NEW YORK, Sept 30 (Reuters) - A recent influx of retail investors into the US leveraged loan market, driven by the prospect of near-term interest rate hikes and rising Libor rates, is helping to push secondary prices higher as loans continue to offer good relative value compared to high-yield bonds.
Retail investors, individuals who invest via bank loan funds rather than institutional investors such as pension funds and endowments, have been targeting the US leveraged loan market since August as signs indicate that the Federal Reserve is intending to raise interest rates.
This has prompted nine weeks of inflows into the asset class, which continues to offer good yields as returns in other products grind lower in a volatile environment driven by political considerations and macroeconomic concerns.
This is the longest stretch of loan inflows into bank loan mutual funds since a 95-week inflow ended in April 2014 as a rate rise grew less likely. The influx of cash, however, is exacerbating a lack of supply in the primary market and driving secondary prices higher.
Average bids in the overall secondary market climbed to 96.96 on September 28 to its highest level since October 2, 2015, and the SMi100, which tracks the 100 most widely held loans, rose to 99.09 on September 28, according to LSTA/Thomson Reuters LPC Mark-to-Market Pricing.
“It’s the combination of Libor rising and expectations that the Fed is signalling a rate increase at the end of the year. Generally, that makes investors more focused on floating rate assets overall, and loans in particular,” said Steven Oh, global head of credit and fixed income at PineBridge.
Retail investors often use floating rate loans - which pay a spread over Libor - to hedge portfolios against rising interest rates. Although the Federal Reserve kept the federal funds rate steady last week, many expect it to rise in December.
The recent spike in the Libor rate - the rate banks charge each other for short-term loans - is also boosting retail appetite. Three month Libor hit a seven-year high of 87bp on September 20, boosted by the implementation of the SEC’s looming implementation of money market reforms on October 14 and the dollar funding needs of non-US banks.
Three-month Libor of 84bp on September 28 is still significantly higher than 33bp a year ago and has pushed a swathe of leveraged loans with Libor floors of 75bp or sub-Libor floors into paying floating rates again.
Libor floors, which guarantee returns for investors, initially limited the benefits of rising Libor for investors, but Libor is now sufficiently high that investors holding loans with 1% Libor floor expect to be paid a spread over the benchmark soon.
“While Libor should come down some in the fall Libor levels are still likely to be higher on a sustained basis, as money market reform will reduce the amount of funds available to these banks for quite some time. Bank loan funds are likely to be a potential beneficiary of this change,” said OppenheimerFunds in a July report.
Leveraged loans are also looking attractive against high-yield bonds, which are trading lower after peaking on September 8, according to the Merrill Lynch High Yield Master II Index.
Leveraged loans have returned 7.7% so far this year, according to the S&P/LSTA Leveraged Loan Index, compared to 14.9% for bonds. High yield bonds’ superior performance this year has left junk bond and loan spreads at nearly the same level, according to S&P/LSTA and Barclays US High Yield Bond Index.
As loans are senior and secured with higher historical recovery rates than bonds, this promises better future returns on loans, sources said.
“The relative value is in favor of loans right now,” a loan and bond investor said.
Retail investors new-found enthusiasm for leveraged loans is expected to funnel more cash into the asset class. Investment is already accelerating - September saw US$1.4bn of inflows, up from US$281m in August. This brings third quarter inflows to US$2.2bn in the first positive quarter for inflows since the first quarter of 2014.
This cash is intensifying the supply-demand imbalance that has characterized the leveraged loan market for most of this year. Retail investors will be competing for assets with US$1.7bn of new Collateralized Loan Obligation (CLO) funds that were issued in September along with separately managed accounts.
“CLOs, retail investors, institutional buyers - everybody wants leveraged loans,” a loan investor said. “That means higher secondary prices.” (Reporting by Lisa Lee; Editing By Michelle Sierra and Tessa Walsh)