U$ retail money has flowed into Leverage Loan Funds over the past 4.5 years, but never more than the past few months.
What is a Leverage Loan? A loan issued by a high yield issuer. Loans are usually secured against assets of the company. Many leveraged loans are classified as "Term Loan B's" which is to say that they are loans with a maturity date of about 5 years and are secured against some assets of the company but are sometimes considered "second lien" security...ie...they are second in line if there is a default. Loans also are "floating rate" debt. That is to say, they price at Libor plus a spread for the life of the loan. A typical Leverage Loan might price at L+400.
So why would investors want Leverage Loans? Well, first of all they are secured. Second of all, they are floating rate debt, so if one is afraid that short term interest rates are going to move sharply higher, you would be somewhat "protected" because your coupon would float with Libor (a 3 month interbank lending rate). And because of their floating rate nature, Loans have much lower duration than fixed rate bonds.
As we said above, money has flowed into Leverage Loan funds at quite a pace. This has been going on since 2009 when most people thought interest rates had no where to go but up. Well, interest rates fell and hard. So if you invested in loans at say L+400 for the past 4 years - and keep in mind that Libor is only .27%! - you would have been clipping out a return of about 4.25% pa over the past 4 years.
Here are a couple of reasons to reconsider this strategy(mania) of investing in Loans and re-think HY bonds:
1. HY bonds, in many cases are also secured. Take AHY.un for example. This is a HY Bond Fund, yet almost 40% of the bonds in the portfolio are secured against assets. Some are 1st lien and some are 2nd lien.
2. The Fed has said explicitly that short term rates (o/n fed funds and the discount rate) will not be going up for quite a while. So let's assume Libor will be stuck in this ~.25% area for another couple of years (pretty disappointing GDP and PCE data this morning for 1Q13). So in a Loan you are stuck with receiving L+400 (4.25%) for the next couple of years. Hardly stout. HY bonds, on the other hand, are fixed rate. So, yes you are taking some duration risk in HY bonds (the portfolio duration of AHY.un is only 3.3 years!) but after such a dramatic move higher in the longer part of the yield curve, maybe assuming some duration risk is not a brutal idea...especially after the weak 1Q13 GDP and PCE just mentioned.
Just like when we talk about various types of risk and how important it is to distinguish between credit risk, interest rate risk, portfolio risk and foreign exchange risk, it is also important to distinguish between interest rates and the yield curve which goes from o/n all the way out to 30yrs. Libor, which loans are based off of, is a 3 month rate. Again, if you think the economy is going to take off like a rocket and the Fed is going to jam fed funds back up towards 3-5% in the next Q, then by all means, knock yourself out and buy some floating rate debt through the Loan market. My bet is Libor will stay locked in this ~.25% area for another 2+yrs...and I am very happy to collect fixed rate debt in the ~8.00% range vs Loans in the ~4.00% range.