RSS FeedBy M. Isi Eromosele
Two concurrent developments have facilitated the increase in institutional investors’ share of the leveraged loan market: the evolution of bank business models from “buy and hold” to “originate to distribute" and a rising demand for securitized products, some of which include leveraged loans as collateral assets.
Shift In Investor Base
The evolution of bank business models and the growth in structured finance products that satisfy the risk-return preferences of diverse investors are key structural factors behind the shift in the investor base for leveraged loans. Additional, there are also important cyclical factors, which include low default rates and low interest rates.
Structural Factors
In the primary market, banks share of leveraged loans have declined sharply during the few years. This has occurred as a result of banks transitioning to an OTD business model so that loan syndications are primarily seen as fee-generating activities. The change in business model was also driven by economic capital allocation decisions as well as Basel II rules, which provide an incentive for banks to transfer non-investment grade exposures to other investors, who may interpret the risk-reward benefits differently.
Innovation that has taken place in the market for structured finance products has also contributed to a broadening of the investor base for leveraged loans. Since institutional investors like pension funds, insurance companies and asset managers face investment restrictions on exposure to non-investment grade credits, leveraged loans were usually not part of their investment strategies. However, structured finance has facilitated the creation of marketable securities from an asset pool through a process called tranching. As such, investors with widely varying risk-return objectives can buy claims to cash flows linked to the same collateral pools of assets but with different priorities.
Role Of Investment Vehicles
Securitized financial vehicles have played a major role in the growth of the leveraged loan market. Collaterized loan obligations (CLO) funds accounted for nearly two-thirds of institutional leveraged loan purchases in Europe in 2009 – 2010. Although bank shares of leveraged loan holdings in the primary market have declined, they still have considerable exposure to the senior tranches of CLOs, perhaps driven by regulatory capital considerations. Meanwhile, asset managers and hedge funds hold more of the equity and mezzanine tranches of CLOs because of their greater focus on returns.
Insurance firms tend to hold a more balanced exposure across various tranches of the CLOs. In contrast, hedge fund holdings of structured products are characterized by a lower proportion of CLOs, as hedge funds display a more notable preference for synthetic collateral debt obligations (CDOs).
Do CLOs Influence Leveraged Loan Characteristics?
Loan characteristics are likely to be influenced by the preferences of asset managers, given the large share of leveraged loans being used as collateral assets in CLOs. CLO managers favor longer-term bullet loans because of their more predictable maturities and interest income streams. The average maturity of term loans has been lengthening. This could be attributed to CLO managers favoring longer-term loan (five to seven years). Managers of CLOs and other investment vehicles usually pay floating rates on their liabilities. This will likely provide incentives to buy leveraged loans that pay floating rates for their collateral assets rather than high-yield bonds, which pay fixed rate coupons.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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