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Posted by on May 29, 2014 in Peritus Asset Management

The Coming Opportunity in Floating Rate Loans

The Coming Opportunity in Floating Rate Loans

By: Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)

 
The clamor at the end of 2013 by most was that interest rates were going to rise in 2014.  As we are now closing in on the first half of the year, we have seen this widely held expectation come into question, with the 10-year Treasury rate falling from 3.0% at the end of 2013, to now about 2.5%.1  With the recent back up in Treasury rates, we are now seeing the sentiment toward floating rate loans change.  Up until the last month and a half, this was a one-way trade, with 95 consecutive weeks of inflows into loan mutual and exchange traded funds.2  However, we have seen that record break, with outflows in 4 of the last 5 weeks.3

Questions are starting to emerge as to what will be the impact on this market if the outflows persist?  Understanding the market dynamics in the loan space begins with understanding the sources of demand for leveraged loans.  The CLO (collateralized loan obligation) market has been the primary purchaser of loans, with CLO’s representing 46% of the outstanding U.S. leverage loan market according to J.P. Morgan.4  J.P. Morgan also notes that the retail loan universe (mutual and exchange traded funds, as tracked by Lipper) represents $143.4 billion5 of the $720.5mm U.S. loan universe6, so another 20% of the outstanding market.  Other players in the space include pensions, insurance companies, banks, hedge funds, and private funds, among others.  With CLOs and retail funds representing such a large portion of the loan market, we’ll focus on those two areas.

First, with CLOs, it is important to note that we have seen a strong recovery in issuance over the past couple years, with some expecting 2014 origination to outpace the prior record set before the financial crisis.  This has undoubtedly helped fuel the strong issuance of new leverage loans.  While CLOs are strong buyers in the loan market, they are also subject to limitations in their buying.  For instance, CLOs can be strong buyers of loans during the initial ramp of the vehicle and incremental buyers as they are forced to reinvest money due to calls of existing loans, but they are generally not viewed as doing a ton of purchases and trading after the initial ramp. They also have ratings tests that must be met, which can make them forced sellers upon a downgrade of a loan, and overcollateralization tests that must be met.  So it seems beyond the initial ramp phase, CLOs are not big natural buyers of secondary loans, and may be forced sellers if any of the test are triggered by downgrades or other factors.

So if the largest player in the market is not a natural buyer, what happens to the loan market if interest rate concerns dissipate and the retail outflows heat up?  Who will be there to be the source of demand?  There have been recent articles questioning how the large loan exchange traded funds will be able to handle large outflows, as unlike bonds, loans can be harder to sell given this fewer natural buyers and the more difficult settlement procedures.

We see any sort of market disruptions caused by a general exodus from the loan funds as a buying opportunity.  Secondary market players who do not face the constraints many of the others in this market face may well be able to pick up loans at very attractive prices/yields.  We are already seeing some attractive opportunities in the loan market, especially as the percentage of the loan market that now trades above par is only 50%, versus 84% at end of January7, which means we are already starting to see some opportunities for discount purchases.  We are not interested in this market due to a take on rising rates—our take has been and continues to be that we see various factors that may well keep rates low for a long time to come.  Yet, we feel this market offers some attractive yield opportunities and expands our investment universe relative to the opportunities we are seeing the high yield bond market.  If the market sentiment shifts and selling pressure in these loan funds heat up, we see this as a strong opportunity for investors like us that are active secondary players.

 

1 Current U.S. 10-yr Treasury Rate as of 5/20/14.

2  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  May 16, 2014, p. 5.

3  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  May 16, 2014, p. 1.

4 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2013 Leveraged Loan Annual Review,”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  January 30, 2014, p. 94.

5 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2013 Leveraged Loan Annual Review,”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  January 30, 2014, p. 84.

6 Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2013 Leveraged Loan Annual Review,”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  January 2014, p. p. 110.

7Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  May 16, 2014, p. 4.

 

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