Investors bet on loans as Fed readies to lift interest rates

Investors rushed into funds that buy US loans over the past week, hoping to profit from higher interest rates as the Federal Reserve readies to tighten monetary policy to combat inflation.

Funds invested in US loans pulled in $1.9bn in the week to 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 prepares to withdraw pandemic stimulus measures and lift interest rates for the first time since December 2018. Minutes from the Federal Open Market Committee meeting in December showed that policymakers may raise interest rates more swiftly than had previously been expected.

Traders are betting the Fed will lift rates between three and four times this year to about 1 per cent, according to futures markets. That view in US financial markets has been reinforced by data showing rising employment and soaring consumer prices, cementing investors’ expectations of a hawkish shift from the central bank.

“I think we may have reached the inflection point. The question is no longer ‘if’ rates will go higher, but ‘how soon and by how much’,” said Jeff Bakalar, group head of leveraged credit at Voya Investment Management. “Every time this has happened, the loan market has become a safe harbour.”

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

The total return on a widely watched index of US leveraged loans run by the Loan Syndications and Trading Association is up 0.5 per cent this year, pushing the average price on the loans up to 99 cents on the dollar, its highest level in more than seven years.

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

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

“Loans provide two much-needed characteristics for investors in 2022 — rate 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 persisting volatility, loans should be a compelling investment.”

Investors have shown less interest in one corner of financial markets that has benefited from rising consumer prices over the past year: inflows into inflation-linked bond funds have dropped. The funds counted about $40m of inflows, down from $1.1bn the previous week.

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

“The Fed appears more sensitive to realised inflation prints than it has been in the past and stronger prints appear to be leading to expectations of more hawkish policy,” Barclays analysts Michael Pond and Jonathan Hill wrote in a note to clients. “If seen as credible and effective, talk of tighter monetary policy should lead to lower forward inflation expectations.”