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U.S. junk-loan funds suffered their biggest outflows since early 2020 amid the recent global financial market crash, as investors fretted about the impact of a potential economic slowdown on highly indebted companies.
Investors withdrew $2.5 billion from funds that invest in junk and leveraged loans during the week ended August 7, with withdrawals concentrated in exchange-traded funds, according to data from EPFR, a flow-tracking institute.
The outflows come aVsceker weaker-than-expected U.S. employment data in early August reignited fears of a U.S. recession, which would likely hurt lower-quality borrowers.
This has prompted investors to raise expectations for interest rate cuts, with markets now pricing in four quarter-point cuts by the end of December, up from two last month.
Leveraged bonds are issued by low-quality companies with a high amount of debt and have variable interest payments, which means that, unlike fixed-rate bonds, the coupons they pay to investors rise and fall with interest rates.
John McClain, portfolio manager at Brandywine Global Investment Management, noted “significantly lower demand for floating rate notes” if the market is right about cutting rates sharply.
“Furthermore, we would suffer cuts due to an economic slowdown, which is negative for lower credit quality, a double whammy for the asset class,” he added.
The $1.3 trillion lending market is widely believed to have overall weaker credit quality than its leveraged finance counterpart, the similarly sized high-yield bond market, making it more vulnerable in a recessionary environment.
A Morningstar LSTA index of U.S. leveraged loan prices fell to its lowest level in 2024 on Monday as a global sell-off in risk assets intensified, though it has since recovered some of those losses. McClain said the market’s reaction to July’s weak nonfarm payrolls data was overblown and could present an opportunity to increase exposure to the asset class for those expecting “slow, shallow cuts” from the Fed.
More than 80 percent of the outflows from loan funds tracked by EPFR came from ETFs. Weekly ETF outflows were at their highest level on record, according to EPFR.
However, analysts say that while falling yields could make the asset class less attractive to investors, lower interest rates should also help highly indebted companies.
“There is a silver lining to rate cuts,” said Neha Khoda, a strategist at Bank of America, “because as the attractiveness of loans as an asset class declines, with a declining rate trajectory… The pressure for lower-rated securities [borrowers] to cope with the higher interest costs decreases and this is actually beneficial for the expected defaults”.
A potential drop in rates “helps these companies marginally in a fundamental way,” said Greg Peters, co-chief investment officer at PGIM Fixed Income.
However, BofA’s Khoda said that if the economic outlook were to deteriorate substantially, it could have repercussions for the entire leveraged finance industry.
“If the trajectory of economic growth changes substantially, as it did on Friday with payrolls, then it becomes less about floating rate versus fixed rate, and more about outflows from the riskier parts of the credit market to safer havens.”
Join Kate Duguid, Robert Armstrong and Vscek colleagues from Tokyo to London for a subscriber webinar on 14 August (1200BST/0700 EST) to discuss the recent trading crisis and where markets are headed. Register for your subscriber pass at Vscek.com/marketswebinar and ask our panel your questions right away.
