The $800 billion U.S. leveraged-loan market is losing mutual-fund investors just as it's about to need them more than ever.
Regulators are approving new rules this week making it more expensive to create funds that are the biggest source of demand for the below-investment-grade debt: collateralized loan obligations (CLOs). Managers of the funds will be required to retain 5 percent of the debt they package or sell, or banks underwriting CLOs will have to hang on to a piece.
The Loan Syndications & Trading Association, the market's main lobbying group, said yesterday the rule will "materially reduce the CLO market."
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This matters because junk-rated companies have found willing lenders in CLO managers as other investors have fled, rattled by warnings from policy makers that the market's showing signs of froth amid a sixth year of record Federal Reserve stimulus.
Investors pulled $946 million from U.S. funds that buy leveraged loans in the week ended Oct. 15, bringing net outflows for the year to $11.2 billion, according to data provided by Lipper. Meanwhile, the CLO market has grown by about $50 billion this year to almost $350 billion, according to Wells Fargo & Co.
If fewer CLOs are raised, "the loan market could shrink, new structures may emerge, or retail and institutional investors would have to increase market share," Wells Fargo analysts Dave Preston and Jason McNeilis wrote in an Oct. 8 report. "Risk retention may become effective at an inopportune time as short-term rates are rising."
CLOs typically purchase 60 percent of new issuance, Wells Fargo data show. Bank of America Corp. analysts predicted in an Oct. 17 report that CLO issuance would reach a record of as much as $130 billion in the U.S. this year.
The purchases by CLOs, which pool loans and slice them into pieces of varying risk and return, have helped offset the drop in demand from individual investors. Prices have declined to 96.4 cents on the dollar, from 99.1 cents in July, as mutual-fund withdrawals have mounted, according to the Standard & Poor's/LSTA U.S. Leveraged Loan 100 Index.
Crisis Response
The new regulations are being enacted in response to the credit crisis that was fueled in part by securitized debt, particularly in the mortgage market. The rules, which may take effect in 2016, are designed to curb excessive risk-taking by making sure managers have some skin in the game.
This "will help ensure the quality of assets purchased by CLOs," U.S. regulators wrote in a document released yesterday.
The CLO machine has enabled borrowers to issue debt with riskier terms. Covenant-light loans—which lack certain protections for lenders such as limits on debt levels relative to earnings—are on track to exceed a record 70 percent of issuance this year, Barclays Plc said in a report last month.
There may be less demand from CLOs starting in 2016, coinciding with rising interest rates and an increase in defaults. This may prove to be a rocky mix for the loan market.
–With assistance from Christine Idzelis in New York.
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