NEW YORK: U.S. loans have outperformed other debt instruments this year because of the protection they offer against rising interest rates, but a sharp deterioration in financial markets in recent weeks has spread even in this traditional refuge.
The Federal Reserve’s plan to tighten financial conditions to fight inflation has weighed on US credit markets this year, prompting a sharp sell-off in investment grade and high-yield bonds, as well as government debt securities.
Leveraged loans tend to be used by buyout companies to finance the acquisition of businesses with low credit ratings. Banks bundle them into securities called secured loan obligations, or CLOs, which are then sold to investors. Unlike fixed-rate corporate bonds, the 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 about relentless inflation and whether the Fed’s tightening monetary policies could tip the economy into a recession have impacted lending in recent weeks.
“Last week we saw greater weakness in all markets and the lending market just couldn’t hide it,” said Andrew Sveen, portfolio manager and co-head of floating rate lending at Morgan Stanley Investment Management.
The price of the S&P Leveraged Loan Index fell to 95.7 at Wednesday’s close, according to Refinitiv data, from around 98 in mid-April and hitting its lowest levels since December 2020.
The SPDR Blackstone Senior Loan ETF traded at $42.6 per share on Thursday, down 4.5% in a month and the lowest level in two years. The Invesco Senior Loan ETF, which tracks the market-weighted performance of the largest leveraged institutional 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% below its peak reached on January 3. High yield bonds have sold off strongly this week.
“Leveraged loans have been one of the casualties in recent weeks – prices have continued to show signs of weakening for the second week in a row,” Deutsche Bank chief executive Conor O’Toole said in a statement. a research note this week.
Barclays expects the Loan Index price to fall to 96 by the end of the year, which would lead to total returns of 2-3% for the rest of the year, down compared to a previous forecast of 3 to 4%.
Still, investors say the asset is attractive given rising interest rates.
Year-to-date total returns have been minus 0.5% for leveraged loans, making them the best-performing debt instrument this year, BofA said in a note this week. That compares to minus 9.2% for high yield bonds and around minus 10% for Treasuries.
“We have already seen a significant reallocation of investment from high-yield loans to leveraged loans, and we generally expect these inflows to continue well into an upside cycle,” said Dan DeYoung, portfolio manager at Columbia. Floating Rate and Columbia High Yield Bond. Fund at Columbia Threadneedle Investments.
Year-to-date, bond funds dedicated to US bank lending have seen inflows of approximately $25.58 billion, while US high-yield bond funds have seen outflows of $25.87 billion so far this year, according to fund flow data from EPFR.
“Leveraged loans remained the best performing fixed income securities year-to-date, benefiting from low rate duration and relatively good credit spread performance, but could weaken “, said BofA strategists.
For Morgan Stanley’s Sveen, loan declines are generally expected to be much smaller than in other asset classes, with loans likely to decline 1% when stocks, for example, fall 10% and yield bonds 3% high.
“It’s pretty incredible volatility we’re seeing in the market so it’s no surprise that everyone is taking a break, including in a market that should be in favor like ours,” he said. declared.