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

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

Leveraged loans are typically used by buyout companies to finance acquisitions of businesses with poor credit ratings. Banks package them into securities known as collateralized loan obligations, or CLOs, which are then sold to investors. Unlike corporate bonds with fixed interest, 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 continued inflation and the possibility that 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 was down 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 its lowest level in two years. The Invesco Senior Loan ETF, which tracks the market-weighted performance of the largest institutional leveraged loans, was $20.78 on Thursday, also its lowest level in two years.

This situation comes as the broader markets have fallen sharply. The S&P 500 was recently nearly 20% below its peak reached on January 3. High yield bonds fell sharply this week.

“Leverage lending has been one of the casualties of the last few 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. research obligation this week.

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

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

Year-to-date, the total return on leveraged loans has been minus 0.5%, making them the best-performing debt instrument this year, BofA said in a note this week. This compares to minus-9.2% for high yield bonds and around minus-10% for treasury bills.

“We have already seen a significant reallocation of investments from high yield to leveraged loans, and we generally expect these inflows to continue through much of the rambling cycle,” said Dan DeYoung, portfolio manager for Columbia Floating Rate and Columbia High Yield Bond funds at Columbia Threadneedle Investments.

Since the start of the year, US bond funds dedicated to bank lending have seen inflows of around $25.58 billion, while US high yield bond funds have seen outflows of $25.87 billion. billion since the start of the year, according to fund flow data from EPFR.

“Leverage lending remained the strongest fixed income performer year-to-date, benefiting from low rate duration and relatively strong credit spread performance, but could weaken “, BofA strategists said.

For Morgan Stanley’s Sveen, loan declines should generally be much smaller than those of other asset classes, with loans likely to fall 1% when stocks, for example, fall 10% and high yield bonds by 3%.

“It’s pretty incredible volatility we’re seeing in the market so it’s no surprise everyone is taking a break, including in a market that’s expected to be supportive like ours,” he said. .