Bloomberg News

Just Try to Get Money Out of Junk Loans When Everyone Else Flees

July 08, 2014

Junk-loan funds harbor a significant, structural risk that’s been masked by a three-year rally: Managers may struggle to raise enough cash to meet investor redemptions if too many try to get out at once.

While investors have plowed into the loan market by purchasing mutual-fund shares that trade daily, it typically takes more than two weeks for a money manager selling loans to get cash in exchange for the debt. The concern is that this discrepancy will make it difficult for fund investors to leave the $750 billion leveraged-loan market, where individuals have been playing a bigger role than ever.

“Should investor flows reverse, the mismatch in bank-loan funds could pose a material risk,” Moody’s Investors Service analysts led by Stephen Tu wrote in a July 7 report. “Methods to address sizable investor redemptions in bank loan funds are inadequate.”

Speculative-grade loans have benefited from a drive toward higher-yielding assets spurred by the easy-money policies of central banks across the globe. They’ve gained about 19 percent since the end of 2011, luring individuals with the promise of floating-rate coupon payments as the economy has shown signs of improvement and the Federal Reserve winds down its unprecedented stimulus.

The funds attracted a record $61.3 billion in 2013, according to Morningstar Inc. (MORN:US) data.

Dark Corner

Many have also come to view the risks associated with loans as comparable to those of junk bonds, but there are some fundamental differences between the two. Loans aren’t securities, which means the market isn’t overseen by the U.S. Securities and Exchange Commission. This dark corner still relies on lawyers and back-office clerks to scrutinize paper documents on each trade.

While mutual-fund investors have lost some of their interest in the debt this year as bond yields have dropped, loan funds have still received a net $2.6 billion in 2014, according to a July 7 report from Wells Fargo & Co. (WFC:US) Investors withdrew $330 million from loan funds last week, the twelfth consecutive week of outflows, the data show.

The net deposits and demand from institutions has “masked redemption risks,” the Moody’s analysts wrote.

Fund managers have several ways to hedge against significant withdrawals, such as holding more cash, keeping a bigger allocation to bonds or securing a line of credit they can draw on in a pinch.

Reputational Risk

Each of those steps has a downside: cash holdings may drag on performance; bonds may cause a divergence from the underlying index; and short-term loans boost their leverage, which is limited by the Investment Company Act of 1940.

Now, as the Fed discusses a timeframe for weaning the world’s biggest economy from record monetary accommodation, analysts are examining the consequences of their programs to suppress borrowing costs. Even central bankers have said junk-rated loans and bonds are among the most inflated by their policies.

Moody’s analysts say this liquidity problem is one that loan-fund managers must be transparent about, or face damage to their reputations. After all, their investors are risking much more than that.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage, Faris Khan


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Companies Mentioned

  • MORN
    (Morningstar Inc)
    • $66.49 USD
    • -0.91
    • -1.37%
  • WFC
    (Wells Fargo & Co)
    • $51.6 USD
    • 0.01
    • 0.02%
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