U.S. Junk Loan Funds Hit by Largest Outflows Since 2020 Amid Recession Fears

U.S. junk loan funds recorded their largest outflows since early 2020, with $2.5 billion withdrawn in the week leading up to August 7. Investor concerns about a potential recession and its impact on highly indebted companies drove the sell-off, particularly in exchange-traded funds.

Investors Pull $2.5 Billion from U.S. Junk Loan Funds Amid Recession Fears and Rate Cut Expectations

U.S. junk loan funds experienced their most significant outflows since early 2020 during the recent global financial market downturn, as investors grew increasingly concerned about the potential impact of an economic slowdown on highly indebted companies.

According to data from flow tracker EPFR (via Financial Times), investors withdrew $2.5 billion from funds that invest in junk, or leveraged, loans during the week leading up to August 7, with most withdrawals concentrated in exchange-traded funds (ETFs).

These outflows followed weaker-than-expected U.S. jobs data at the beginning of August, which reignited fears of a U.S. recession—an event likely to adversely affect lower-quality borrowers. As a result, investors increased their expectations of interest rate cuts, with markets now pricing in four quarter-point reductions by the end of December, compared to two expected the previous month.

Leveraged loans, issued by low-grade companies with substantial debt burdens, have floating interest payments. Unlike fixed-rate bonds, the coupons paid to investors fluctuate with interest rates. John McClain, a portfolio manager at Brandywine Global Investment Management, noted that there would be "meaningfully lower demand for floating-rate securities" if the market's predictions of significant rate cuts proved accurate.

Leveraged Loan Market Faces Double Threat as Economic Slowdown and Record ETF Outflows Shake Confidence

McClain also pointed out that such cuts would likely result from an economic slowdown, which is detrimental to lower credit quality—a "double-whammy" for the asset class, in his view.

The $1.3 trillion loan market is widely regarded as having poorer credit quality than its counterpart in the leveraged finance world—the similarly sized high-yield bond market—making it more susceptible to a recessionary scenario. A Morningstar LSTA index of U.S. leveraged loan prices fell to its lowest level of 2024 on August 5 as the global sell-off in risky assets intensified, although some losses have since been recouped. McClain suggested that the market's reaction to July’s weak non-farm payrolls data was exaggerated and could present an opportunity to increase exposure to the asset class for those who anticipate “slow and shallow cuts” by the Federal Reserve.

EPFR data revealed a staggering fact: over 80 percent of the loan fund outflows were from ETFs, marking the highest weekly ETF outflows on record. This unprecedented event underscores the severity of the situation and the heightened concern among investors.

Despite the potential for falling yields to diminish the appeal of the asset class to investors, analysts noted that lower interest rates could be a boon for heavily indebted companies. “There is a silver lining to rate cuts,” said Neha Khoda, a strategist at Bank of America, “because while the appeal of loans as an asset class decreases with a declining rate trajectory, the pressure on lower-rated borrowers to meet higher interest costs also decreases, which could reduce projected defaults.” This balanced view provides a comprehensive understanding of the situation.

Greg Peters, co-chief investment officer of PGIM Fixed Income, agreed that a potential rate drop might "on the margin help these companies out fundamentally." However, Khoda cautioned that if the economic outlook deteriorates significantly, it could profoundly impact the entire leveraged finance industry. “If the trajectory of economic growth changes materially—as it did on payrolls Friday—then it’s not a question of floating to fixed; it becomes a question of outflows from riskier parts of the credit market into safer havens.”This warning highlights the potential risks and keeps the reader informed.