Healthy demand for leveraged loan exposure among large non-bank institutional investors has transformed the role played by U.S. banks in leveraged credit, according to Fitch Ratings. As new loan activity has remained strong in 2013, banks have increasingly shifted their focus away from holding loan positions to serve primarily as facilitators and distributors in the market.
A key driver of heavy leveraged loan issuance again in 2013 has been the big appetite for higher-yielding floating-rate investments among institutional loan buyers such as business development companies, credit funds, pensions, endowments and CLOs. The breadth of non-bank demand has supported strong liquidity, both at origination and in the secondary market, even during the period of rising interest rates since May, Fitch said.
Recent industry data reflects the expanded participation by non-banks. In the first half of 2013, leveraged loan investments by these institutions totalled $298 billion, surpassing the full-year 2012 level of $295 billion, the rating agency noted.
Banks have traditionally held pieces of newly originated sub-investment grade loans on their balance sheets, in part because broader market demand was limited, and high-yield assets did not incur regulatory penalties. New capital regulations, together with the wider opportunities for distribution in the secondary market, have shifted banks’ focus toward participation principally as facilitators in the leveraged loan market, Fitch added.
Large banks continue to serve as market makers in the secondary loan market, leading them to maintain significant inventory positions. As a result, sensitivity to ups and downs in the loan market will flow through the fixed income, currency and commodities (FICC) revenue category, while direct exposure to credit risk for the largest banks becomes less important, according to Fitch.
Fitch said it has observed that some banks, particularly smaller ones, increasing the allocation of their investment portfolios to CLOs with the intent of both increasing the floating rate position of their portfolios and also improving overall yields. As a result, some credit risk from leveraged loans offloaded at origination by some banks has resurfaced in other banks via the use of CLO structures.
Fitch noted it will release a special report soon addressing various aspects of leveraged loan demand in the non-bank institutional market, as well as the changing role of banks in the process.