In the second week of February there was a $1.5 billion inflow into US loan funds, 2.5% of total net assets, according to BAML. Indeed, average weekly inflows throughout 2013 have equalled 1.5% of total assets. Flows in Europe are starting to follow suit.
This intense focus on loans is a by-product of two things: investor nervousness around the impact on fixed income of interest rate rises and investor nervousness around bond market returns. “As there is more stress around duration risk and the fixed-income market becoming too tightly priced, loans look like terrific value – particularly in the US, where there is a greater prospect of rate rises as leading indicators are more positive,” says Martin Horne, managing director at Babson Capital in London. “We were making the case for loans even when bond spreads were slightly wider than loan spreads,” he says. “Bonds are largely unsecured and carry duration risk, loans are secured, with no duration risk.”
Tripp Smith, senior managing director at the Blackstone Group and a founder of GSO Capital Partners, believes, however, that the market momentum is simply the by-product of the irrational pricing in leveraged finance. “If both products are offering similar yields, as they are at the moment, then investors should move into loans from high-yield bonds as they are senior in the structure and floating rate,” he says, warning that, “investors are chasing yield in the high-yield market hoping that they can be the first one out if rates start to increase.”
Gary Herbert, portfolio manager, global high yield at Brandywine Global in Philadelphia, agrees that investors must take care. Brandywine Global has $42 billion of assets under management, with more than $35 billion in fixed-income strategies. “There is a particular concern around rising rates, which is well founded,” he says. “People are moving from US high-yield bonds into US loans in search of credit safety and a fall in interest rate sensitivity. But they are trading one problem for another: underwriting standards. Leverage multiples for the lowest quartile of the loan market are fast approaching 2006 levels and 82% of loans in the US market trade above par.” Indeed, covenant-lite issuance is approaching all-time highs in the US, with $87 billion of such deals in 2012 accounting for 30% of all institutional loans.
The spread compression in fixed income might, however, be drowning out investor concerns over loan quality. “This movement of funds is simply being driven by investors thinking: ‘If I take a portion of my non-investment-grade portfolio out of fixed-rate bonds and put it into floating-rate loans how wrong can I be?’” reckons Denis Coleman, head of European leveraged finance at Goldman Sachs.
As focus returns to loans there is an interesting debate as to just how much importance is given to covenant protection by loan buyers in today’s market. The growth of multi-strategy funds that invest in both loans and bonds means that many investors are used to investing in instruments with either maintenance or incurrence covenants and therefore might be more comfortable with the latter. The retrenchment of the banks coupled with the rise of large and powerful asset managers means that investor priorities in the loan market are very different today to what they were pre-crisis. The likes of BlackRock and Apollo have never relied on maintenance covenants and they now make up such a large part of the market that things will change as they do not have the same natural bias. “Post-2008 investors value liquidity far more than maintenance covenants,” claims Coleman.
And if investors have learned one thing over the past five years, it is to do their own homework. “Loans have traditionally been very documentation- and covenant-driven, which may have given investors a false sense of protection,” claims Mathew Cestar, co-head of the EMEA leveraged finance and sponsors group at Credit Suisse. “Now maybe you don’t need so much protection, but you need to do the credit work yourself.”
