Ian Toner, Seattle-based director of strategic research at Wurts, also said the gains in bank loans and high yield “are not a surprise.” But he also said they were more “the result of investors making positive moves toward assets with particular yield, duration, credit and other risk properties” rather than negative moves against investing in other alternatives to fixed income.
“Not everything that investors use as an alternative to fixed income is an alternative within fixed income,” Mr. Toner said. “What matters is the risk exposures they achieve at the total portfolio level. You can't read into the flows too much. These shifts are likely only partly about fixed income, but also about the rest of the portfolio's total risk exposures.”
Mark Ruloff, director of asset allocation at Towers Watson & Co. in Arlington, Va., agreed that the increases in bank loans and high yield are a shift to return-seeking investments while diversifying from equities, not always a shift within fixed income. And the reasons for the shift vary with the kind of investor making the move.
“For corporate (pension) plans, the shift from equities to high yield is made to diversify where they're getting their risk and return,” he said. “For public plans, they need that 7½% to 8% return, and that isn't happening with bonds giving 2%, so they're moving to high yield from traditional fixed income.”
Mr. Ruloff said he's recommended that institutional clients that want to go into alternative credit move into bank loans and high yields, and not the other credit classes.
Legg Mason Inc. led managers of internally managed bank loans for U.S. institutional tax-exempt clients in 2013 with $7.36 billion, up 57% from the previous year. Thomas McMahon, product strategist at Legg Mason unit Western Asset Management Co., Pasadena, Calif., said the asset gains for its bank loan strategies last year have continued into 2014. As of March 31, U.S. institutional tax-exempt assets internally managed in bank loans have reached $10.1 billion, Mr. McMahon said.
“There's been a general interest in bank loans because of their structural nature,” added Donald Plotsky, head of Western Asset's product group. He said institutional investors, including pension fund executives, are moving to bank loans because their prices remain stable as rates move; bank loans have a floating rate indexed to the London interbank offered rate rather than the fixed coupon rate used in traditional fixed income. Also, bank loans are considered senior debt, generally collateralized typically with hard assets, and are the first payments made in case of a bankruptcy.
“The overriding reason for being in bank loans is the downside protection from rate increases,” Mr. McMahon added. “But there are other attractive benefits from them as well.”
Mr. Plotsky said floating-rate fixed-income strategies mean investors can get the income from a fixed-income allocation even though rates are expected to increase — though there aren't a lot of options out there. “More and more investors are going to floating rate, but the market is thin for those products, except in bank loans,” he said. “People will want income, and even though rates will go up, you'll still get the income (through bank loans).”
Distressed debt, however, is another story.
“In general, high-yield companies are in solid financial shape (while) default rates are near the historic lows,” Mr. McMahon said. “There just aren't a lot of companies who are in a distressed state. For example, the Credit Suisse distressed index (Credit Suisse High Yield Index: Distressed Sector) has a total of only 30 issues in it at this time. That compares to 300 issues back in 2003-2004 and 150 companies in 2009-2010. In addition, the current market value of the distressed index is $11 billion, or less than 1% of the broader high-yield market.”
State Street's Mr. Meier said he was surprised that collateralized debt obligations did not see asset gains in 2013, because bank loans often are repackaged into CDOs. He also said inflation-protected securities didn't see an increase because developed markets are more concerned about deflation, but “if inflation gets closer to 2%, that becomes a more attractive strategy for investors, because of the avoidance of pain (from low cash yields) and the pursuit of yield.”
State Street had $22.26 billion in inflation-protected securities as of Dec. 31, down 2.5% from a year earlier, but still at the top of P&I's ranking of managers with internally managed inflation-protected securities for U.S. institutional tax-exempt clients. SSgA had $84 million in CDOs, down 55% from a year earlier.
Fundamental credit is “in good shape,” Mr. Meier said, with continued earnings growth and fewer defaults. “With the economy still growing, that should continue,” he said, adding the overall decline in fixed-income investments wasn't as large as one might have expected with talk of a “great rotation” in the market.
“Everyone was expecting that "great rotation,'” Mr. Meier said, but the relative small percentage decline in fixed income “begs the question, do we really think that will come to pass? I don't think it's unreasonable to assume that rates will move higher, but they may stay low for a long period.”