July 29 (Bloomberg) -- U.S. mutual funds that focus on speculative-grade corporate loans are underperforming a benchmark as investors stage the biggest retreat from the market since 2011 and regulators warn of lax underwriting standards.
Returns of 2.1 percent this year for such funds tracked by Morningstar Inc. are falling short of the 2.5 percent gain in the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 index. In all of last year, the funds rallied 5.7 percent, versus 5 percent for the gauge.
Mutual fund managers are struggling with redemptions swelling to $7.4 billion since April following record net deposits of $57.4 billion last year when investors sought debt that helped hedge against rising interest rates. Those higher rates have failed to materialize, while the Office of the Comptroller of the Currency has warned that underwriting standards are weakening and may lead to bigger losses than in previous cycles.
“When you have large inflows and outflows, that’s expensive” because you have more trading costs, Mark Okada, Chief Investment Officer of Dallas-based Highland Capital Management LP, said yesterday in a telephone interview.
Sitting on higher cash balances to manage withdrawals can also eat into returns, said Okada, who is also co-founder of the firm.
Investor withdrawals since mid-April snapped 95 straight weeks of inflows, according to Lipper. The $6.7 billion second-quarter outflow was the most ever after the record $8.4 billion in the third quarter of 2011 and followed $6.7 billion of deposits in the first quarter.
The Federal Reserve’s easy-money policies aimed at spurring the economy has been a boon to borrowers. It’s also meant that investors are willing to sacrifice safeguards for higher yields as benchmark rates remain close to zero for a sixth year.
Banks have arranged about $352 billion of leveraged loans that were sold to institutional investors such as mutual funds and collateralized loan obligations this year, after a record $695 billion of such issuance last year, according to data compiled by Bloomberg.
The pool of new loans this year with a B rating, which indicates adverse business, financial, or economic conditions will likely impair the borrower’s ability to meet its commitments, has swelled to 58 percent of covenant-light debt issued this year, according to a July 14 report from S&P. That’s up from 38 percent in 2007.
Covenant-light loans lack standard lending protections such as financial maintenance requirements.
“We passed on 80 percent of deals” in the last 12 months, Highland’s Okada said. “I’m staying away from the middle market.”
Okada, who manages a $1 billion loan mutual fund for the firm, said he’s investing in larger loans that are easier to trade, while paying close attention to credit agreements.
His bets have produced 2.6 percent returns for the Highland Floating Rate Opportunities Fund, exceeding the S&P/LSTA Loan index.
Leveraged loans, which are first to be paid in bankruptcy, have coupons tied to the London interbank offered rate. Three-month Libor was 0.234 percent July 25, compared with a record low of 0.22 percent this year.
Interest-rate margins for new loans sold to institutional investors averaged 4.09 percentage points more than benchmarks on July 17, down from as high as 5.89 percentage points in July 2010, according to S&P Capital IQ Leveraged Commentary & Data.
Smaller loans issued by weaker companies can be harder to sell in a downturn, and low coupons may mean bigger losses if investors are forced to unload them.
“This is where preparation matters more than predictions” of where rates are headed, Okada said.
Highland hasn’t faced difficulty in managing this year’s outflows through the sale of loans in its portfolio, with the record pace of new CLOs being raised providing plenty of demand, according to Okada.
About $71 billion of CLOs have been issued this year in the U.S., according to Wells Fargo & Co. Highland also has a $350 million revolving credit line it could tap to handle withdrawals from its mutual fund, said Okada.
“Because of the recent proliferation of ’B’ rated loans, the next downturn will likely see higher default rates than the previous one,” S&P credit analysts wrote in the report.
Loan funds lost about 30 percent in 2008, according to Morningstar data, the year that the failure of Lehman Brothers Holdings Inc. deepened the financial crisis. Prices of the high-yield, high-risk debt dropped that year to a record low of 59.2 cents on the dollar, according to the S&P/LSTA loan index. They averaged 98.7 cents yesterday.
“Defaults are not an imminent concern over the next couple years,” Christopher Remington, an institutional portfolio manager for loans at Eaton Vance Corp., said in a phone interview. Money managers that are ahead of the benchmark this year may have made more aggressive bets on low-rated loans as well as high-yield bonds, he said.
Junk bonds have outperformed loans this year with 5.17 percent gains, according to a Bank of America Merrill Lynch index.
The trailing 12-month global default rate for speculative-grade corporate debt was 2.2 percent at the end of June, the lowest since the last quarter of 2011, according to Moody’s Investors Service. The rate will decline to 2 percent at the end of this year, the ratings company predicted on July 10.
Global defaults, which remain below the historical average of 4.7 percent since 1983, spiked to almost 14 percent in November 2009 as the U.S. economy suffered the worst recession since the Great Depression.
“The absolute yield for these loan funds is still very low,” Mark Pibl, the New York-based head of high-yield research and strategy at Canaccord Genuity Inc., said in a phone interview. It would take “only a few defaults” with below par recoveries to create losses big enough to wipe out returns for an entire portfolio, he said.
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