Now loan investors are heading for the exits

As prices fall and issuers sweeten terms, loans represent the last domino to fall

Speculative-grade loans, a rare bright spot in the fixed-income world for most of the year, have hit a rough patch, posing challenges for businesses that have relied on the market.

Investors have pulled $5.4 (U.S.) billion from loan-focused mutual funds since mid-October, including $4.1 billion in the past three weeks alone, according to data from Lipper.

That’s quite the turnaround: Investors had poured nearly $12 billion into loan-focused mutual funds in the year up to mid- October, even as they withdrew more than $22 billion from high-yield bond funds, according to Lipper.

While mutual funds represent just one source of demand for loans, the recent outflows have had a big market impact, leading to sharp declines in the prices of existing loans and prompt- ing more investor-friendly terms on a shrinking supply of new loans entering the market.

To some extent, loans—often referred to on Wall Street as “leveraged loans”—are the last domino to fall in a dismal year for fixed-income investors.

Investment-grade corporate bonds have already been hurt by rising interest rates, and speculative-grade corporate bonds have proved nearly as sensitive as stocks to swings in market sentiment.

Loans held up for longer partly because, unlike most bonds, they offer floating-rate coupons that are more attractive at times when the Federal Reserve is raising rates. Loans also sit atop corporate capital structures, typically leading to lower losses in bankruptcy proceedings.

But loans aren’t impervious to much of the gloom weighing on markets. Should U.S. economic growth slow considerably next year, as more investors fear, it could lead to more defaults by businesses and a slower pace of rate increases by the Fed.

“Loan markets see demand in rising rate environments” and become less appealing when investors don’t think rates are going up, said Frank Ossino, senior portfolio manager at Newfleet Asset Management.

The recent downturn in loan prices is already contributing to a slowdown in borrowing, causing businesses to postpone fundraising deals or pay investors higher rates.

Continued weakness in speculative-grade debt markets could eventually drag on the U.S. economy by making it harder for businesses with low credit ratings to fund investments or refinance coming bond and loan maturities. Loan sales last month dropped to $21 billion, while there was just $5.1 of high-yield bond issuance—the lowest combined volume of speculative grade debt supply since February 2016, according to LCD, a unit of S&P Global Market Intelligence.

In October, loan issuance was a robust $51 billion, according to LCD, although high-yield bond sales had already dropped to just below $10 billion.

Most businesses still have access to the loan market. But that access is coming at a price.

Cleveland-based auto parts distributor Dealer Tire last week sold a $975 million loan backing its acquisition by private-equity firm Bain Capital at a 9.4% yield. That was well above its initial proposal of around 7.2% to 7.5%, according to LCD. Neither Dealer Tire nor Bain responded to a request for comment.

Some recent loans have also been tweaked during the marketing stage to give investors stronger protections, such as lower limits on future debt issuance or dividend payments by borrowers. That is a shift from a long-term deterioration of protections that had raised concerns that recovery rates on loans that default during the next economic downturn could be lower than the historical average.

Overall, a total of 26 new loans were sold last month at yields that exceeded initial guidance, versus just nine loans that were sold at lower yields, according to LevFin Insights.

Recent downturn in loan prices is already contributing to a slowdown in borrowing, causing businesses to postpone fundraising deals or pay investors higher rates