital Limited (HWC).

According to HWC the net annual yield from loans to UK SMEs, after taking into account historic losses and recoveries, has been approximately 4.6% compared with a net yield of just 1.9% on European high yield corporate bonds.

Traditionally, many investors have assumed that unrated SME loans were more risky than rated bonds, however, the historical low default rate and high recoveries from defaulted SME loans suggests that this may not be the case. Net losses on UK SME loans have averaged an annualised 30 basis points – just 0.3% – since 1990.

HWC says money lent to SMEs is usually invested directly into the business which should improve the performance of the business and its ability to service its loans. In contrast, high yield corporate bonds are often used to fund leveraged buyouts, recapitalisations, and other M&A or corporate finance activity.

This often adds debt onto the business without necessarily improving its fundamental business prospects, which can reduce financial resilience during weak economic periods.

Recent research by the Bank of England shows that large businesses’ net bond issuance hit £11bn in the month of May, the highest amount on record, which the Bank of England said had been driven by M&A activity.

HWC explains that much of the lending to SMEs may be secured against real assets such as machinery, property, or other business assets that can be liquidated, if needed, by a lender. This has played a key role in the recovery rate on defaulted secured bank loans standing at 80% over an extended period of time. In comparison, the recovery rate on European and US high yield corporate debt has only been 51%.

HWC says that there tends to be an increase in the issuance of leveraged debt before the top of the economic cycle, often just before the economy begins to weaken. This increase in leverage may further increase the relative risk of investing in large business, high-yield corporate debt for investors compared to SME loans.

Mike Schozer, Chief Investment Officer at Hadrian’s Wall Capital, comments: “Historic performance does suggests that investors should be careful when selecting fixed income funds – SME loan funds and high yield bond funds are clearly very different propositions.”

“Borrowing by SMEs does not tend to go through the boom and bust cycles that occur in the debt market for bigger companies. Whilst the Bank of England has pointed out that high yield bond issuance is rising sharply, levels of debt amongst SMEs are static or even falling.”

“Taking into account their smaller losses, SMEs loans may offer attractive risk adjusted returns relative to other debt products available to investors.”