Who's buying leveraged loans anyways?

The booming loan market for highly indebted companies has faced a lot of scrutiny in recent months. The IMF has repeatedly aired its grievances. Multiple central banks, as well as the banker of central banks, the Bank for International Settlements, have chimed in with their concerns as well. And last week, Massachusetts Senator Elizabeth Warren called for tighter regulation on what she believes is “a significant risk to the financial system and the American economy.”

Beyond deteriorating protections for lenders, critics have grown wary of just who is buying these loans. In recent years, it has increasingly been retail investors.

For the most part, leveraged loans are bought by specialised investment vehicles that package the loans together and then divvy up slices based on their riskiness. These products are known as collateralised loan obligations (CLOs).

However, as leveraged loans have ballooned into a $1trn-plus market, thanks to their floating rate structure and higher returns than their high-yield counterparts, so has the number of loan-focused mutual funds and exchange traded funds (ETFs). Unlike CLOs, these are investment vehicles available to the ~~naive~~ humble retail investor.

Here's a chart from Citi's Michael Anderson showing the growing proportion of retail investors in the market over the past six or so years:

Retail types do represent the smallest slice of the overall investor base, but their growth looks quite impressive when stretched further back to the financial crisis, as the IMF shows in the below chart. Assets under management (AUM) for bank loan mutual funds and ETFs have grown exponentially since 2008 as CLO issuance has expanded:

In fact, one of the largest of the eight ETFs that invest in leveraged loans has seen its AUM rise over 40 per cent this year to roughly $3.4bn, according to IHS Markit. The largest ETF has more than $7bn AUM. And this year alone, retail investors have ploughed over $5bn into these kinds of funds, as well as other open-ended bank loan mutual funds, per EPFR Global.

The issue here is that ETFs and mutual funds are highly liquid instruments, meaning investors can enter and exit positions easily. The problem is, the bank loan market is not quite the same.

The Loan Syndications and Trading Association calculates that in the third quarter, $162bn of leveraged loans were traded on secondary markets. On a monthly basis, that's roughly $50bn. For comparison, the corporate bond market trades as much in about a day and half, according to the Securities Industry and Financial Markets Association.

Not only are bank loans traded infrequently, but they also take some time to settle. On average, it's about 11 days from the time of trade. The standard settlement time for fixed-income assets is three days.

This means there is a so-called liquidity mismatch between the underlying assets — the leveraged loans — and the investment products holding them — the ETFs and the mutual funds.

While liquidity mismatches doesn't cause much trouble when prices are rising, it can quickly stir up some when the cycle ends, warns Douglas Peebles, the chief investment officer of fixed income at AllianceBernstein:

In a downturn, loan liquidity would likely become even more scarce as investors rush to sell their fund shares at the same time. Mutual funds would be forced to sell at marked-down prices, and investors who want out would likely have to take big losses.

This is obviously worrying for anyone holding these loans, but when it comes to the stability of the entire financial system, the impact of this market heading south is likely to be far less extensive. While Senator Warren compares today's run-up to the pre-2008 subprime mortgage market, Citi's Anderson is not so worried about systemic risk.

For one, banks have far less exposure to leveraged loans than they did to mortgage-backed securities before the financial crisis. Plus, the CLO triple-A tranches that banks tend to favour have much more subordination now than in recent years, meaning they have a bigger cushion against losses.

Instead, Anderson says the leveraged loan market (which he is not calling a bubble) is more likely to go the way of the 2000 dotcom crash. Rather than an existential shock like the one that rippled through the global financial system in 2008, exposed investors will take a sizable hit when the cycle turns. And the banking system, he says, will hold up just fine.

Related Links:
Leveraged loans are way past “cov-lite” — FT Alphaville
Warnings mount for leveraged-loan market — FT Alphaville
Please don't tell individual investors to buy leveraged loans — FT Alphaville