Leveraged loans hit turbulence, but investors still see long-term outperformance

NEW YORK: US loans have outperformed other debt instruments this year because of the protection they offer from rising interest rates, but a sharp deterioration in financial markets over the past few weeks has spilled even into this traditional safe haven.

The Federal Reserve's plan to tighten financial conditions to fight inflation has weighed on US credit markets this year, causing a sharp selloff across investment-grade and high-yield bonds, as well as government debt securities.

Leveraged loans tend to be used by buyout firms to fund acquisitions of companies with weak credit ratings. Banks package them into securities known as collateralized loan obligations, or CLOs, that are then sold to investors. As opposed to corporate bonds where interest is fixed, loans pay a floating interest rate, which rises as benchmark rates rise, making them attractive to investors when central banks tighten monetary policy.

However, market concerns over unrelenting inflation and whether the Fed's tightening monetary policies could tip the economy into a recession, have spilled into loans over the past few weeks.

"In the last week we saw greater weakness across all markets and the loan market just couldn't hide from that," said Andrew Sveen, portfolio manager and co-head of floating-rate loans at Morgan Stanley Investment Management.

The price of the S&P Leveraged Loan Index was down to 95.7 as of Wednesday's close, according to Refinitiv data, from about 98 in mid-April and hitting its lowest levels since December 2020.

The SPDR Blackstone Senior Loan ETF traded at $42.6 a share on Thursday, down 4.5 percent in a month and at a two-year low. The Invesco Senior Loan ETF, which tracks the market-weighted performance of the largest institutional leveraged loans, was at $20.78 on Thursday, also a two-year low.

This comes as broader markets have sold off sharply. The S&P 500 was recently nearly 20 percent below its high reached Jan. 3. High-yield bonds sold off sharply this week.

"Leveraged loans have been one of the casualties over recent weeks - prices continued to show signs of weakening for the second week in a row," Conor O'Toole, managing director at Deutsche Bank said in a research note this week.

Barclays expects the loan index price to fall to 96 by year-end, which would lead to total returns of 2 percent - 3 percent for the rest of the year - down from a previous forecast of 3 percent – 4 percent.

Still, investors say the asset is attractive given interest rates are rising.

Year-to-date total returns have been minus-0.5 percent for leveraged loans, making them the best performing debt instrument this year, BofA said in a note this week. That compares with minus 9.2 percent for high-yield bonds and about minus10 percent for treasuries.

"We've already seen a significant reallocation of investment from high-yield into leveraged loans, and generally we expect those inflows to continue well into a hiking cycle," said Dan DeYoung, portfolio manager of the Columbia Floating Rate and Columbia High Yield Bond Funds at Columbia Threadneedle Investments.

Year-to-date, dedicated US bank loan bond funds saw inflows of around $25.58 billion, while US high-yield bond funds saw outflows of $25.87 billion so far this year, according to fund flow data from EPFR.

"Leveraged loans remained the best fixed-income performer year-to-date, benefitting from low rate duration and relatively well-behaved credit spread performance, but could weaken," BofA strategists said.

For Morgan Stanley's Sveen, loan declines are generally expected to be much smaller than in other asset classes, with loans likely to move down 1 percent when equities, for example, move down 10% and high-yield bonds down 3 percent.

"It's pretty incredible volatility we're seeing in the marketplace and so it's not surprising that everyone is going to take a pause, including in a market that should be in favor like ours," he said.