Bank loans have been a hot investment. Through 2014, bank loan mutual funds and exchange-traded funds were on pace to top two years of positive weekly inflows.
That's practically unheard of. Few asset classes ever manage to stay hot, week after week, for a period spanning years. But now investors are pulling out.
An investor exodus could be good for a unique clan of high-yield names, from New Mountain Finance (NYSE:NMFC) to Fifth Street Finance (NASDAQ:FSC), and the sector oddball, American Capital (NASDAQ:ACAS).
Why it matters
Generally speaking, high-yield business development companies all but avoid liquid credit markets. Leveraged loans are broadly syndicated loans used to finance everything from corporate M&A to leveraged buyouts.
The added liquidity and investor familiarity with leveraged loan borrowers result in substantially lower yields. Recently, a leveraged loan index revealed that investors could expect a modest 4.4% yield-to-maturity from a basket of the 100 most liquid loans on the market.
But a few BDCs are turning to the liquid bank loan market to generate yield from what is largely seen as a safer alternative to middle-market lending.
American Capital recently inked a deal for a $750 million credit facility to be used exclusively for bank loan investments. Likewise, New Mountain Finance and Fifth Street Finance invest in bank loans through their senior loan funds, which allow for greater leverage and higher returns before credit losses.
A "frothy" market
Investors are yanking cash from bank loans at a time when many have grown concerned with an overheated market. In recent months, we've seen story after story pointing to the rise of so-called covenant-lite loans -- loans which require very little of the borrower.
As funds pull back, yields should rise, and covenants should improve. All of this happens just as American Capital and Fifth Street Finance plan on beefing up their exposure to bank loans in their investment portfolios.
It pays to avoid the crowd in lending. It's a simple supply demand issue. The more demand, the better the terms for the borrower, and the worse the terms for the investor.
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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.