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

div classBodysc17zpet90 cdBBJodivpBy Davide Barbusciap

pNEW YORK Reuters – U.S. 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.pdivdivdiv classBodysc17zpet90 cdBBJodiv

pThe Federal Reserves plan to tighten financial conditions to fight inflation has weighed on U.S. credit markets this year, causing a sharp selloff across investmentgrade and highyield bonds, as well as government debt securities.p

pLeveraged 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.p

pHowever, market concerns over unrelenting inflation and whether the Feds tightening monetary policies could tip the economy into a recession, have spilled into loans over the past few weeks.p

p“In the last week we saw greater weakness across all markets and the loan market just couldnt hide from that,” said Andrew Sveen, portfolio manager and cohead of floatingrate loans at Morgan Stanley Investment Management.

The price of the S&P Leveraged Loan Index was down to 95.7 as of Wednesdays close, according to Refinitiv data, from about 98 in midApril and hitting its lowest levels since December 2020.p

The SPDR Blackstone Senior Loan ETF traded at 42.6 a share on Thursday, down 4.5 in a month and at a twoyear low. The Invesco Senior Loan ETF, which tracks the marketweighted performance of the largest institutional leveraged loans, was at 20.78 on Thursday, also a twoyear low.p

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

“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 OToole, managing director at Deutsche Bank said in a research note this week.

Barclays expects the loan index price to fall to 96 by yearend, which would lead to total returns of 23 for the rest of the year – down from a previous forecast of 34.p

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

Yeartodate total returns have been minus0.5 for leveraged loans, making them the best performing debt instrument this year, BofA said in a note this week. That compares with minus9.2 for highyield bonds and about minus10 for Treasuries.

“Weve already seen a significant reallocation of investment from highyield 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.p

Yeartodate, dedicated U.S. bank loan bond funds saw inflows of around 25.58 billion, while U.S. highyield bond funds saw outflows of 25.87 billion so far this year, according to fund flow data from EPFR.

“Leveraged loans remained the best fixedincome performer yeartodate, benefitting from low rate duration and relatively wellbehaved credit spread performance, but could weaken,” BofA strategists said.

For Morgan Stanleys Sveen, loan declines are generally expected to be much smaller than in other asset classes, with loans likely to move down 1 when equities, for example, move down 10 and highyield bonds down 3.

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

Reporting by Davide Barbuscia editing by Megan Davies and Sam Holmes

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