Retail: It’s the credit, stupid

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As retail money accounts for an ever-larger percentage of leveraged finance, investors must not lose sight of what this asset class is all about.

By the time retail investors in the US high yield market had recovered from their bout of summer nerves, nearly 5% of retail assets under management had been withdrawn from the asset class in a matter of weeks. According to Bank of America Merrill Lynch, between late June and late August $17 billion was withdrawn from the market. Inflows resumed during the week of August 25.

The market’s mini-meltdown was almost inevitable after Janet Yellen’s pointed comments in June about the risk building up in leveraged finance. This compounded investor fears sparked by Fed board member Jeremy Stein’s speech in February on credit market overheating.

Intense focus

Despite the intense focus on high yield throughout the last year, however, outflows from the asset class were very much on the same scale as they have been during previous bouts of volatility. Last year’s taper tantrum led to outflows of 5.2% of AUM, while 2011’s debt ceiling disruption sparked withdrawals of 5.4%.

However, the growth in retail AUM targeted at leveraged finance over the last five years has been remarkable. BAML calculates that US high yield mutual funds now own 27% of the high yield bond market, up from just 10% in 2007. And loan mutual funds, which have attracted huge inflows from retail investors looking for rate protection, have come from nowhere to now own 22% of the US leveraged loan market.

The maturity mismatch inherent in daily liquidity mutual funds investing in what can be a highly illiquid asset class has not gone unnoticed by regulators and market participants alike. The market is understandably jumpy when large numbers of retail buyers head for the exit. However, the summer has shown that – absent a large, unanticipated shock – the mix of retail and institutional buyers in the high yield bond market means that it still functions reasonably well despite persistent secondary illiquidity.

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Nevertheless, as focus on the retail component of leverage finance intensifies, events in the UK in early September are a timely reminder of what investing in high yield is all about. On September 1, Vodafone’s decision not to renew its contract with UK mobile phone retailer Phones 4U saw the latter’s deeply subordinated PIK toggle notes trade as low at 30 on the same day. To add insult to injury, this £205 million 10% 2019 deal was issued just last September to pay majority owner private equity firm BC Partners a £223 million dividend.

Phones 4U subsequently entered administration on Monday, rendering both the PIK toggle note and £430 million of senior bonds practically worthless.

The episode highlights just why there is still more yield in this asset class than elsewhere: there is more risk. And understanding the credits that you are investing in inside-out should be a prerequisite of participation. Retail investors: take note.