Does high liquidity for leveraged loans mean strong demand?

Market Realist

Key trends in high yield bonds, Treasuries, and leveraged loans (Part 6 of 6)

(Continued from Part 5)

Steady and stable

Weekly fund flows are a great momentum indicator that can signal changes in investor sentiment. When fund flows increase, they suggest that institutions’ and individuals’ investments in the leveraged loan market have increased, which uplifts the liquidity in the market, and vice versa. Many investors prefer leveraged loans (BKLN) over high yield bonds (JNK) when interest rates are rising or expected to rise, as this asset class offers a floating interest rate. However, when interest rates decline, investors can suffer due to low returns in the leveraged loan market.

As the chart above shows, the leveraged loan market (BKLN) saw an inflow of $257 million last week, maintaining a very strong and steady pace for several months now. While this is lower than the $327 million we saw the previous week and the $574 million we saw two weeks ago, it marks the 93rd straight week of cash inflows.

The four-week trailing average dipped to $379 million from $483 million last week and $504 million two weeks ago. Year-to-date inflows totaled $6.8 billion, compared to last year’s inflows of $13.3 billion during the same period.

The S&P/LSTA U.S. Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, declined slightly, by 0.01% for the week end March 28, 2014, in conjunction with a decline in U.S. ten-year Treasury rates.

The major ETF that tracks the S&P/LSTA U.S. Leveraged Loan 100 index is the PowerShares Exchange-Traded Fund Trust II (BKLN). BKLN posted a net outflow of $7.6 million last week compared to a $43.5 million fund outflow in the previous week. Another major leveraged loan ETF is the Pyxis/iBoxx Senior Loan (SNLN). The index comprises about 100 of the most liquid tradable leveraged loans, as identified by Markit’s Loans Liquidity service. It posted a fund outflow of $0.46 million compared to the $0.45 million outflow we saw the previous week.

Both these ETFs, with top holdings in Clear Channel Communications Inc. (CCMO) and Dell International LLC (DELL), saw price appreciation last week, due to the decline in yields.

Outlook

Since interest rate sensitivity remains low in the leveraged loans space (BKLN), investors’ only fear remains credit or default risk. Because credit risk is the risk that an issuer will default on payments of interest and principal, it affects investors’ sentiments for that particular market. If one or more credit rating agencies downgrade a bond issue (or the market thinks this may happen), the price of a bond generally drops. While the downgrade doesn’t happen overnight, there are several factors that contribute to a downgrade, including a fall in the economy, in the issuer’s industry, and or in the financial or competitive standing of the issuer. However, considering that as the U.S. economy’s growth falls, credit risk lessens. Plus, leveraged loans’ 12-month default rates are at their lowest level, at 0.96%, compared to the previous month’s 1.17% default rate. So the market may continue to see a trend favoring leveraged loans over high yield bonds to negate an interest rate hike while reducing exposure to credit risk.

To learn more about investing in fixed income ETFs, see the Market Realist series Why Treasuries were strong while investment-grade bonds were muted.

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