CLO Rule Change Clouds Outlook for Bank Loans by Gershon Distenfeld, AllianceBernstein
Retail investors fell out of love with US bank loans this year, but demand from issuers of collateralized loan obligations (CLOs) has remained strong. New regulations may change that. Should investors be concerned? We think so.
First, a bit of background. In recent years, investors large and small have poured money into bank loans. Most were attracted by loans’ relatively high yields and their floating-rate coupons, which would provide insulation against an eventual rise in interest rates. At one point, loan mutual funds—a good gauge of retail demand—pulled in fresh money for 95 weeks in a row.
That streak ended earlier this year. Since then, retail investors have pulled money out of loans for 23 weeks running. At the margin, the reversal may have had something to do with concern about credit quality. As we’ve noted before, high demand for loans has allowed companies with fragile credit profiles to borrow on favorable terms without offering traditional protections to lenders.
But the bigger culprit, in our view, was changing interest-rate expectations. As it became clear the Federal Reserve would likely hold rates low for longer than many thought, it became less attractive to sacrifice the higher yields available on high-yield bonds for loans’ promise of floating income.
CLO Investors Play a Large Role in the Loan Market
A shift in demand as abrupt as the one loans experienced this year would normally cause considerable volatility. But the market weathered the change well. The reason? Issuers of CLOs—loans pooled together and issued with varying levels of risk and yield—have kept buying.
Now, new rules that require CLO issuers to retain a bigger slice of the loans they package and sell to investors may change that. The changes, part of the Dodd-Frank regulatory reforms, are meant to limit excessive risk-taking by ensuring that CLO managers have some skin in the game.
Instead, they may drive some CLO issuers out of the market. That’s because the risk retention rules make it more expensive for smaller players to create new funds. It’s unclear just how much this will affect demand. But the rule changes could sow the sort of volatility that the loan market managed to avoid when retail demand dried up.
While much was made of retail investor behavior in recent years, it’s clear that the leveraged loan market depends most heavily on CLO investors. As the Display shows, CLOs represented 44% of current leveraged-loan buyers through June. A change affecting nearly half the market is worth paying attention to.
High-Yield Bank Loans’ Known Unknowns
Of course, CLO issuers won’t disappear overnight. The new rules were approved in October and won’t go into effect for two years. As such, next year might bring increased activity as CLOs rush to issue before the rules change. But over the longer run, we think things could get more complicated.
For one thing, it’s not clear who will step in to pick up the slack if CLO demand does taper off. Will retail investors come back? If not, will companies that have come to rely on the loan market for financing be forced to tap the bond market when their existing loans come due? Will bond investors play ball?
The answers to these questions are far from clear. It’s possible that investors will come up with creative ways to minimize the impact of the change. But in our view, the only thing that’s reasonably certain is that the leveraged loan market—and loan investors—face plenty of uncertainty.
As we’ve noted before, we think investors are already being undercompensated for the risk associated with bank loans. In our view, most of the perceived advantages of the asset class—high returns, floating rates,capital structure seniority—aren’t all they’re cracked up to be.
High-yield bank loans can be a part of a well-diversified fixed-income portfolio. But with so much uncertainty on the horizon, investors should be sure to weigh risk and reward carefully. In our view, a low-volatility high-yield strategy makes the most sense in the current environment.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Gershon Distenfeld is Director of High-Yield Debt and Michael Sohr is Portfolio Manager–High-Yield, both at AllianceBernstein (NYSE:AB).