Monday, September 24, 2012

Retail investors jump into syndicated loans

High Yield corporate loans (sometimes also called "institutional", "syndicated", "leveraged", "par", or "bank" loans) continue to be in high demand. And it's not only hedge funds and CLOs (see post) who like this product. Retail investors are piling in as well. Institutional loan mutual funds' assets under management are close to record, as inflows stay high.

Loan funds AUM (source: LCD)

These are loans to sub-investment grade firms such as HCA, Harrah's Entertainment, Reynolds, Avaya, First Data, etc. What makes this product so attractive? Investors like it because the assets pay floating rate (LIBOR plus spread). That means if short-term rates begin to rise, the coupon payments will increase. If inflation picks up for example, most expect these assets to compensate them for the loss in real value (although the risk is that the dovish Fed keeps short-term rates low in spite of inflationary pressures). Also because these loans are senior secured, there is more protection (collateral) than is offered by HY bonds in case of default. And default rates have been relatively low recently.

HY Corporate Loan Default Rates (% per year)

A popular retail product that provides exposure to this asset class is a closed-end fund called Eaton Vance Senior Floating Rate Trust (EFR). The fund is up 21% year-to-date on a total return basis (including dividend).

12/31/2011 = 100

When a fixed income fund has such an outstanding return, it is always important to compare it to the representative index. The S&P/LSTA Loan Index year-to-date return is 8.09%. So how is it that EFR was over 20% with roughly the same type of assets? The outperformance here is not just about picking the right names as would be the case with equity funds. Just as mortgage REITs (discussed here), most of these loan funds run some leverage. The EFR fund prospectus clearly says: "Performance results reflect the effects of leverage resulting from the Fund's issuance of Auction Preferred Shares" (a form of debt). Which means that if the loan index is down, this fund would be down much more.

As spreads stay low and investors reach for yield, demand for leveraged product - even at the retail level - is going to become commonplace in fixed income.
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