Leveraged Loans

Amid investor retreat from risk, leveraged loan fund assets shrink to 21-month low

March 23, 2023

Assets under management at US loan funds declined in February as market sentiment soured and investor outflows intensified.

Data from Morningstar Fund Flows and LCD show loan fund coffers declined by $2.52 billion, putting an end to a brief reprieve from negative readings. Since May 2022, loan fund assets have fallen by nearly $44 billion.

The value of AUM now stands at $112.9 billion, the lowest since May 2021.

Once again, retail investors were the driving force behind the decline in AUM, withdrawing $2.6 billion from loan mutual and ETF funds, per weekly reporters to Morningstar fund flows. The price component of asset values did little to prop AUM holdings, ending the month nearly unchanged. The weighted average bid of the index rose nearly half a point, to 94.71, from the beginning of the month to Feb. 9, before reversing course. By month-end the average bid had fallen to 94.15, down roughly seven basis points from where it started February.

In the flight to safety, high-yield bonds suffered their worst outflows since January 2022, according to Morningstar US fund flows. US equity funds, meanwhile, suffered a $25 billion outflow in February.

As investors sought a safe haven in favor of more-conservative options, intermediate-term core bond funds (which invest primarily in investment-grade US fixed-income issues including government, corporate, and securitized debt) were the outperformers, according to Morningstar data, reeling in $17 billion during the month.

Following the flows
Looking ahead, retail outflows from leveraged loans appear poised to continue, if not accelerate.

For one, the banking turmoil of recent weeks has served to remind that markets can change quickly, bringing with it tightening financial conditions and soaring borrowing costs — particularly in risk assets.

As Newfleet’s Bank Loan Sector Head Frank Ossino writes in a March 17 report, these events may be the catalyst to accelerate the cycle and push the US into recession. “While the loan maturity wall in the next two years is negligible, the inability to raise capital/funding for refinancing debt maturities, growth CapEx, M&A, or other corporate finance activity, could slow growth further and negatively impact risk assets." Ossino adds that the investment firm has already de-risked portfolios since November 2021, cutting loan exposure in half in the multi-sector portfolios and positioning with an up-in-quality bias in the dedicated loan strategies.

Amid the banking mayhem, outflows from US loan funds, at $1.64 billion for the week ended March 15, were the largest since the week ended Sept. 28, 2022.

Meanwhile, an increase in underlying Treasury rate yields from Fed rate hikes would increase interest payments for companies with floating-rate loans, making debt servicing costs, and fresh funding, more costly.

On the flip side, LCD data shows that a falling yield environment has not always boded well for floating-rate loans either. Indeed, expectations of the Federal Reserve cutting interest rates historically have prompted some of the biggest withdrawals from floating-rate loans. Save for the pandemic exit of March 2020, and the GFC-driven drop in AUM from December 2007 to December 2008, the next biggest AUM decline on file is a loss of $18.6 billion in December 2018, which was prompted by the Fed signaling rate-cut expectations for what would become the start of a sustained and significant decline in US Treasury yields.

As of March 17, the 10-year US Treasury yield had declined nearly 51 bps from where it stood at the end February, to 3.39%, as investors piled into haven assets.

The average yield to maturity for loans in the Morningstar LSTA US Leveraged Loan Index jumped back above 10% for the first time since mid-January, to 10.45% on March 17, from 9.98% at the end of February.

For context, on March 17, 2022, the average yield to maturity was just 4.82%.

Another factor in the market is a potential slowdown in CLOs, which could dampen the demand for (and supply of) new loans.

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