Why investors shun leveraged loans despite rising yields

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Investors shun leveraged loans despite rising yields

Five Collateralized Loan Obligations (or CLO) deals for $3.7 billion came through in the week ending August 1. This was up slightly from the previous week’s levels, when $3.1 billion was issued over six transactions. Last week brings the year-to-date (or YTD) issuance and transaction figures to $74.8 billion and 138 deals, respectively (Data source: S&P Capital IQ/LCD).

Why do CLOs continue to thrive?

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CLOs have certain advantages for investors because they are able to slice credit risk into tranches. As a result, an investor with a low risk appetite may get exposure to AAA-rated debt tranche in a CLO, while an investor with a higher risk tolerance can earn higher yields by investing in lower rated tranches.

The market for CLOs has touched new highs in 2013 and 2014 with a record number of transactions and issuance volumes. Low yields on safer debt securities like investment-grade debt (BND) have forced investors to “reach for yield” in high-yield debt (HYG) and leveraged loans (BKLN).

Part 9

Secondary markets: Leveraged loan investor net flows for 2014 now in negative territory

Net outflows from leveraged loan (BKLN) mutual funds in the week ending August 1 came in at $406 million, compared to a net outflow of $413 million in the previous week. Last week brings the total net outflows from leveraged loan mutual funds to $54 million YTD (Source: Lipper).

Since leveraged loans pay a floating rate of interest, the prospect of low yields due to continued monetary stimulus from the Fed make them unattractive as an asset class for investors.

Returns on leveraged loans

YTD returns on the S&P/LSTA U.S. Leveraged Loan 100 Index have come in at 2.08%. For the week ending August 1, the Index decreased by 0.43%. As explained in Part 3 of this series, the Argentinian sovereign debt default, along with signs of stress in European banks, increased the yields on high-yield debt (JNK) last week, which led to a fall in bond prices.

These factors affected returns on major indices like the NASDAQ-100 (QQQ), which fell by 2.2% over the week.

Since leveraged loans are issued on a floating rate basis, a change in rates can affect short-term returns for investors. You can read about the outlook for leveraged loans and other forms of corporate debt in the next section.

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