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 Federal Reserve Chair Janet Yellen's reassurances that the Fed will
prolong its near-zero interest rate strategy to stimulate the tepid
U.S. jobs market and economy, after earlier indicating rate hikes
could come more quickly than widely expected, doused the urgency to
stock up on loans at current low yields.
Investors pulled about $249 million from bank loan mutual funds and
exchange traded funds (ETFs) in the week ended April 16, after
flocking into these products for 95 straight weeks, according to
Lipper.
"The door to sustained outflows is open now, and wider than it has
been in a long time," said Jeff Tjornehoj, head of Lipper Americas
Research. "It's all about sustained low interest rates and the need
for protection against rising rates just doesn't seem so strong
anymore."
Retail investors had been building new positions, or rebuilding
post-financial crisis allocations to leveraged loans, seeking a
hedge against the rising rates that accompany an expanding economy.
Those allocations are fairly full, especially now that rate hikes
may be further down the road when the economy is on more solid
footing, analysts and investors agree.
The pace of inflows had been tapering, from weekly peaks well above
$1 billion through much of last year, to less than half of that in
recent weeks. In the week ended April 9, loan funds drew in about
$48 million, the smallest amount since July 4, 2012, Lipper data
show.
"People were excited about loan funds because they feared 2014 would
bring a spike in interest rates," Tjornehoj said. Instead, "people
rushed into Treasuries and corporates, and yields came down. That's
taken away a lot of the enthusiasm for loans."
Bank of America Merrill Lynch analysts noted in a report that mutual
funds and ETFs are reporting inflows to rate-sensitive emerging
market bonds, "while inflows to high-yield loan funds, viewed as
defensive against interest rates, have stopped."
Biased toward borrowers
The U.S. leveraged loan market, thanks largely to the almost two
years of unrelenting loan fund buying and sizable demand from
collateralized loan obligation funds, is biased toward borrowers.
Low-rated companies have in record numbers come to market to slash
borrowing costs and take on debt with fewer investor protections.
Now as the record refinancing spree subsides, leveraged buyouts and
mergers and acquisitions are heating up, in what still remains
largely an issuers' market.
Buyers put up minimal resistance, eager for floating-rate exposure
in loan products that offer seniority in the capital structure to
high-yield bonds. So far in this cycle, investors are insulated by
low defaults.
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The U.S. leveraged loan default rate ended the first quarter at 1.4
percent, down from 2.2 percent in the prior quarter and from 3.0
percent a year earlier, according to Moody's Investors Service.
"One would expect continued demand for an asset that offers
relatively high yields, near-zero duration and a reasonably
contained credit risk. Few areas of the capital markets deliver that
mix," said Christopher Remington, institutional portfolio manager at Eaton
Vance.
But any sustained retail loan fund outflows, based on investors
being fully allocated and interest rates staying historically low
for at least another year, will pressure yields up and lure in other
investors, industry participants agree.
As most leveraged loans have Libor floors, the first 75 basis points
of Fed rate hikes will not translate to higher loan yields,
Remington noted. Still, loans benefit by being less vulnerable to
rising rates than bond prices.
"What could drive continued inflows into loans? One factor would be
the continued grinding lower of yields elsewhere," he said. "Bond
market volatility is another, as investors wake up to the realities
of duration risk."
While retail has become an increasing presence in the loan market
over the past two years, most analysts and investors agree there are
plenty of other investors prepared to step in if retail sharply
withdraws.
"If there is a quick and significant outflow from retail loan funds,
it shouldn't surprise anyone to see loan prices fall. If and when
they do, that's when you see crossover buying start," Remington
said. "High-yield managers, multi-sector mandates and distressed
debt funds will come flying in to pick up attractive values. When
someone loses, someone else wins."
Banks, insurance companies and hedge funds may also pick up the
slack, Tjornehoj said.
Through early April, the total return for high-yield bond funds was
about 3 percent, triple the return for loan funds.
(Editing by Leela Parker Deo and Jon Methven)
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