Why leveraged loan funds continue to see outflows

Market Realist

High-grade and high-yield bond markets assess risks ahead of FOMC (Part 9 of 9)

(Continued from Part 8)

Leveraged loan funds continue to see outflows

Collateralized loan obligation (or CLO) deals continued to find favor with both issuers and investors, as six CLO deals for $3.1 billion came through in the week ending July 25. This was up from the previous week’s levels, when three CLO deals for total issuance volumes of $1.4 billion came through. Last week brings the year-to-date (or YTD) issuance and transaction figures to $71.1 billion and 133 deals, respectively (Data source: S&P Capital IQ/LCD).

The market for CLOs has touched new highs in 2013 and 2014 with a record number of transactions and issuance volumes. Low yields on safer debt securities like investment-grade debt (BND) have forced investors to “reach for yield” in high-yield debt (HYG) and leveraged loans (BKLN).

CLOs have certain advantages for investors because they are able to slice credit risk into tranches. As a result, an investor with a low risk appetite may get exposure to AAA-rated debt tranche in a CLO, while an investor with a higher risk tolerance can earn higher yields by investing in lower rated tranches.

Secondary market activity

Net outflows from leveraged loan (BKLN) mutual funds in the week ending July 25 came in at $413 million, compared to a net outflow of $440 million in the previous week. Last week brings the total net inflows in to leveraged loan mutual funds to $352 million YTD (Source:Lipper).

Net flows into mutual funds provide clues to investor sentiment regarding the asset class. Leveraged loan flows, which were positive in all weeks in 1Q14, have been steadily eroded since the 2Q14 as the Fed continues to reiterate its commitment to monetary accommodation.

Leveraged loans are issued on a floating rate basis. While issuers benefited from the low yields scenario brought about by an accommodative monetary policy, investors preferred to exit due to the prospect of low and declining yields.

Also, a number of Fed officials, including Fed Chair Janet Yellen, have warned of signs of froth and lower underwriting standards in the leveraged loans and junk-rated bond markets. YTD, ~62% of new institutional loans were issued as covenant-lite compared to ~57% in the same period in 2013.

Return comparisons

YTD returns on the S&P/LSTA U.S. Leveraged Loan 100 Index have come in at 2.52% up to July 25. For the week ending July 25, the Index increased by 0.05%, compared to an increase of 0.01% in the S&P 500 Index (SPY).

The S&P 500 Index was adversely affected towards the end of the week due to the 2Q14 earnings releases from Amazon and Visa, which caused significant price movements in the prices of both stocks. Visa is also a component of the Dow Jones Industrial Average (DIA), which fell by 0.83% over the week. The decline in the Dow was primarily on account of Visa, which disclosed a disappointing revenue outlook for 2014.

Although most companies in the S&P 500 Index reported better-than-expected earnings, the Index return was weighed down by disappointing earnings from both Amazon—the world’s largest online retailer—and Visa. Shares prices of both companies declined significantly after their respective earnings announcements.

You can learn more about the outlook for bonds and other asset classes in the Market Realist series, Asset classes react differently to inflation and economic growth.  

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