Amid concerns about rising inflation, investors poured unprecedented flows into bank loan funds. Now they are withdrawing some of that money due to concerns about credit quality and the risk of increased defaults.
In 2021 and through April this year, Moningstar’s $117 billion bank lending peer group funds took in $70 billion net, or nearly 60% of their current $117 billion, while Inflation fears were mounting, filling the floating rate business loan funds. which makes them almost inflation proof, very attractive.
The trade-off these bond investors make is that these loans are issued by companies whose credit status is below investment grade. While the floating rate feature is a boon in an inflationary environment, significant rate increases will also interfere with these companies’ profit margins and therefore their ability to repay that debt.
Loans have held up well against the rest of the bond market so far, but investors have withdrawn $17 million from funds in the category since May, or 24% of the money they invested over the past few years. previous 16 months.
It is currently unclear whether this is a sensible move or not. While the category’s average fund is down 2.52% for the year to Sept. 15, that small loss — some of which is due to the regular high-yield bonds that most bank loan funds own – is overshadowed by the 12.3% slump recorded by the Bloomberg US Aggregate Index
Although difficult to prove, it is possible that investors will sell their bank loan funds because, due to their modest losses, parting with them as opposed to other, more battered bond funds inflicts the least amount of permanent depreciation on a portfolio.
It could also be because they are worried about the quality of the credit they hold.
Robert Cohen, head of global credit at DoubleLine Capital, said his outlook was “increasingly cautious on credit quality as the year progresses”, but he also doesn’t think the bank lending category has disappointed investors or is about to experience undue stress in the future. .
Cohen and Philip Kenney manage the $289 million DoubleLine Floating Rate (DBFRX) fund, which posted a loss of 2.06% for the year to September 15, ranking it 25th among 62 funds in the category with complete records this year.
The fund’s three-year annualized gain of 2.14% through mid-September makes it the 20th best among 62.
The bond market’s troubles at the start of the year were “due to rising rates,” Cohen said, and DoubleLine now expects a change as credit concerns become more prominent.
Pimco officials broadly take a similar view. An article published by the Bond Shop in May noted that “nearly 80% of the negative return in U.S. investment grade and high yield has come from interest rate moves this year as the market reacts to policy changes. of the central bank”.
With credit risk expected to be greater from now on, this will put more pressure on bank lending funds, but could also provide an opportunity for skilled bond pickers.
Estimates for defaults next year in the bank loan and high yield bond markets are benign, in the range of 2% to 2.5%.
Cohen describes the small losses in the markets this year as “orderly stress.” There was an “asset revaluation, but nothing seized up,” he said.
Despite inflation and geopolitical issues, it doesn’t look like the market is facing anything like it did during the 2008-9 and Covid lockdowns.
All of this means that the credit quality of the DoubleLine fund is increasing, slowing the addition of higher quality individual loans and secured loan obligations (CLOs).
‘[The] was to gradually reduce the risks,” Cohen said. “We tend to have a higher credit quality than our peers – a higher BB rating, a lower CCC rating and a bit less of a B rating.”
The Pimco paper noted how rate hikes could impact companies that issued B-rated securities.
“For the typical low-level B bank loan issuer, a 300 basis point increase in the federal funds rate will increase interest costs by 60% to 70%. Such an increase in interest charges could significantly erode debt servicing capacity.
The $327 million Pimco Low Duration Credit (PSRIX) fund, managed by David Forgash and Michael Levinson, holds about 60% of its assets in bank loans and most of the rest in short-term corporate bonds. It fared worse than the DoubleLine fund, losing 3.32% for the year to mid-September, putting it 48th out of 62 bank loan funds for the year.
Straightforward corporate bond spreads have widened relative to Treasuries this year, and they have fared worse than bank loans and many CLOs.
It might not necessarily be the time to flee the bank lending category to try and find lower losses elsewhere, but it might be worth checking the credit quality of your fund.