Investment

Family offices should consider their exposure to loan funds after warning from Fed Reserve of New York

The Federal Reserve Bank of New York has warned that loan funds, often favoured by family offices as a source of income, are vulnerable to a fall.

At worst, loan funds could trigger financial instability because they mainly invest in leveraged loans which are relatively illiquid and could default in periods of stress.

Our research suggests that much of this lending is riskier than high-yield bonds, despite being senior secured.

The New York Fed research – Monetary Policy and the Run Rate of Loan Fundspoints out their investors expect to be able to redeem their shares on demand.

“This incentive to redeem first generates a self-reinforcing relationship between investor outflows and poor fund performance, leading to run a risk.” 

But sales of loans to meet fund redemptions can be fouled up by the bespoke nature of loans, their complexity and their illiquidity.  Rising interest rates lift the charges paid on loans which protect the income received by investors. But it also creates default risk. It is possible that borrowers will renegotiate leveraged loans in certain periods, further increasing the sensitivity of investors to events.  

The New York Fed concludes: “Loan-fund investors are, on average, more sensitive to the performance of their funds than bond-fund investors, and higher sensitivity occurs when fund returns are in negative territory.” Flow dislocations can go on to “amplify the initial shock” during periods of poor return.

Leveraged loans are often put together by private equity firms seeking to pile corporate debt on top of debt employed for transactions to enhance returns.

Since the 2009 credit crisis, the sector has grown by 7.4% a year, against a 5.8% increase in high yield bonds. Taken together, their sales topped $1 trillion in 2021, according to Standard & Poor’s.

Family offices have been attracted to loan funds offering returns close to 5% a year in 2021 when cash was paid very little and corporate bond yields were 3%.

According to family office adviser Verdad: “Our research suggests that much of this lending is riskier than high-yield bonds, despite being senior secured. 

“Low ratings, illiquidity and opaque structures make this a problematic asset class. There is a real risk that in a future crisis the leveraged loan market could freeze up, grinding to a halt one the most significant credit-creation engines in the US economy.”

Family office advisers agree that loan fund terms appeared stretched prior to the recent shakeout in the bond market. 

The US Federal Reserve’s decision to hike rates to contain inflation has produced an extraordinary 11% drawdown in the Bloomberg Global Aggregate bond index from its January 2021 high.

Coupons paid on high yield debt can cover the cost of moderate inflation. But family office advisers no longer trust the asset class to deliver a sufficient return. Instead, they are looking at assets that directly protect against inflation.  

Robert Sears, chief investment officer at multi-family office Capital Generation, says investors should consider a 40% weighting in defensive assets comprising gold, commodities, macro funds, long/short hedge funds. 

Sears says the weighting should include inflation swaps offering protection at a cost of 2.6% which will look cheap if or when wage rises send inflation into a spiral.

He relies on equities to generate growth, assuming they are sufficiently resilient.  Investing in bonds is not a good idea, but investors should be ready to take a view on cheap bond options if demand shock triggered by a collapsing economy bears down on inflation. Corporate debt levels are much higher than household debt, Sears says.

Sears does not rule out stagflation in the wake of the Ukraine invasion, following a hike in oil and gas prices: “Many governments would rather let inflation eat away at their debt burdens than try and raise taxes….inflation protection is extremely important in portfolio construction.”

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