Hawkish cenbanks send leveraged loans to highest since 2007

[January 20, 2022]  By Yoruk Bahceli

(Reuters) -U.S. leveraged loan prices have surged to their highest levels since 2007 as investors snap up assets that will offer compensation while central banks start hiking interest rates.

Leveraged loans are often taken out by companies with high levels of debt, usually with non-investment grade credit ratings, and are often used by private equity firms to fund their acquisitions of these companies.

Unlike bonds, they pay a floating interest rate, which rises as underlying interest rates rise, making them attractive to investors at a time when central banks embark upon rate hikes.

The U.S. Federal Reserve is expected to deliver a rate hike as soon as March to combat inflation at a 40-year high and markets are pricing in another three hikes by the end of the year.

That has heightened demand for assets that pay out as rates rise, sending the price of the S&P/LSTA Leveraged Loan Index to its highest levels since July 2007 at 99.066 at Wednesday's close, according to data from Refinitiv and S&P Global's Leveraged Commentary and Data.

"There is the expectation of rate increases, which inevitably pushes more retail money into the asset class," said Neha Khoda, credit strategist at BofA in New York.

"Given the selloff we've seen in the rates market, that's been prompting increased retail inflows into U.S. loan mutual funds."

Loan funds saw the highest inflows since 2013 at $1.84 billion for the week ending on January 12, according to Refinitiv Lipper data.

Government bond prices have tumbled and yields have surged over the last month as markets have ramped up rate hike bets.

A view of the Federal Reserve Building in Washington, September 16, 2008. REUTERS/Jim YOUNG/File Photo

Analysts also expect new leveraged loan issuance to slow slightly this year after a record year in 2021, a factor also expected to provide technical suppport to prices.

The rally in leveraged loans contrasts with U.S. high yield bonds - often sold by similar companies - which are down around 1% this year, according to BofA. High yield debt pays fixed coupons so is more vulnerable to rising rates.

Leveraged loans have outperformed junk bonds - often issued by similar borrowers - on an annual basis in only eight of the past 26 years and some of those years involved some level of Fed policy tightening, according to research firm CreditSights.

After peaking in 2007, leveraged loan prices slumped sharply at the onset of the financial crisis.

A subsequent era of low interest sent investors chasing higher yield assets in recent years, leading eventually to a surge in demand for leveraged assets and deterioration in protections known as covenants that give lenders additional control over what borrowers can and cannot do.

"The point to understand about the loan market is that it's not the same market as it was pre-GFC (global financial crisis)," Khoda said. "The documentation is worse, rating quality is worse, the issuer composition is worse."

(Reporting by Yoruk Bahceli; Editing by Saikat Chatterjee and Andrew Cawthorne)

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