Friday, February 1, 2013

Fears of rising interest rates have investors focused on leveraged loans

Expectations of rising interest rates in the US are creating demand for traded HY corporate loans (also called "leveraged loans" - see discussion). These products typically pay LIBOR plus a fixed spread, which means that the coupon will grow if short-term rates increase. As an example, Invesco’s PowerShares Senior Loan fund (ticker: BKLN), which is supposed to track the price and yield of the S&P/LSTA Leveraged Loan 100 Index, has recently reached $1.5bn in assets. The fund's yield is currently below 5% (keep in mind these are sub-investment-grade companies), making it vulnerable to credit shocks.

BKLN total return (source: Ycharts)

Yet the floating-rate nature of the portfolios keeps investors flooding in, as they become less sure about the timing of the Fed's eventual tightening. In fact, relative to the the market size of each of the asset classes, leveraged loans have seen by far the largest inflows.

Source: Barclays Capital

The demand for this asset class can be seen in the outperformance of loan closed-ended funds. These funds can trade at a premium or a discount to NAV, which can result in out/under-performance vs. the underlying index.

Source: Barclays Capital

With the CLO market booming (CLO's securitize these corporate loans - see discussion), Barclays remains bullish the loan asset class (in spite of the recent rally). There simply isn't enough floating rate product in the market currently to meet this demand.
Barclays Capital: - The insufficient quantity of new loan product has forced investors to continue harvesting the secondary market to avoid accumulating too much cash, as demand technicals continue to be very strong across all major classes of leveraged loan investors. With more than $9bn in new CLOs priced, January was the busiest month for CLO creation since 2007. In addition, loan mutual fund inflows have been robust of late, as investors continue to look for ways to protect against rising interest rates. Cumulative flows for the first four weeks of the year already exceed $3bn. ... Unless rates reverse course and move materially lower, we expect favorable loan flows to continue.


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