U.S. loan funds remain appealing in 2018 as Fed hikes rates

NEW YORK (Reuters) - Retail investors are expected to keep pouring money into leveraged loan funds this year as they continue to show a clear preference for floating-rate assets in a rising interest rate environment, portfolio managers said.

Net inflows of nearly $13 billion in 2017 were 34% higher than in 2016, despite moderate outflows in most weeks since early August, according to Thomson Reuters Lipper.

Rising inflation is expected to push interest rates higher and eat into the returns of fixed-income securities, which will fire up demand for loan mutual and exchange traded funds as the year progresses.

The strength of demand for floating-rate funds contrasts starkly with the $22 billion withdrawn from high-yield bond funds last year, which eclipsed the $9.75 billion of inflows to high-yield funds in 2016.

“Floating-rate loans provide the opportunity to escape the negative effect of rising rates on most other bond positions – whether it’s emerging markets or high yield, or investment grade,” said Chris Remington, institutional portfolio manager at Eaton Vance.

The Federal Reserve is expected to hike rates three times this year, as it did last year, based on an upbeat economic outlook, a Reuters poll of Wall Street banks found.

US consumer prices posted the biggest increase in 11 months in December. The increase, along with a $1.5 trillion package of tax cuts signed into law last month by President Donald Trump, reinforces the view that inflation will accelerate this year, Reuters reported. 

“Retail demand definitely has room to pick up in this asset class in 2018 because valuations are pretty extended lots of other places, and you have rising rates, a pick-up in inflation expectations, lots of reasons why someone might land in this neighborhood” of loan funds, Remington said. “Floating over Libor is a good place to be.”

Loan investors generally show a herd mentality, which produces one-directional flows with many months of unbroken inflows or outflows before reversing. The market has been seeing outflows since midsummer, which is expected to usher in months of inflows when it reverses, based on recent patterns.

The next catalyst for consistent net inflows is expected to be the looming Fed rate hikes that are anticipated in March and June.

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Bank loan yields of around 5% are currently more attractive than high yield bonds at 5.75%, according to Adam Brown, senior portfolio manager and co-head of high yield at Macquarie Investment Management, Americas.

“You’re only getting paid 75bp-100bp to move down the capital structure from the senior secured level of bank loans down to the mostly unsecured level of high-yield bonds,” said Brown.

Loans are senior and secured, unlike high-yield bonds, and rank higher in capital structures, which typically provides for better recovery rates in default situations.

Traditionally, the spread differential would be wider, often 150bp, Brown said, to better compensate bond investors for increased risk.  

“We would make the argument that you are not getting paid appropriately to move from loans to high yield, and be impacted by higher levels of volatility that you could see in the high yield market.”

Strong demand from retail investors combined with heavy purchases by Collateralized Loan Obligation (CLO) funds, the largest buyers of leveraged loans, took US leveraged lending to a new record in 2017.

Leveraged lending to highly indebted companies surged 62% to an all-time high of about US$1.33trn last year, topping the prior record of US$1.13trn in 2013, according to Thomson Reuters LPC data. Net new supply was constrained, however, with repricings and refinancing accounting for two-thirds of the volume.

Robust demand for available floating-rate assets allowed most deals to sail through the market in 2017, and helped borrowers to lock in more favorable terms before further interest rate rises.

CLOs may be heading for a record year in 2018, with institutional investors looking to build floating-rate exposure as a hedge for rising interest rates. US issuance could top the $117 billion of CLOs raised last year, which was the second-largest issuance year ever, LPC previously reported.

(Reporting by Lynn Adler; Editing By Tessa Walsh)