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Risk-off shift brings banks back to leveraged loan market

Banks and hedge funds, which over the past few years have taken a back seat to collateralized loan obligations and other institutional investors in the $1.19 trillion U.S. leveraged loan market, have regained market share in recent months amid a rockier, more risk-off environment.

This shift in investor base comes in the wake of a fitful 2018 fourth quarter, capped by a brutal December, when leveraged loans lost a startling 2.54%, and as retail investors withdrew nearly $13 billion from loan funds and exchange-traded funds, according to Lipper, as the specter of further interest rate hikes from the Fed dimmed.

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Floating-rate assets such as leveraged loans typically see increased interest and investment in a rising-rate environment, which was the case for much of 2017 and 2018. Conversely, when rates look like they might hold or fall, investment in the segment can suffer.

That 2.54% loss in December was the biggest monthly slide in more than seven years for what has traditionally been a low-volatility asset class, and it was the worst December since 2008, during the height of the financial crisis, according to LCD. While the loan market rebounded in the first two months of 2019 and largely treaded water on a returns basis in March, issuance remains slow and investors continue to be deliberate, according to sources.

Looking more closely at market share: Institutional investors — primarily CLOs and retail funds — snapped up 86.4% of all U.S. leveraged loans offered for syndication over the past six months (through March). That is a significant portion of the market, obviously, though it is well off the all-time high of 91.3% in 2018, when the segment still was seeing tailwinds from roughly two years of rate increases. The share taken by banks/securities firms and hedge funds over the past two quarters, meanwhile, increased to 13.6%, according to LCD. That is the most since 2015, and is up from a record low 8.7% in 2018.

Unsurprisingly, the share of less risky pro rata loan issuance — amortizing term loans and revolving credits, which can be unfunded — jumped to roughly 40% over the last two quarters, amid the risk-off sentiment, from a 27% average over the first three quarters of 2018, while the share of amortizing term loans jumped to roughly 20% from about 10% over the same period, according to LCD.

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Pro rata loan debt is considered less risky than B term loans, which entail little or no amortization and usually have longer tenors than amortizing term loans.

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As would be expected, A term loans are heavily skewed toward better-quality issuers within the speculative-grade space — those rated BB–, BB or BB+. That is a range traditional banks target, as most of those concerns have restrictions on holding debt below this double-B ratings bracket.

As a result of the shift in market sentiment, the share of total loan issuance to double-B borrowers is roughly 30% over the last six months, up from just 14% in the 2018 third quarter — before the late-year loan market slide picked up steam — and from around 25% in the first half of last year. The share of issuers rated B+ or lower, meanwhile, accounted for about half of all U.S. leveraged loan issuance over the past six months, down from a recent high of 68% in the third quarter, according to LCD.

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The other big story over the last six months: Hedge funds and like-minded relative-value players regained ground amid the recent market gyrations. The share of new loans taken up by this traditionally aggressive investor segment over the past six months reached a relatively towering 11.4%, the most since 2012, up from just 3.4% in all of 2018.

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The reason for this surge: After a prolonged period with clearing yields on leveraged loans near record lows, amid sustained investor demand for assets, the fourth-quarter selloff finally pushed yields to levels that nontraditional loan investors found compelling. In the first quarter of 2019 the average institutional spread over the London interbank offered rate for single-B issuers rose to L+441, 81 bps wider than a year earlier, while the yield to maturity for these loans rose to a lofty 7.64%, almost 2 points above levels seen in the first quarter of 2018, according to LCD. The rise in three-month Libor contributed here, as well. It started 2018 at 1.56%. It is currently about 2.60%.

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Looking beyond just single-B names shows that, after loan issuance skidded to a halt in December — there was a microscopic $3.8 billion of new issuance during the month — clearing yields rose across the board, with few transactions yielding below 6% and the share of deals with yields topping 8% accounting for a much bigger slice of the overall pie.

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In fact, the share of B-term loans with a yield to maturity of 8% or better skyrocketed to 62% in December from about 21% in November and from just 8% at the end of the third quarter. While these high-octane loans became more scarce as 2019 progressed, with 24% of deals offering that yield in March, that is way above the 7% average between January and September 2018. This yield surge explains why hedge funds were jumping into market, as these levels are smack in the returns wheelhouse for these funds.

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Of course, no story about the loan market these days would be complete without taking note of the segment's most important investor. For the first time since 2014, CLOs saw their share of the market decline — albeit nominally — as noninstitutional investors elbowed their way into the space. CLOs snapped up 66% of new loan issuance over the last six months, down slightly from 68% in 2018.

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While it's decidedly rougher going this year for CLO players, retail investors have been in full retreat. Since November, mutual funds and ETFs that invest in leveraged loans have withdrawn some $23 billion from the asset class, according to Lipper weekly reporters. As a result of this massive withdrawal, the fund investor share of overall U.S. leveraged loan allocations has taken a predictable dive, to 14.2% in the six months to March, from 21.4% in 2018.

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