NEW YORK, Dec 1 (Reuters) - US credit managers are looking at new shorter-dated term trust structures as investors continue to target leveraged loans as a hedge against further interest rate rises by the Federal Reserve.
Leveraged loans, which typically finance private equity buyouts, offer some protection against rising interest rates as interest payments float over the benchmark Libor rate, which rises as rates increase.
Investment firms First Trust Advisors and Eaton Vance have raised term trust funds in the last 12 months to invest in the US$939bn US leveraged loan market, according to deal documents.
Octagon Credit Investors teamed up with XA Investments for a term trust fund that may invest in first- and second-lien loans, and hold as much as 50% of its portfolio in the debt and equity of Collateralized Loan Obligation (CLO) funds.
Term trusts have a set maturity unlike closed-end funds that remain outstanding in perpetuity. This mitigates investors’ concerns about typical closed-end funds, such as the possibility for large swings between discounts and premiums, according to William Housey, a senior portfolio manager at First Trust.
“The transactional closed-end term trust seems like the next evolution and I do believe it’s a very viable structure for a number of asset classes,” he said.
Open-end mutual funds, which allow holders to make daily redemptions, are common investments in retirement accounts and college saving plans. Open-end loan funds had US$156.5bn in assets in October, a small part of the overall US$18.9trn of assets held in 2016 by US mutual funds and exchange-traded funds, according to data from Thomson Reuters LPC and the Investment Company Institute.
Term trusts have a set maturity date to repay shareholders, unlike perpetual closed-end funds.
Term trusts have traded well in the secondary market to date, whereas closed-end funds have historically traded at a discount to net asset value, a measure of mutual funds’ price per share.
Funds will trade better if investors know that they can be repaid at up to 100 cents on the dollar on a specific date, which eliminates the concern of being stuck in a fund indefinitely, said Nathan Greene, head of law firm Shearman & Sterling’s registered funds and investment adviser regulatory group.
“When a new structure comes out and performance to-date has been pretty good, that is usually a precondition for that type of product development to continue,” said Alex Reiss, a closed-end fund analyst at Stifel. “Nothing succeeds like success.”
US closed-end loan funds were trading at an average discount of 6.9 percent on November 24, according to the trade group Closed-End Fund Center citing Lipper data. The average discount in December 2016 was as high as 5.3 percent and the average discount at the end of 2015 was 9.5 percent. The XAI Octagon Floating Rate & Alternative Income Term Trust was trading at a premium of US$10.026 November 28.
“It’s hard to bring new-issue closed-end funds [to market] when discounts are so wide in the secondary market,” said Jeff Margolin, a closed-end fund analyst at First Trust.
Target term trusts “trade at smaller discounts and the likelihood of a return at a specific price does have an appeal to investors,” he added.
Investors are increasingly seeking protection from rising rates via leveraged loans and CLO investments where yields increase as rates rise, according to Kimberly Flynn, a managing director at XA Investments. The Fed has increased rates four times in the last two years and JP Morgan forecasts four additional hikes in 2018.
Term trusts also offer investors exposure to leveraged loans without the worry of new open-end mutual fund regulations that require compliance by next year.
As interest rates rise, interest in the funds continues to grow and more loan term trusts are expected in the future.
“I think term trusts have shown some staying power it solves for a number of key problems,” said Christopher Remington, an institutional portfolio manager at Eaton Vance. (Reporting by Kristen Haunss; Editing by Tessa Walsh)