Money managers are hoping pension funds and insurance companies will become big buyers of leveraged loans, picking up the slack from CLOs.
It’s a new asset class for many institutional investors. To the extent that pension funds have invested in bank loans in the past, it’s often been through CLOs. Insurance companies are more familiar with leveraged loans, but they tend to have exposure through CLOs, too. That’s partly because, before the financial crisis, loan spreads were low and CLOs allowed them to leverage their returns.
“Given the ebbs and flows of the market over the last five years, more of these investors want to own the outright asset, rather than getting their exposure through a structured vehicle,” said Leland Hart, who heads the bank loan team in BlackRock’s leveraged finance group. “In addition, loans are cheap outright on a price or spread bases, and leverage is not needed to create a high return.”
BlackRock, the world’s biggest money manager, already has many pension funds and insurance companies as clients. The firm is pitching loans to these kinds of investors, both on the basis of their returns and as a way to diversify.
“My gut is that, in the next three to five years [pension funds and insurance companies] will be one of, if not the most important incremental investors to the market,” Hart said. “In many ways it will be an offset to the CLO industry, which is slowly shrinking.”
The $250 billion currently in CLOs account for roughly half of the leveraged loan market’s $500 billion in assets (although these structured investment vehicles don’t invest exclusively in loans). Historically, CLOs have snapped up an even larger percentage of new loan issuance. But most of the CLOs outstanding were issued in 2006 and 2007 and are nearing the end of their reinvestment periods. Despite a mini-boom in the first part of this year, new CLO issuance isn’t enough to replace this lost investment capacity.
“We don’t expect CLOs to be as big a part of the market as they have been historically,” said Steve Rixham, head of product management for high yield investments at Babson Capital Management. “They should be a meaningful piece, but retail will be bigger than it was historically, and institutions will be a bigger piece as well.” He said this would result in “a more balanced investor base.”
Until recently, it looked like bank loan mutual funds might plug the gap as retail investors and small businesses poured money into these products in anticipation of rising interest rates. But the Federal Reserve’s commitment to keep interest rates low has reduced the appeal of bank loan funds, and over the past 10 weeks they have seen more than $6 billion walk out the door, according to Lipper.
Rixham said that a number of pension funds have exposure to loans through high yield funds, though it tends to be relatively small. There are also pension funds that dipped their toe into the cash loan market after the credit crunch, when valuations were hit so hard that it made sense to look at these instruments as a tactical or strategic investment.
“Some could not move fast enough, they did the research, then put their pencils down,” he said. “Now they’re revisiting it, trying to figure if it’s a strategic or core allocation: we believe it should be core, we think the question should be are you market, over or underweight.”
Wooing pension funds and insurance companies is a slow process, however. Hart says that, while their interest in leveraged loans is “material and increasing,” winning investment mandates is “more of a march, instead of a race.”
The loan market’s idiosyncracies may be a hurdle for some investors. Settlement of trades is much slower than it is for more liquid, listed instruments. And unlike high yield bonds, loans are private contracts. Some pension funds are restricted to investing in securities. Institutional investors may also need to get comfortable with the lack of call protection loans offer relative to junk bonds.
“Clearly, when the market ebbs and flows, investors ask for call protection ... but also remember that loans are secured, so there’s a trade off,” Hart said. “You have to weight one against the other as an investor. And the issuers do the same.”
On the other hand, he said, bank loans are analogous to private placements, an asset class insurance companies, at least, are very comfortable with, “only [loans] are floating-rate, shorter-term instruments that happen to be more liquid. Philosophically, that’s not that big a leap of faith, or it shouldn’t be for them.”
John Bell, a portfolio manager in the fixed income group at Loomis Sayles, said his firm has been educating pension funds about bank loans for years, starting in 2004. “We were often the first in the door, because it’s a new asset class for some,” he said. “They put it in an alternatives bucket, comparing it to hedge funds. It should be in the high yield bucket.”
Bell thinks leveraged loans may be a tough sell for some institutional investors so long as interest rates remain low. “Pension fund investing is driven by consultants, who want to be pushing the latest, best thing. So they may wait until rates rise” to pitch loans, he said.
“Interestingly, the retail market has been more focused on rising rates than the institutional market,” Bell said. “This time retail was faster (to invest), partly because they were in money market funds. I generally feel small business owners and people like that are very concerned about when rates will rise, whereas pension funds that hear about risk may actually wait to see if rates rise.”
Loomis, which is better known as an institutional money manager, launched its first retail investment product offering exposure to banks this month. The Loomis Sayles Senior Floating Rate Fund was seeded with $40 million. It is run by Bell and Kevin Perry, who co-manage between $2 billion and $3 billion in private funds and separate accounts dedicated to bank loans.
The mutual fund is less of a pure play on the bank loan market; its mandate requires it to put at least 65% of assets to work in floating rate loans, but it can also put to work as much as 35% of assets in other kinds of debt, including investment grade and high yield corporate bonds, convertible bonds, securitizations and government issues, depending on the managers’ outlook for the credit cycle.
This flexibility is intended to allow the managers to enhance yield, but it also allows makes it easier to handle cash flow in a vehicle that provides investors with daily liquidity. While trading volume is robust, it can take seven days or more for purchases and sales of bank loans to settle.
Also, Loomis believes retail investors are interested in a more diversified product. "Our institutional product is a pure asset allocation, there are no second-liens, no middle-market loans, it's very narrowly defined," Perry said.