The clamor at the end of 2013 by most was that interest rates were going to rise in 2014. As we are now closing in on the first half of the year, we have seen this widely held expectation come into question, with the 10-year Treasury rate falling from 3.0% at the end of 2013, to now about 2.5%.1
With the recent back up in Treasury rates, we are now seeing the sentiment toward floating rate loans change. Up until the last month and a half, this was a one-way trade, with 95 consecutive weeks of inflows into loan mutual and exchange traded funds.2 However, we have seen that record break, with outflows in 4 of the last 5 weeks.3
Questions are starting to emerge as to what will be the impact on this market if the outflows persist? Understanding the market dynamics in the loan space begins with understanding the sources of demand for leveraged loans. The CLO (collateralized loan obligation) market has been the primary purchaser of loans, with CLO’s representing 46% of the outstanding U.S. leverage loan market according to J.P. Morgan.4
J.P. Morgan also notes that the retail loan universe (mutual and exchange traded funds, as tracked by Lipper) represents $143.4 billion5 of the $720.5mm U.S. loan universe6, so another 20% of the outstanding market. Other players in the space include pensions, insurance companies, banks, hedge funds, and private funds, among others. With CLOs and retail funds representing such a large portion of the loan market, we’ll focus on those two areas.
First, with CLOs, it is important to note that we have seen a strong recovery in issuance over the past couple years, with some expecting 2014 origination to outpace the prior record set before the financial crisis. This has undoubtedly helped fuel the strong issuance of new leverage loans. While CLOs are strong buyers in the loan market, they are also subject to limitations in their buying.
For instance, CLOs can be strong buyers of loans during the initial ramp of the vehicle and incremental buyers as they are forced to reinvest money due to calls of existing loans, but they are generally not viewed as doing a ton of purchases and trading after the initial ramp. They also have ratings tests that must be met, which can make them forced sellers upon a downgrade of a loan, and overcollateralization tests that must be met. So it seems beyond the initial ramp phase, CLOs are not big natural buyers of secondary loans, and may be forced sellers if any of the test are triggered by downgrades or other factors.