At $1 Trillion, Leveraged Loans Are Closing In on Junk Bonds

(Bloomberg) -- The leveraged loan market just achieved something it hasn’t been able to do since 2008 -- moved within $100 billion of the U.S. high-yield bond market.

Fueled by demand from collateralized loan obligations and retail investors eager for protection against rising interest rates, the amount of leveraged loans outstanding has doubled since 2010 to more than $1 trillion, according to a note from Bank of America Merrill Lynch that cites S&P Global Market Intelligence data. There’s around $1.1 trillion parked in high-yield bonds, which have increased by less than a quarter in the same period.

“While the syndicated loan market has been around since the turn of the century, its popularity has seen an unparalleled surge in this credit cycle,” BAML strategists Neha Khoda and Oleg Melentyev wrote in the note.

That’s due to a number of factors, according to the strategists, including the fact that mom-and-pop investors entered the market in droves. From near zero in 2010, the proportion of loans held by retail products climbed to a peak of 25 percent in 2013, they wrote. It’s currently at about 15 percent.

With the exception of last month, loans have been outperforming junk bonds this year. They’ve returned 1.9 percent since January, compared with a 0.3 percent loss for high-yield credit. As the contracts pay floating rates, they’re seen by many as a better bet when monetary conditions are tightening.

Fund flows data shows investors plowed $6.4 billion into U.S. leveraged loan funds through the first four months of the year. Meanwhile, they pulled money out of high-yield bonds over the same period, according to an April 27 report from BAML.

Loans are also safer than junk bonds, at least in theory, with lenders getting repaid before creditors when firms get into trouble. Though because they’re contracts rather than securities, leveraged loans trail junk bonds in several measures of investor-friendliness, with slower settlement times and more opaque pricing compared with high-yield debt.

Alarms are also sounding about deteriorating investor protections in the legal covenants between lenders and borrowers. Moody’s Investors Service last month described the risks as “tremendous.”

“We think that compromising on covenants is a natural outcome of where we are in the credit cycle,” the BAML strategists wrote. “It does pose a threat for recoveries when the next default cycle arrives.”

©2018 Bloomberg L.P.

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