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Why leveraged loan flows staying strong provides price support

US Leveraged Capital Market Flows 2013-07-01Enlarge GraphAnother week, another billion-plus in the funds door

We’ve seen once again that fund flows reflect how investors feel about an asset class. Over the past month, leveraged loan prices have been extremely resilient in relation to high yield bond prices. While unscathed, leveraged loans have dropped a fraction of what high yield bonds have dropped.

Fund flows show how much money investors put into or remove from mutual funds focused on an asset class. High yield funds have seen almost $10 billion in outflows year-to-date, while leveraged loans have seen record inflows of $27 billion after the $1.1 billion inflow last week.

Loans pay a floating interest rate that benefits from increases in interest rates—unlike bonds, which pay a fixed coupon that causes the bond price to drop when interest rates rise. This is referred to as “duration risk,” which is the rate at which the price of a bond changes inversely with changes in interest rates.

Loan prices starting to bounce

Over the past week, the LCDX20, which tracks 20 large liquid loans, was up slightly over 0.5% after some losses the prior weeks. The market fundamentals continue to favor leveraged loans since fund flows are steadily strong, and some analysts expect increasing interest rates.

Loans dropped slightly over the past two weeks despite the fact that increasing interest rates should benefit loans. A very likely reason for this drop is that several fixed-income managers were facing large redemptions from their high yield allocations, so instead of selling bonds in a dropping market, managers sold loans that remained reasonably strong to raise cash in order to fulfill the redemptions.

In the near term, once the massive outflows from high yield bonds stop, loan prices should be able to adjust upwards as investors build in the benefits of higher interest rates.