NEW YORK (Reuters) - Retail investors yanked money out of bank loan funds in the latest week, breaking a nearly two-year streak of inflows, as the interest rate hikes buyers of these floating-rate products are counting on now appear likely later rather than sooner.
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 sizeable 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.
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