Markets rarely give second chances.
But investors who suffered through the fourth-quarter downturn in leveraged loans can reposition their portfolios and sell at prices close to their highs, new research from Schroders concludes. Leveraged loans and other securities have largely bounced back, but the risks that sent prices down at the end of 2018 are still there.
Markets sank and liquidity disappeared in the fourth quarter because of worries over the quality of collateral backing loans, a rise in covenant-lite loans offering fewer protections to investors, and high valuations amid uncertainty over global growth, according to Schroders.
But many investors have been ignoring two additional technical reasons to sell, said Michelle Russell-Dowe, head of securitized U.S. fixed income at Schroders, in an interview.
For one, investors have gravitated to leveraged loans in part because they offer so-called floating rates, which increase as interest rates rise. Investors have been buying the securities for their attractive yields and as a hedge against rising rates, which push down the value of most credit instruments. But in recent months, the Federal Reserve has signaled that it won’t be raising rates anytime soon.
On Wednesday, Fed chairman Jerome Powell testified to Congress that economic uncertainty in the U.S. has increased, signaling to the market that the Fed is on a path to cut rates.
If rates are not rising, leveraged loans lose some of their appeal. Demand should lessen and prices should fall, Schroders said.
Russell-Dowe also noted a slowdown in purchases by collateralized loan obligation (CLO) issuers, a big institutional buyer of loans, which are also concerned about rising rates.
“Rarely do you get a full recovery in price,” Russell-Dowe said. “You can say, ‘Do I want to experience the fourth quarter again?’ You don’t have to take a loss now to reduce risk,” she said.
Declining demand has to show up in the numbers at some point, she added.
Schroders’ research also highlights structural risks in the market. Retail mutual funds now hold record volumes of leveraged loans and other CLO securities. But these funds offer shareholders the daily freedom to cash out even though leveraged loan trades often take up to 30 days to settle. Schroders’ experts worry about what will happen if investors redeem en masse, pressuring managers’ ability to meet their redemptions.
“We are now seeing some selling of these securities with little notice,” wrote Russell-Dowe in the firm’s research. “We believe this indicates that these funds are getting redemptions, and in turn, reducing their liquidity. This, we believe, will impact both CLO spreads and loan spreads creating negative price activity.”
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Russell-Dowe said Schroders believes that investors will be better compensated for the risk they are taking by moving into securitized credit.
Since the financial crisis, as rates have remained at historic lows, investors have moved into areas providing higher income, such as high-yield bonds, leveraged loans, private credit, and other fixed income categories. Yet interest has lagged in securitized credit like asset-backed securities. These assets remain saddled with reputational issues because of their role in the financial crisis, she noted.
But that’s why there’s value for investors, said Russell-Dowe.
“We think securitized credit should be viewed as a means to diversify risk exposure away from the QE-induced excesses seen in many parts of the corporate credit market, both from a supply and a valuation perspective,” she wrote in the paper.
“It also seems there is a catalyst to begin the rotation now, as liquidity and redemptions from credit programs begin. In our view, investors don’t have the luxury of waiting until the next recessions begins,” she continued.