Managing Liquidity in the Bank Loan Market
By Frank Ossino, Senior Managing Director, Bank Loan Sector Head
The prospect of a Fed rate hike later this year has brought volatility to fixed income markets, and with it, an increasing focus on liquidity. Bank loans – and by extension bank loan funds – have come under particular scrutiny. While bank loans do present certain trading challenges, liquidity in the loan market has actually improved dramatically.
Bank loans have remained fairly liquid during periods of high volatility over the last few years. This was the case during the 2008 credit crisis and 2011 European financial crisis, and now the last 15 months when loan funds have been subject to consistent outflows as investors appear unconcerned that the first Fed rate increase may be upon us soon.
Participation in loans has grown significantly, with liquidity provided by a large, well-established secondary loan market. A record number of investors – over 317 at last count – participate in the loan market, including retail (mutual funds and ETFs) and institutional investors. More than half of the loans available trade more than 20 times per quarter – another record. Also important to note, just 16% of loan assets are in retail hands. Institutions control most of the loan market, with 56% of loan assets in collateralized debt obligations (CLOs), structured portfolios of “stickier” assets which tend to trade less frequently.
A bigger issue than trading liquidity but less talked about is the slow settlement times for loans. Due to their structure, bank loans trade as private transactions and take 14-20 days to settle compared to about three days for bonds which trade electronically on the over-the-counter market. This creates specific challenges for loan funds, which, as a general fund industry practice, strive to meet shareholder redemptions in three days or less, well under the seven days required by law. Loan funds need to be able to sell portfolio holdings and receive the cash proceeds in a timely manner that allows the fund to keep up with redemptions. Understandably, this issue is of greater concern when markets are under extreme duress and redemptions are more likely to rise.
The good news is, fund managers like us have several effective liquidity strategies at their disposal to manage the working capital needed to meet shareholder redemptions. One strategy is to maintain a position of more marketable securities like high yield bonds, which have shorter settlement times and can be converted to cash more readily. An effective second line of defense is establishing a line of credit, which can be used not only to address redemptions, but also allows the portfolio manager to sell holdings thoughtfully, without having to adopt a “fire sale” mentality.While a significant pickup in loan fund redemptions would put pressure on loan prices, it would also create buying opportunities for investors willing to step in at a price where the challenge becomes an opportunity. This might initially be painful – as was certainly the case in 2008 when prices dipped to the low 60s (on a 100 par value loan) – but could also represent attractive longer term investment potential.
Source of data cited: S&P LSTA, as of 3/31/15.