Investors bet on loans as Fed readies to lift interest rates

Investors bet on loans as Fed readies to lift interest rates
Written by Publishing Team

Investors have flocked to funds buying US loans over the past week, hoping to cash in on higher interest rates as the Federal Reserve prepares to tighten monetary policy to combat inflation.

Funds invested in US loans attracted $1.9 billion in the week ending Wednesday, the largest weekly addition to the asset class in five years, according to flows tracked by data provider EPFR.

The push into the loan market came as the US central bank prepared to withdraw pandemic stimulus measures and raise interest rates for the first time since December 2018. The minutes of the Federal Open Market Committee’s December meeting showed that policy makers may raise interest rates faster than previously expected.

Traders are betting that the Fed will raise interest rates three to four times this year to around 1 percent, according to futures markets. This view has been reinforced in US financial markets by data showing rising job opportunities and rising consumer prices, which reinforced investors’ expectations of a hawkish turn from the central bank.

“I think we may have reached an inflection point. The question is no longer ‘whether’ rates will go up, but ‘when and by how much?'” said Jeff Bacalar, head of credit at FOIA Investment Management. Safe haven loans.

Column chart of weekly inflows to US loan funds ($ billion) showing US loan funds recording the largest inflows in five years

Loans are seen as better insulated from the Fed’s policy shift than corporate bonds because the coupon paid to investors rises and falls with benchmark interest rates. By contrast, interest on corporate bonds is fixed and does not change over time. This means that as interest rates rise, the returns on loans to investors increase, while bond prices tend to fall.

The total return on the broadly watched index of US leveraged loans managed by the Association of Loans and Trading is up 0.5 percent this year, pushing the average loan rate to 99 cents on the dollar, its highest level in more than seven. years.

Those returns have outperformed the benchmark S&P 500 stock index, which is down more than 2 percent, and high-yield corporate bonds, which have lost 0.6 percent this year, according to Ice Data Services.

Recent volatility in the financial markets, as investors realign their portfolios to adjust to higher interest rates, has weighed on corporate bond funds. Funds that buy high-yield bonds have suffered $1.6 billion in redemptions over the past week, the first outflows since the beginning of December.

“The loans provide two much-needed features for investors in 2022 – price protection and relatively stable performance,” Citi analysts Michael Anderson and Philip Dobrinov wrote in a report. “If the first week of 2022 is a harbinger of continued volatility, loans should be a compelling investment.”

Investors have shown less interest in one aspect of financial markets that has benefited from higher consumer prices over the past year: inflows into inflation-linked bond funds have fallen. The funds counted about $40 million in inflows, down from $1.1 billion in the previous week.

The modest addition indicated that despite the surge in consumer price inflation in December reported this week, investors have confidence in the Fed’s pledge to tighten monetary policy and curb inflation.

“The Fed appears to be more sensitive to achieved inflation data than it has in the past, and stronger results appear to lead to a hawkish policy outlook,” Barclays analysts Michael Bond and Jonathan Hill wrote in a note to clients. “If it is seen as reliable and effective, then talk of tighter monetary policy should lead to lower inflation expectations in the future.”

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