Investors who have been pouring money into funds that purchase leveraged loans need to be wary of a reversal in demand, according to Justin Gmelich, the head of credit trading at Goldman Sachs Group Inc.
“It’s been a bit of a one-way freight train,” Gmelich said in a question and answer session, posted on the company’s website yesterday. “I would just caution those that are involved in the loan space to be mindful of the fact that they’ve been beneficiaries of inflows for 88 straight weeks and the tide can turn.”
The floating-rate debt, which offers a shield for investors from rising rates, has seen unprecedented demand with the funds that purchase the debt receiving deposits every single week since the summer of 2012. That enabled speculative-grade companies to raise $676 billion last year of bank debt, with more than 80 percent of that used to escape maturing debt deadlines, according to data compiled by Bloomberg.
Leveraged loans in the U.S. have returned 1.2 percent this year, after gains of 5.3 percent in 2013, according to the Standard & Poor’s/LSTA Leveraged Loan index. Loans, which are ranked higher up in the capital structure than junk bonds in case of a bankruptcy, are better protected from rising interest rates since they are generally pegged to floating-rate benchmarks. The value of a fixed-rate security diminishes with an increase in rates.
“Folks have been shrewd enough to try to protect against some of the rate shock,” Gmelich said. “When you see fund flows reverse, irrespective of whether or not the credit quality is good, you see a risk retracement.”
Retail inflow into loan mutual funds exceeded $63 billion last year and have already netted $4.6 billion this year, according to a Feb. 20 report from Bank of America Corp. Companies have been able to find willing lenders as the assets managed by mutual funds investing in the debt swelled to more than $150 billion from about $70 billion at the start of last year, according to data from the bank.
Leveraged loans and high-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at S&P.