Mutual fund investors have been big buyers of bank loan portfolios over the past five years, pumping an estimated $100 billion net into the funds. The open tap from investors wallets to these funds has prompted creation of dozens of new funds since 2010, and led to 95 straight weeks of positive net sales.
But that streak was broken this April, and mutual fund investors have been pulling substantial amounts of money from the vehicles sincenearly $3 billion net for the first three weeks of June alone. The change in sentiment begs the question: Are some retail investors and their advisors overreacting to a performance soft patch, or will their recent stroll toward the exits turn into a stampede?
From a performance perspective there are a few troubling signs these days: Weekly average performance in Lippers Loan Participation Funds category has been negative for eight of the first 24 weeks this year, compared with 12 weeks of negative performance for all of 2012 and again for 2013. Although the frequency of losses has picked up, its hard to make a case for an unhinged market when more than half of this years bad weeks were losses of 10 basis points (0.10%) or less. After all, that is the sort of loss short-duration Treasury funds have.
Why would investors start to shrink away now? The common explanation is that their expectations for rising interest rates in 2014 have been unmet even shot down altogether by a very accommodative Fed and their reaction has been to shift loan fund assets into more enticing spread products such as junk bond funds.
There is some evidence of this phenomenon: Products in Lippers High Yield Funds group accumulated $2.3 billion of net inflows for the eight weeks through the end of June, which was more than the $1.2 billion net they took in during the prior eight weeks. Although its a reasonable (but unprovable) explanation for about one-third of the net outflows from loan funds, the hypothesis leaves the bulk of outflow activity unexplained; without trade-level activity its even less likely we can draw a line between outflows from one product and inflows to another.
A better argument could be made that advisors are steering their clients away from loan products, based on their observations of the loan market.
Bank loan volume has grown by leaps and bounds since before the financial crisis. According to Thomson Reuters, global issuance reached $1.1 trillion for Q2 2014, 19% more than for Q1 and the largest amount since Q2 2007. While not all of that was for new loans (given the typical three-year life of a loan, about one-third of the market turns over each year), double-digit growth for an already huge asset class does raise concerns, among them the growing volume of mergers and acquisitions deals. While a potentially good sign for stock market activity, M&A loans for blockbuster dealsbuyouts done with $10 billion or more of debtare considerably riskier than junk bonds. According to Moodys, these mega-deal leveraged loans have a default rate of 17.8% over the past five yearstriple the rate of defaults for junk bonds. Granted, not all private equity firms come with the same sorry track record, but then again not all loan fund managers can wait for the right deals from which to pick and choose.
Along with an increased risk of default from more M&A loans in the market comes the increasing power of borrowers over creditors. Loans are typically written with certain conditions (covenants) on the borrower that require minimum standards for interest coverage and loan-to-value ratios and also prohibit other activities that could alter the borrowers risk profile. These covenants are meant to protect the creditors interests and maintain the borrowers fiscal discipline. But as money has flooded into loans this year, borrowers have found they have the advantage and theyve increasingly demanded fewer and fewer covenants.
In fact, according to data from S&Ps Leveraged Commentary & Data (LCD), 62% of loans this year lack any covenants at all; the percentage of these so-called covenant-lite or cov-lite deals in J.P. Morgans Leveraged Loan Index is now almost 54%from 2007 to 2012 it never reached more than 20%. These relaxed standards have caught the eyes of both the Federal Reserve and the Bank of England, with one Fed official stating in May that stronger supervisory action may be needed and the BoE signaling concerns about deteriorating underwriting standards. What especially troubles some investors is that not all cov-lite loans go toward capital expenditures or acquisitions: Eddie Bauer, the clothing retailer, took out a $225 million loan just so it could pay its private equity owner a dividend.
Todays loan investors not only face burgeoning risk in their portfolios, they dont get paid better for taking it. Investorsboth retail and institutionalhave been surprised by this years lower-interest-rate environment, and with borrowers in the drivers seat these days, lower yields from loan portfolios have taken some of the shine off these goods. Most bond investors have benefitted from lower yields this year as prices for bonds have risen. But loan investors dont receive the same treatment. Their yields are tied to LIBOR, and that rate (about 0.23% for the three-month U.S.-dollar LIBOR) is not only quite low, but todays loans are already receiving their minimum yield (called the floor) because LIBOR is less than 1%. In other words, yields on loans wont float up (one of the main draws for these products) until LIBOR goes above 1%a level last seen five years ago.
Also worth noting is the potential liquidity trap loan fund investors have set for themselves. As mutual fund and exchange-traded fund investors plowed money into loan portfolios they displaced a good number of hedge fund investors, such that the high-liquidity products (mutual funds and ETFs) now command roughly twice the share of the loan market than low-liquidity products (hedge funds and distressed funds). In the event the retail crowd gets anxious, will there be a mechanism to keep high-liquidity products from turning the market into chaos? In August 2011 loan mutual fund and ETF investors sold $4 billion net from their portfolios in just two weeks and returns dropped 400 basis points. Then, those products had just one-third of todays assets. Its questionable whether a similar hiccup today would find tens of billions of dollars ready to step in.
NO NEED TO PANIC
That said, its probably not time to hit the panic button, either.
Loan prices tend to stay stablea feature that appeals to many conservative investors. Only during periods of deep stress (the meltdown of 2008 being the obvious example) have loan aggregate values changed substantially. They otherwise show few effects from bond and stock market fluctuations. Because refinancing is the bulk of loan activity and loans mature in just a few years, prices dont drift much. While more and more loans are being sold at par instead of at a discount, these values dont indicate an overheated market.
Another way of looking at loan values is to consider their spread to other instruments. According to BMO Capital Markets, the all-in spread of BB loans to LIBOR actually rose to about 400 basis points in June from 335 basis points at the end of March, reversing a nine-month trend toward tighter spreads. The timing of this widening could be related to regulators concerns about underwriting standards, and that in turn might cool the fires beneath the loan marketsomething issuing companies might grumble about but retail investors might appreciate because its keeping yields a bit higher.
Is it time to bail on loan funds? With the market pushed toward riskier deals, fewer creditor protections and a virtual cap on yields for the foreseeable future, putting more money to work here doesnt seem particularly prudent. Although defaults are low and spreads have widened slightly, the loan market increasingly looks played out. Is it headed for an outright fall? Its too soon to tell. But its no surprise that some investors and their advisors are shying away.
Jeff Tjornehoj is head of Americas research at Lipper.
- Gross Says Investors Should Say Good Evening' to Asset Gains
- Trailblazing Breakaways Challenge Wirehouse Model
- Suit Up! Merrill Lynch Boot Camp Preps Clients