Can’t Get Enough Floating-Rate Debt? Big Funds Get Creative
Floating-rate loans are white-hot. Prices are up, and supply is tight as investors seek protection from rising rates. So some of Wall Street’s biggest funds have turned to a workaround: They’re engineering their own floating-rate securities.
Managers at fund companies such as J.P. Morgan Asset Management and PGIM Fixed Income are increasingly mimicking the floating-coupon aspect by buying fixed-rate corporate bonds and using derivatives to hedge out the rate risk. The result is what some refer to as “synthetic floating-rate” securities.
Welcome to a world where investor appetite for loans is chewing up supply, even as takeovers produce fresh deals and borrowers capitalize on demand with a frenzy of repricings. Investors are flocking to floating-rate debt such as leveraged loans because of the potential benefits if the Federal Reserve continues to raise borrowing costs in 2017, as it’s expected to do. For investors, the popularity of these loans means either throwing elbows to get to the front of the line or getting a little creative.
“We’re making our own,” says Bob Michele, who oversees $470 billion as head of global fixed income, currency, and commodities at J.P. Morgan Asset Management. The loans that banks sell, which have floating-rate coupons that track rates, are difficult to come by because so much of the market is going there, Michele says. That’s why he’s taken another way in. “We buy corporate issuers’ fixed-rate debt and swap it back to a portfolio of pure credit sensitivity,” he says.
It’s a strategy preferred by many with the resources to pull it off: Columbia Threadneedle Investments and Penn Mutual Asset Management are also among the major managers using Treasury futures and interest rate swaps to protect against Fed rate hikes. The process is simple, but it looks a bit different for each company.
At Columbia Threadneedle, it begins with a call between the firm’s corporate bond trader and his securities dealer of choice, during which the trader arranges to buy a chunk of a given company’s debt. He wants to make a pure bet on the credit, isolated from the wider rate environment, so as soon as the two agree on a price for the bonds, the corporate trader turns to his colleague on the Treasuries desk to arrange the second leg of the deal.
A quick check of the company’s internal risk-management system shows how much duration the company just took on, and the second trader uses his trading platform to offload a chunk of Treasury-bond futures with the equivalent duration measure.
The two transactions cancel each other out as far as interest rate risk is concerned, leaving only credit, or “spread,” exposure, on Columbia Threadneedle’s books.
The second way into this type of hedge is through an interest rate swap, another derivative instrument readily available to large asset managers. At PGIM, traders use these two strategies more or less interchangeably to hedge duration, depending on which is cheaper at the moment, says Greg Peters, who helps oversee more than $600 billion there.
Leveraged loans offer coupons that rise along with benchmarks such as Libor or the Fed’s overnight Treasury yield. That means they possess lower interest rate risk compared with fixed-rate unsecured corporate bonds of similar maturity.
At Muzinich & Co., traders are buying investment-grade and high-yield bonds maturing in 10 years and hedging with U.S. Treasury futures contracts, says Michael McEachern, head of public markets at the company, which oversees about $28 billion of assets. Penn Mutual is doing likewise as opportunities appear, says Scott Ellis, a corporate securities specialist at the $21 billion firm.
The approach isn’t new, having been used in everything from corporates to munis, but it’s an important tool that Columbia Threadneedle has been using since the Fed started signaling further rate hikes, says Gene Tannuzzo, senior portfolio manager at the company. “We’re doing it more than we were doing two to three years ago,” he says, adding that the practice increased after the Fed in December broadcast plans to raise the benchmark for the first time in a year. Policymakers again raised rates at this month's meeting, as expected.
The strategy isn’t available to everyone. For one thing, trading certain derivatives requires a minimum amount of capital. The smallest unit in Treasury-bond futures contains 1,000 contracts, which at a value of about $124,000 is a bit of a stretch for a mom and pop’s budget. Even institutional companies can be shut out of this trade, depending on their size and mandates: Multibillion-dollar companies such as J.P. Morgan and PGIM have at least a few funds with minimal guidelines and restrictions; many others are prohibited altogether from buying and selling derivatives.
This practice has its detractors. Gershon Distenfeld, director of credit at AllianceBernstein LP, cautions that hedging out rate risk essentially means doubling down on credit risk. “You may be getting the same yield as a loan, but it’s not the same exposure,” he says. “You’re basically levering up your credit portfolio and increasing your high-yield exposure.”
Krishna Memani, OppenheimerFunds Inc.’s chief investment officer, adds that loans have appeal far beyond their rate-hike resilience. “Loans are senior to bonds in the capital structure, so defaults are lower,” he says. “Loans also have a wider group of buyers, better covenants, and better Sharpe ratios than high-yield bonds. You don’t just buy loans to reduce your interest rate sensitivity,” Memani adds.
Despite some cooling in April, appetite for leveraged debt continues to run high. That’s enabled company after company to drive down their interest costs on new or existing loans. Heavy order flow convinces companies they can offer investors lower interest payments on the funds they lend without scaring anyone away.
Banks arranged about $434 billion of leveraged loans in the first three months of 2017, the most for a quarter going back to at least 1999, according to data compiled by Bloomberg. The tally now stands at $577 billion, with repricing loans accounting for about half of that volume, the data show.
Faced with these supply-and-demand dynamics in the market for leveraged corporate loans, asset managers are all too happy to pivot to a cheaper alternative. To PGIM’s Peters, the funds still buying bank loans are simply missing the point. “We look at these floating-rate securities like bank loans, and in aggregate they look pretty expensive,” he says. “You’re forcing investors into a very expensive asset class, when you can just buy securities and hedge out the duration.”
Ronalds-Hannon covers high-yield credit at Bloomberg News in New York. Bakewell covers corporate finance in New York.