LONDON (Reuters) - Leveraged loans are replacing high-yield corporate bonds as the most appealing credit market this year as investors seek high yields and insurance from inflation against the backdrop of an improving economic climate.
The strong comeback of such loans -- debt for companies with below-investment grade ratings -- is a dramatic turnaround for a market which was one of those at the center of the credit storm which blew up in 2007.
Funds focusing on leveraged loans have attracted $5.3 billion of inflows so far this year, four times faster than inflows of 2010 and also outpacing high yield bonds, according to Thomson Reuters Lipper data.
On Merrill Lynch Wealth Management's measure, flows into funds focusing on leveraged loans absorbed record consecutive flows of up to $1 billion per week in January.
Leveraged loans -- largely used to finance acquisitions based on borrowing -- already returned 2.1 percent this year, compared with 10.2 percent for the whole of 2010, according to JP Morgan.
Moreover, they rank senior compared with other bonds and rates are mostly floating -- meaning the price of the loans will not decline even if interest rates rise, as with fixed rate bonds.
"These are two examples why this sector is currently attracting attention -- reasonable yield in excess of cash, and positive exposure to rising interest rates," said Johan Jooste, portfolio strategist at Merrill Lynch Wealth Management.
He added loans will outperform high yielding bonds if short-term interest rates rally, which would impose capital losses on bond holders but gains to loan investors.
While default rates are low globally, leveraged loans also offer investors an additional benefit should the economy turn sour: they rank senior in the capital structure of most companies compared with traditional bonds.
"They tend to be secured instruments, as opposed to unsecured in the case of high yield bonds. This means that in the event of bankruptcy, an investor is likely to recover a greater amount than would have been the case for an unsecured bond," Jooste said.
Standard & Poor's global corporate speculative grade default rate has fallen 12 months in a row to hit 2.4 percent in January -- nearly a fifth of a November 2009 peak of 11.4 percent.
The leveraged loan market made a loss of more than 30 percent in 2008, hit by the credit crisis.
From a broader asset allocation perspective, the return of flows to it seem to be chiefly due to rising inflation and the outlook for interest rates.
Investors are fully pricing in the Federal Reserve to raise interest rates in September while the Bank of England has opened the door to a rate rise as soon as May after UK inflation hit a two-year high of 4 percent in December.
Despite efforts to reign in rising prices, China's inflation excluding food hit its strongest in at least a decade.
Corporates that are expanding their businesses also help. According to JP Morgan, the financing surplus -- the gap between cash flows and capital expenditure -- in G4 non-financial companies shrank for a third straight quarter.
This means companies, confident about the economy, will spend and expand using leveraged buyouts (LBOs) -- a factor normally negative for conventional credit instruments.
Thomson Reuters data shows volumes of leveraged loans at a global level rising 13 percent on the year to $23.1 billion, with emerging Asia -- albeit starting from a low base -- showing exponential growth. At the same time, M&A volumes have risen 69 percent to around $310 billion.
In the primary market, an 850 million euro all-senior leveraged loan backing private equity firm Apax's buyout of German clothing retailer Takko picked up strong support this week from investors.
JP Morgan said the Apax/Takko deal is the largest all-senior LBO facility in Europe since the onset of the financial crisis.
Sage Nakamura, managing director of GE Capital Markets, says the first few deals this year priced the yields 50-100 basis tighter compared with 2010.
"We had investors funneling cash into the asset class, lenders eager to deploy capital, continued improvement in the economy and a shortage of traditional leveraged loans. Against this backdrop, 2011 is expected to be another strong year for (the) leveraged loan," he said.
"While yield compression is expected to continue throughout the year, it may plateau if private equity firms start deploying hundreds of billions of dollars they've amassed for LBOs, resulting in a spike in loan volume."
Editing by Patrick Graham