Widening discounts have hit corporate loan closed-end funds as investors fear a change in the credit cycle and an ending of Federal Reserve tightening. This in turn will hamper efforts to sell new funds, according to a report from Mariana Bush, closed-end fund analyst at Wachovia Securities.
She explains that pressure from larger sellers such as hedge funds or institutional investors that had positions in the funds is a major factor in the widening. "We speculate some of these players owned these funds to play the carry trade game," she said. "We think they borrowed inexpensively at short rates and at the same time went long corporate loan closed-end funds, whose Net Asset Values (NAV) are not as interest-rate sensitive and whose yields were higher than their borrowing cost." But faced with redemptions or the carry trade becoming unprofitable, these investors have cut exposure.
In general, closed-end funds are held principally by retail investors, but Wachovia tracked the ownership of the funds and noticed that a few large investors hold shares. "And in a few cases they have recently reduced their positions."
Bush believes the discount will hamper the flow of new funds in the market. "As long as the existing corporate loan funds trade at a discount, it will be difficult to justify a new offering, which have typically started trading at around a 5% premium because the offering expenses are deducted from the fund's initial NAV.
Among the 18 funds, discounts have widened on funds including the First Trust Four Corners Senior Floating Rate Fund, the Eaton Vance Senior Income Trust and the Pioneer Floating Rate Trust. Discounts range from approximately 7.2% to 10% for the 18 funds.
Bush noted the current discounts are unlikely to hit the same levels close to 15% -- as discounts for the funds in 2002. High yield bond default rates are not expected to rise as much as they did back then and short rates are not expected to decline in the foreseeable future.
Additionally changes in pricing methodology will also help. "Liquidity has improved tremendously... and 100% of loan funds are marked to market, that's why volatility goes up and down so much more than five or 10 years ago," Bush said.
