LPC: Prolonged Fed rate hike wait discourages loan fund buyers

By Lynn Adler

NEW YORK (Reuters) - Retail investors will keep dragging their heels before returning as consistent buyers of floating-rate loan funds, now that surprisingly weak U.S. jobs growth has further prolonged the wait for Federal Reserve rate hikes, analysts and investors said.

Pegging demand to the prospect of rising interest rates, retail buyers have been sporadically adding to leveraged loan funds in anticipation of the Fed’s follow-up to the December 2015 hike, which was the first in almost a decade. April’s tepid U.S. jobs report, however, dashed expectations for a June Fed move.

In response, most economists now expect a hike no sooner than September, according to a Reuters poll. The soft economic indicator also prompted some banks to lower their interest rate hike expectations for this year to one from two before the report.

“With Fed rate hikes moving at a snail’s pace, a primary motivator for investors seeking inflation protection - the rate reset feature of loans – is greatly diminished,” said Jeff Tjornehoj, head of Americas Research at Lipper.

Retail investors yanked US$6.4bn from loan mutual funds and exchange traded funds this year through May 4, the latest Lipper data show, on the heels of withdrawing US$21.6bn in full-year 2015.

“While we’re very unlikely to see the US$20bn-plus outflows of the previous few years, these funds will continue to struggle with redemptions this year,” said Tjornehoj.

High-yield bond funds, in contrast, have pulled in US$10.5bn this year after losing US$16.4bn in 2015.

TOO FAR TOO FAST

Loans in the secondary market have jumped since mid-February on the back of bargain-hunting as oil and stock prices gained, but have been treading water for the past three weeks.

The average bid in the SMi100, the 100 most liquid loans, was 98.1 cents on the dollar on May 9, wavering little since April 21. The bid stagnated after spiking quickly from a recent low of 95.3 cents on February 22.

The rally stalled on the new signs reminding market players of the long-playing story: slow U.S. economic growth signaling low interest rates for even longer.

Without imminent rising rates, floating-rate loan prices have escaped a big drop because of increased demand from Collateralized Loan Obligation (CLO) funds, the biggest leveraged loan buyers, and dealflow that has been slowed by volatility and economic uncertainty.

Institutional loan issuance sank to a four-year low of US$39bn in the first quarter, according to Thomson Reuters LPC data.

CLO creation, although growing, will be sharply lower than in 2015, limiting the prospect of further loan price increases. Wall Street forecasts span from US$35bn to US$60bn of CLO volume, sharply below US$98.5bn last year.

The loan rally, similar to high-yield bonds, has “run too far too fast, and will likely undergo a correction,” according to BofA Merrill Lynch Global Research.

However, loans ultimately will post positive returns this year, outperforming negative returns on high-yield bonds, the analysts wrote in the May 11 report.

“As investors are faced with increasing credit risk on the back of poor high-yield fundamentals and a deteriorating economy, we see them migrating up the capital structure into the relative safety of senior secured paper,” they said.

(Reporting By Lynn Adler; Editing by Chris Mangham and Jon Methven)

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