Pension Funds Hunting Yield Return to Bonds Tied to Risky Loans

Pension funds seeking higher returns as global central banks suppress interest rates have stepped up their purchases of securities that bundle high-risk corporate loans.

The funds acquired about 8 percent of the top-rated U.S. collateralized loan obligation notes issued in the first half of this year and 7 percent of the riskier mezzanine slices of the deals, according to Citigroup Inc. data. That compares with “minimal” amounts a few years ago.

“Yield-starved pension funds have made an arrival into the CLO space and seem to be here for the loan haul,” Citigroup analysts including Ratul Roy and Maggie Wang wrote in a report Tuesday.

The renewed pension-fund buying of CLOs, which slice high-yield loans into securities with varying risks, is helping to support a market that fuels lending to indebted companies, including those backed by private-equity firms. U.S. issuance exceeds $63 billion this year, according to data compiled by Bloomberg, after a record $123.6 billion were sold in 2014.

Pension funds are also again considering investing in the riskiest so-called equity slices of CLOs, based on their historical outperformance relative to other assets, Wang said by telephone.

In the smaller European market, pension purchases are now even more important, accounting for 26 percent of new top-rated debt, according to Citigroup’s data.

Regulatory Scrutiny

The demand for CLOs partly reflects their higher yields relative to benchmark rates that have been created by banks facing regulatory hurdles to investing in the securities, Wang said. The pension managers also saw “that the asset class performed tremulously well through the crisis,” with less than 1 percent of speculative-grade slices defaulting, she said.

Banks bought 38 percent of AAA rated U.S. securities sold through June, their lowest amount since the 2008 financial crisis and down from 85 percent in 2012, according to Citigroup data. They also acquired just 9 percent of mezzanine CLO notes sold this year, also a post-crisis low and down from 35 percent in 2012.

In the U.S., banks are retrenching as they face increased regulatory scrutiny over their exposure to leveraged loans as well as new mandates, such as demands that they hold more capital and easy-to-trade assets.

Furthermore, the so-called Volcker Rule, which took effect this week, prohibits banks from investing in certain CLOs. A Federal Deposit Insurance Corp. rule in 2013 requiring banks to pay more for the agency’s guarantees on customer deposits when they’re holdings riskier assets has also affected their demand, Wang said.

Asset managers are “catching up quickly” to banks’ past role as the primary buyers of senior-ranked notes, purchasing 35 percent of the top-rated debt this year, while insurers acquired 17 percent, according to the Citigroup report.

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