Leveraged loan holdings at US ETFs and mutual funds fell for a sixth straight month in October. Helped by rebounding prices in the secondary market, the pace of the decline in asset values last month did ease to $3.65 billion, from a $10.62 billion drop in September.
An important note on the underlying fund flow data used to calculate the value of assets under management: Starting September 2022, all figures are based off Morningstar Direct Asset Flows. Previously, LCD calculated AUM readings using data provided by Lipper FMI, and certain funds reporting publicly. The pricing component of the AUM calculation is unchanged. The full history has been restated. Please contact [email protected] with any questions.
In aggregate, the value of holdings at US leveraged loan funds is down by $35.18 billion since May’s global market selloff brought about a shift in sentiment toward floating-rate loans, according to Morningstar fund flow data and LCD.
This puts the total net asset value under management at US leveraged loan funds at $121.62 billion, the lowest holdings for retail investors since August 2021.
Looking at the price equation of the AUM valuation, the weighted average bid of the Morningstar LSTA US Leveraged Loan Index in October gained 27 bps, to 92.19, from its September closing level of 91.92.
On the demand side, despite sentiment improving, outflows persisted for leveraged loan funds. Morningstar data shows investors withdrew $4.2 billion in October, after the market in September suffered the largest exodus since March 2020, at $6.9 billion.
Among other risk assets, high-yield funds reeled in $7.9 billion last month and US equity funds attracted $18.3 billion of inflows, according to Morningstar Direct Asset Flows data.
Looking ahead, the worsening macroeconomic outlook has increased investor risk aversion in the second half of 2022. This is especially a concern for floating-rate assets where companies — in addition to margin compression from rising inflation and softening demand — also face the prospect of higher debt servicing costs in the rapidly rising rate environment.
Preston Caldwell, Morningstar’s head of US Economics, wrote in a Nov. 10 report titled “Why We Expect Inflation to Fall in 2023,” that there will be less cause for concern about inflation in 2023 and beyond.
“We forecast inflation to average 2.6% over 2022-26 as a whole (in terms of the personal consumption expenditures price index), only slightly above the Fed’s 2% target,” the report reads. Above this 2% rate, the Fed is seen as likely to initiate a contractionary monetary policy.
With that, Caldwell expects the Fed will pivot to easing monetary policy in mid-2023 as inflation falls back to its target and the need to shore up economic growth becomes a top concern. Caldwell projects a year-end 2023 federal-funds rate of 3%, compared with a 4% consensus.
More imminently, the Federal Open Market Committee will almost certainly raise its policy rate next month from a current target rate of 3.75-4%. The most recent Reuters poll of economists says the Federal Reserve will downshift to a 50 bps hike, but the economists polled say a longer period of US central bank tightening and a higher policy rate peak are the greatest risks to the current outlook.
For leveraged loans specifically, defaults are expected to pick up in 2023 as companies begin to face pressure on cash flows, further hampering retail demand in the asset class. On the institutional side for loan demand, Street analysts are predicting a slower pace of CLO creation in 2023. Morgan Stanley has issued a 2023 US CLO new-issue volume forecast of approximately $100 billion, with the industry working through an overhang of open warehouses and market conditions that have limited primary issuance and pressured spreads wider in 2022.
Although rising interest rates are “likely” to burden corporate-debt borrowers and lead to higher downgrade and default rates in the loan market, Morgan Stanley believes these events are already priced into current spreads.
On Oct. 31, the 10-year US Treasury yield was 4.10%, 255 bps higher than a year prior. Three-month Term Sofr was 4.12% at the end of October, which compares to 0.48% a year prior, while three-month Libor was at 4.46%, versus 0.14% a year prior. The average yield to maturity for loans in the Morningstar LSTA US Leveraged Loan Index jumped to 9.27% at the end of October, compared to 4.19% in October 2021.
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