Mom and pop wager against hedge funds in junk-rated loan market

Mom-and-Pop investors have had it with junk-rated loans. Professional money managers, meanwhile, are still piling in and using borrowed money to buy them up.

History will decide who's the smart money here.

For now, the big boys are winning: Hedge funds and other institutions using leverage to boost returns have overwhelmed the impact of five consecutive weeks of withdrawals from mutual- fund investors. They've helped propel leveraged loans to a 0.58 percent gain in May, their best monthly return since January, according to data from Standard & Poor's and the Loan Syndications and Trading Association.

"In the leveraged-loan market, strength has returned," in part because buyers are using more leverage, Barclays Plc credit strategists Jeffrey Meli and Bradley Rogoff wrote in a May 16 report. While this will be concerning over the longer term, "we do not expect any downside from this trend in 2014."

What we have is another game of chicken between investors seeking to squeeze a few more nickels out of a five-year rally and those heading for the exits.

Professional investors are using borrowed cash to buy top- rated bonds of collateralized loan obligations that are backed by the risky debt, the Barclays strategists wrote. Others are using leverage to increase returns on the loans themselves through derivatives known as total-return swaps, the analysts said.

Little Upside

It's not surprising investors feel the need to do so given the effective yield on loans with ratings below investment grade has plunged to 4.18 percent, according to Royal Bank of Scotland Group Plc data, less than the average yield on 10-year Treasuries over the past two decades.

Meanwhile, mutual-fund investors are growing more adamant in their anti-loan stance, withdrawing $255 million last week in the fifth straight outflow, according to a May 15 Wells Fargo & Co. report.

Individuals are souring on the floating-rate loans after pouring money in for 95 consecutive weeks, the longest stretch on record, as they sought debt that promised higher yields when benchmark interest rates rose.

While the Federal Reserve is scaling back its monthly bond purchases, it's still holding overnight borrowing costs at about zero. Fed policymakers may not be raising interest rates, but they are expressing concern that lending standards in this market have loosened up too much.

Todd Vermilyea, a Fed regulator, said last week in Charlotte, North Carolina, that the quality of junk loans has "continued to deteriorate" in 2014 despite efforts by the central bank to improve underwriting standards.

"We urge investor caution in the bank loan space," Brian Rehling, chief fixed-income strategist at Wells Fargo Advisors, wrote in a May 12 report. "We see little upside."

Smaller investors are taking note.

Bigger investors aren't.