Fed's dovish turn sends ripples through loan demand
By David Brooke
Twenty consecutive weeks of outflows
After withdrawing US$792.6m from loan funds in the week ending April 3, just over half the sum of the prior week, retail accounts now represent just 11% of the investor base for US leveraged loans, the lowest share since LPC began tracking the data in August 2012.
It was the 20th consecutive week of outflows in the asset class and follows the Fed's announcement on March 20 to maintain the benchmark interest rate at 2.25%-2.5% while signalling steady rates all year.
The share of retail investment in leveraged loans has not been as low since the first half of 2016, when loan funds made up 12% of the market from January to July. The Fed has been raising interest rates since December 2015.
In total, 2018 saw total outflows of US$4.2bn after a sell-off in November and December. Throughout the vast majority of the year there was inflows into the market.
Loan funds had assets of US$167.76bn last November before dropping to US$141.2bn in March, according to LPC, a unit of Refinitiv. As a proportion of the leveraged loan market, that dropped from 14% on November 18 to 11% in March.
Many investors have switched to bonds as per the shift in the Fed's strategy, driven by evidence of a slowing economy. High-yield bonds saw an inflow of US$589.7m in the last week of March and US$1.796bn in the previous week, according to Lipper.
CLO funds continue to make up the largest base of loan buyers at around 50%, according to LPC.
The softening in retail demand opens up the space for institutional investors to be more selective over credits coming to the market, but some are concerned it may have a cascading effect on the primary side.
"It's not surprising that we are seeing that preference hit the high yield market rather than the loan market," said Jon Poglitsch, head of credit research at Highland Capital.
"It's a contrast with last year when high yield bond issuance came off and second-lien loans came into favour in certain circumstances. There may be a reversal of that as appetite for high yield paper increases and firms will also downsize term loans," he said.
After the Fed raised rates in December, and announced that it was likely to slow down the pace in 2019, loan fund outflows reached new levels in a direction of capital that has continued since November.
The latest announcement from the Fed saw outflows reach a new high for a full week in 2019 and such swings in the availability of retail money is a contrast from institutional investors that are less dependent on interest rates.
"It helps to have long-term capital in the face of technical volatility. If there is something we want to buy, we can make space in funds needing to build to par or funds that have a total return focus," said Lauren Basmadjian, senior portfolio manager at Octagon Credit.
"There has been more volatility in the secondary loan market and that has been driven by outflows in the first three months of the year. It's pretty rare for one quarter to see such movement that is technically driven," she added.
Red-hot demand for loans in the last couple of years has meant borrowers have been able to push for greater flexibility in documentation.
The majority of primary issuance is covenant-lite, but borrowers have also sought to inflate Ebitda add-backs and include incremental facilities to hand themselves greater freedom to manage assets in the event of a downturn.
But a continued reduction in the retail investor base may open the door for institutional investors to push back on flexible documentation packages.
"We passed on a number of deals that weren't attractive, due to inappropriate capital structures or deficiencies in the documentation," Poglitsch said.
"But with increasing outflows there is likely to be more scrutiny of the terms in some situations, a reversal of the environment that persisted for much of 2018 when large retail investor inflows provided a conducive climate for borrower-friendly issuance," he said.
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