All Dressed to Short and Nowhere to Go
It’s been a terrible two years for the $800 billion leveraged-loan market, judging by the steady stream of withdrawals from funds that invest in the debt.
It’s getting so bad that investors are not only searching for the exits, they are actively looking for ways to profit from the downturn. There's a catch: Traders can't borrow the actual loans to short them, the way they can with bonds and stocks. There are derivatives tied to loans, but they aren't traded all that frequently. But there is one vehicle that can serve that purpose -- the exchange-traded fund.
Investors have borrowed almost the maximum amount of shares possible from the biggest leveraged-loan exchange-traded fund, the $3.8 billion PowerShares Senior Loan Portfolio, to short them. About 7.8 percent of the fund's shares were on loan as of Jan. 14, up from just 1 percent of the shares in October, according to data provider Markit.
This comes after investors pulled $57 billion from mutual funds that invest in the debt since April 2014, data compiled by Wells Fargo show. The loans have lost almost 6 percent since the end of May, and last year's new issuance of the debt plummeted to the lowest since 2012.
To be fair, leveraged loans are performing better than high-yield bonds, which have lost almost 11 percent since May because of falling oil prices and rising forecasts for corporate defaults. But it’s surprising the loans haven’t returned even more compared with the bonds because a smaller proportion of them are tied to energy companies. Also, they usually get repaid before bonds if the borrower becomes insolvent.
So what's the source of such forceful disfavor? Well, first of all, many portfolio managers own both high-yield bonds and leveraged loans and will sell what they can when they receive redemptions. If the loans are perceived as more desirable by the market, then they may be the first to go.
Second, many credit hedge funds bought the lowest-ranked pieces of collateralized loan obligations, which are securitizations that account for a significant part of the U.S. loan market. These hedge funds have been hit with some severe losses in the past six months, and credit relative-value hedge funds are reporting some of their biggest withdrawals since 2009.
Some hedge funds have closed. Others have reduced their risk and girded for withdrawals. That reduces the bid for the riskier loans and adds to selling pressure.
Third, retail investors have pulled back. Just a few years ago, they poured record amounts of cash into the debt because it was pegged to floating-rate benchmarks, meaning it would ostensibly pay more as interest rates rose. That promise has lost its allure as benchmark borrowing costs have fallen, and individuals are now moving away from the loans as they generally withdraw from all risky assets in the face of slowing global growth.
Morgan Stanley analysts led by Adam Richmond expect cumulative U.S. leveraged loan-defaults to rise from 3.7 percent within the next year to 8 percent in two years as the credit cycle deteriorates, they wrote in a report earlier this month.
It is becoming more difficult to see where the demand will come from for this debt. That leaves investors looking to cash in on the weakness.
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