Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Investors are falling back in love with the U.S. leveraged-loan market.

In the first three weeks of 2017, investors plowed $2.5 billion into loans to speculative-grade companies, accounting for almost 2 percent of total assets managed by these funds, according to Bank of America Merrill Lynch data. Investors are looking to take advantage of the fact that these loans pay higher rates as benchmark yields rise, as opposed to bonds, which are generally pegged to fixed yields.

But those who are piling into broad-market, passive loan funds may have already forgotten recent history, which shows that this debt tends to do worse when it's this popular. 

Here's the rub: The more money comes in, the more companies gain power over their lenders. As prices on their loans rise above 100 cents on the dollar, borrowers can simply go back to investors and demand to pay a lower rate. 

Lofty Zones
Leveraged-loan prices have surged to levels that allow borrowers to renegotiate terms
Source: The S&P/LSTA U.S. Leveraged Loan 100 Index

Indeed, about 73 percent of the JPMorgan Leveraged Loan Index is now trading over par, according to a Bloomberg News article by Krista Giovacco on Wednesday. In response, companies are repricing their debt at a torrid pace, setting a record in January and accounting for more than half of the month's loan sales. 

The weight of these repricings "is putting pressure on spreads, which have been squeezed to levels not seen since 2008," according to Giovacco's article. 

This is reminiscent of what happened in 2013. Investors piled into these same loans in response to the prospect of the Federal Reserve slowing its pace of bond purchases, a move that was ostensibly going to lead to higher benchmark yields. 

At the time, Treasury yields rose for a few months but then quickly fell back down in the face of slow economic growth. The reversal prompted significant withdrawals from high-yield loan funds, exacerbating losses on the debt. 

The latest round of demand for loans started last year, when U.S. Libor, which serves as a benchmark for leveraged loans, started rising in response to a regulatory change to money markets. The interest has continued in the wake of the U.S. election in November, which prompted many asset managers to boost their expectations for a broader set of benchmark yields.

Libor Lift
Leveraged loans became more attractive to investors as their benchmark rate, Libor, rose
Source: ICE Benchmark Administration

Every week, another flood of cash comes into leveraged-loan funds as illustrated by the biggest exchange-traded fund that invests in the debt, Invesco's $8.6 billion PowerShares Senior Loan Portfolio.

Big Money
The largest leveraged-loan ETF has been a magnet for cash in recent months
Source: Bloomberg

But here's the thing: That ETF has been flat so far in 2017, compared with a gain of about 1 percent for the biggest junk-rated corporate bond ETF. And it's easy to see how the debt could continue underperforming given borrowers' penchant for repricing their loans. 

Relative Returns
While a junk-loan ETF outperformed heading into the end of last year, it has lagged behind in 2017
Source: Bloomberg

It's understandable why investors find leveraged loans appealing. The economy appears healthy. These companies have historically low default rates. But there are some real risks. Even putting aside the possibility that the economy deteriorates in the months to come, this market faces a ceiling that makes it less appealing the more popular it becomes. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net