Forget Yellen Froth Alarm: Junk Loans Are Hot, Per Funds

The Federal Reserve can send all the warnings it wants about froth in the junk-loan market, but some of the biggest buyers aren’t listening.

Instead of backing away from the $750 billion U.S. market, they’re targeting the lowest-ranked portions of collateralized loan obligations, which pool the debt and slice it into pieces of various risk and return.

Hedge fund Marathon Asset Management has created the Marathon CLO Equity Fund LP, according to a regulatory filing this month. AR Capital LLC, formerly known as American Realty Capital II LLC, is forming a new finance company that will invest in loans including through CLO equity, which are first-loss pieces of securities backed by pools of speculative-grade loans, a July 16 filing says.

Prospect Capital Corp., a $3.7 billion firm focused on lending to smaller companies, said it’s generating “yields in excess of 20 percent” by purchasing the lowest-ranked portions of CLOs, according to a July 1 call with investors.

“We think we’re the No. 1 U.S. CLO equity investor on the planet now through this strategy,” said Grier Eliasek, Prospect Capital’s president and chief operating officer, on the call.

CLO Demand

Bigger buyers are swooping in to pick up any slack in demand as the smallest investors lose interest in high-yield loans. Investors withdrew more than $3 billion from leveraged-loan mutual funds in June, according to a Wells Fargo & Co. report. They started yanking cash from the funds in April, ending 95 consecutive weeks of deposits.

Firms from Apollo Global Management LLC to GSO Capital Partners LP, the credit unit of Blackstone Group LP, are offsetting that and arranging the CLOs at the fastest pace ever, according to data compiled by Bloomberg. JPMorgan Chase & Co. predicted sales may reach a record $100 billion in 2014.

The frenzy is fueling gains in the debt, with loans to the most-indebted companies returning 2.5 percent this year and 19 percent since the end of 2011, according to Standard & Poor’s/Loan Syndications and Trading Association index data. They’re up 0.1 percent in July even as junk bonds lose 0.3 percent.

This hot market is raising eyebrows at the Fed, where policy makers are trying to temper investors’ appetite for risk while also holding their benchmark interest rate near zero for a sixth year.

“Signs of excesses that could lead to higher future defaults and losses have emerged in some sectors, including for speculative-grade corporate bonds and leveraged loans,” according to a report published this week by the central bank as part of Chair Janet Yellen’s semi-annual testimony to the Senate Banking Committee.

The Fed can keep trying to damp animal spirits in the riskiest debt markets with oral admonitions. But the longer it keeps benchmark interest rates at about zero, the longer some investors will see a green light to buy.

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