NEW YORK, Sept 2, 2016 (Reuters LPC) - Demand for the limited supply of US leveraged loans is rising as investors try to lock in floating-rate exposure while yields on other asset classes remain depressed and the Federal Reserve gets ready to raise rates again.
Secondary loan prices climbed steadily over the summer but further gains should be gradual because eventual interest rate hikes are expected to happen slowly.
“If the Fed were to start to raise rates, even if it’s gradual, it’s a nice diversifier in our portfolio to have some floating-rate assets as a hedge,” said Greg Zappin, portfolio manager at Penn Mutual Asset Management.
The firm is looking to buy individual loans for the first time, in addition to its current holdings of Collateralized Loan Obligation funds.
“In a sideways market, these assets will perform better than equities because they are at the top of the capital structure,” said Michael Forman, chief executive officer of FS Investments, formerly known as Franklin Square Capital Partners.
Average secondary prices of the 100 largest leveraged loans rose to 98.7 cents on the dollar from 97.9 in late June, according to the SMi 100 gauge, after hitting a low of more than four years of 95.3 during February’s volatility.
“I’m a skeptic on rising interest rates. We believe we are in a lower for longer period,” said Forman.
With interest rates negative in other countries and the US economy performing relatively strongly, the firm’s assets are concentrated in floating-rate products, he said.
These assets will “perform very well in a rising interest rate environment and be a hedge against rising interest rates and inflation,” Forman added.
The expected ongoing advance in secondary loan prices could be magnified, investors said, if a rise in appetite for loans comes without a comparable burst of new issue supply to soak up the liquidity. US leveraged loan issuance in the first eight months of this year is 5.6% lower than the same time last year, according to Thomson Reuters LPC data, and arrangers are trying to sell lower quality deals into stronger demand.
“The quality of deal flow lately has been below average,” said one middle market lender. “We are seeing a lot of cyclicals, as well as businesses with significant customer concentrations” that are vulnerable if key accounts leave.
Investors will however be closely monitoring borrowing volume trends between the September US Labor Day holiday and the November US elections. CALLING RETAIL SHOPPERS
Retail investors have been slow to re-warm to leveraged loan funds, deterred by repeatedly dashed hopes of near-term Fed rate hikes. But with at least one rate hike expected before-year end, money has started to trickle in to loan funds after a long outflow streak, albeit with some caution as the macroeconomic environment remains volatile.
The Fed last raised rates in December 2015 for the first time in a decade and external global pressures have piled on top of moderate economic growth since then, keeping further hikes at bay.
“Despite an average return of 5.9% for the year to date investors have not rediscovered the leveraged loan group,” said Lipper analyst Pat Keon.
While inflows have picked up recently, investors pulled a net $5.4 billion from leveraged loan funds this year through August 24, according to Lipper data. This comes after $43.8 billion of withdrawals in the last two years due to volatility and the lack of interest rate rises.
In contrast, high-yield bond funds have returned 10.8% on average for the year to date through August 30, McKeon said. Investors poured $9.8 billion into these funds this year through August 24, after yanking $47.7 billion out in the previous three years.
The market turmoil expected as a result of Great Britain’s surprise June vote to exit the European Union, in a move known as Brexit, has so far been relatively contained in the United States, investors said. If anything, some said, the vote’s outcome has enhanced the reach for more yield in US assets.
“With stocks shrugging off their initial concerns about Brexit, the market for risk has rallied,” said Lauren Basmadjian, portfolio manager at Octagon Credit Investors.
“As government yields contracted after Brexit, it looks as though investors became even more desperate for yield,” and high-yield bonds have so far this year offered more than leveraged loan funds, she said. (Reporting by Lynn Adler and Leela Parker Deo; Editing By Tessa Walsh)
Our Standards: The Thomson Reuters Trust Principles.